The Ukraine-Russian war broke out on Feb 24, and it has been ongoing for more than 200 days (207 days to be exact as of this writing). Since the war broke out, both crude oil and natural gas prices have not only increased substantially but also gyrated widely and therefore creating immense uncertainties for energy investors. Sadly, according to Lindy's Law, the longer a war has dragged on, the larger its chance of dragging on longer. After going on for 200 days, the war's chance of going on for another 200 days actually INCREASED, not decreased. And therefore, I anticipate such large gyrations to continue, and energy investors should be prepared by understanding how different energy stocks respond to large natural gas and oil price oscillations.
The war significantly disrupted the global energy supply as Russian crude oil represents about 6% of the total global market before the war. Particularly in Europe, it provides nearly 40% of the EU's natural gas needs and more than 25% of its oil needs. To wit, the supply-demand imbalance has caused oil prices to rocket from $52.2 per barrel at the beginning of the year to a peak level of $130.5 in March shortly after the war broke out (see top panel below), exceeding the $130 mark for the first time since 2008. Then it fell to about $85.3 as of this writing, a whopping 35% decline off the peak. Natural gas prices have fluctuated even more. it surged from $2.7 at the beginning of the year to a peak level of $9.68 in August (see bottom panel below), again, the highest price unseen since 2008. Then it fell to about $7.87 as of this writing, a 19% decline off the peak. Despite the sizable drop, natural gas prices are still up 191% YTD.
Against this backdrop, this article analyzes several major energy stocks. Readers familiar with our writing know that we are in general bullish about the whole energy sector under current conditions. And we have written extensively on many of them individually.
In this article, we will take a different approach and provide a more comprehensive overview of the entire energy sector. We will examine the impacts of oil and natural gas prices on several major energy stocks, and also assess their role of them as a hedge against geopolitical risks. So that investors can make an informed decision tailored to individual risk profiles and needs.
As such, this article is a bit longer (actually A LOT longer) than our usual articles that focus only on 1 or 2 stocks. Thus, here let me provide an outline to help you navigate this article in case you want to skip certain parts. The remainder of the article consists of four main sections.
As aforementioned, my view is that leading integrated players such as Exxon Mobil (XOM) are best poised to weather the uncertainties ahead and benefit if energy prices further rise. The same analysis and conclusion are applicable to other major integrated players such as CVX, SHEL, BP, and SU. And here I will just focus on XOM for the sake of brevity.
I have been bullish on XOM before the Russian/Ukraine war broke war. For example, my article published in Oct 2021 argue that XOM is a "Key Piece of The Risk Puzzle" under the market conditions at that time. The main arguments in that article are summarized below. The overall market was at an extremely expensive valuation back then. And XOM has delivered a total return of 58% compared to a loss of 10% suffered by the overall market. And I see these reasons are still valid today (probably even more so given the likelihood of the Russian/Ukraine war lasting another 200 days):
- XOM is an investment that is not only shielded from the major market risks (inflation, interest rate, and extreme market valuation) but also helps investors to fight against these risks.
- As oil prices stay well above Exxon's breakeven price (about $45 per barrel based on my analysis), XOM will generate plenty of free cash.
- And there are good reasons for oil prices to keep staying well above Exxon's breakeven prices. Oil prices have been consistently beaten inflation in the past until it stopped in the past 10 years. Crude oil price, before the surge caused the Ukraine/Russian conflict, was about $90 - the same as about 10 years ago. As a result, a rally in oil prices is overdue even if just to compensate for inflation.
Looking forward, I see the arguments laid out above are still valid. And moreover, I see a few additional catalysts on the near horizon now given the events that have transpired since the war broke out.
Oil and natural gas prices could rise from their current level substantially as winter approaches and also supply dwindles. As an example, in a recent interview with CNN, U.S. Treasury Secretary Janet Yellen said gasoline prices could surge again this winter as the European Union sharply reduces its purchases of Russian oil. European Union is expected to stop most of its purchases of Russian oil. It also imposed a ban on services that allow Russia to use oil tankers to transport crude oil. The G7 countries also reached an agreement to ban the provision of "services which enable maritime transportation of Russian-origin crude oil and petroleum products globally" above the price cap. As these measures are expected to be ready around December, international natural and oil prices are bound to fluctuate, and most likely upward in my view.
And XOM, as a major integrated player with an emphasis on production, is best poised to benefit if energy price does rise and best poised to weather the turbulent if it does not. As seen from the chart below, XOM features well-diversified streams for revenues encompassing upstream and downstream operations. It produces about 2.3 million barrels of oil per day in recent years and about 8.5 billion cubic feet of natural gas. As a result, its operating income is positively, actually strongly positively, correlated with both crude oil and also natural gas prices. As seen from the second chart below, the correlation coefficient with crude oil prices has been above 0 most of the time. The long-term average is a strong 0.484. And the peak correlation, which is what we are experiencing now, hovers around 0.91 (i.e., an almost perfect step lock correlation).
As seen from the third chart below, the correlation coefficient with natural gas prices has been equally strong (and currently even a bit stronger than oil prices). It has also been above 0 most of the time. The long-term average is a strong 0.451. And currently, correlation stands at 0.94, even stronger than the current correlation with oil prices.
To put things under perspective, the NG sales are about 19.2% of the oil sales for XOM. Therefore, the revenue from NG is a considerable segment of its production, but oil still dominates. Therefore, in terms of projected returns, as shown in the next chart, I only considered the effects of oil price changes. The current oil price of around $85 a barrel is well above its breakeven point (assumed to be around $45 per barrel). Based on XOM's current production, every $1 increase in oil price would contribute $2.3M of additional income per day for XOM at its current production rate. And on an annual basis, this translates into about $0.84B of additional income or $0.2 per share.
Therefore, with a combination of a $95 per barrel oil price and a valuation of 9.5x cash flow, a target price in the triple digits can be supported. And my view is that those numbers highlighted in red are the most likely scenario given the business fundamentals and catalysts in the near term.
Finally, before leaving this section, it is worth noting that the target price projected here would be on the conservative side in my mind for several reasons. As just mentioned, the projection considered the profits driven by oil price only. It ignored other profit drivers such as natural gas and its downstream segments.
Now let's move onto to pipelines. This section focuses on ENB. And again, the same analysis and conclusion are applicable to other major pipelines EPD and ET.
In contrast to the producers, whose operation income strongly and positively correlates with rising oil and natural gas prices, the pipelines have low or no correlation to oil and NG prices, as you can see from the two charts below. The pipeline segment is also called the midstream segment in the energy sector because they kind of serves as the middleman. Instead of producing or selling, they provide transportation and storage services for oil and natural gas products. They are like the railroad system to the energy enterprise, and hence their profit is insensitive to the prices of the goods they are transporting/storing.
You can see such insensitivity clearly from the following two charts. These charts show the correlation between ENB's operating cash flow versus oil/natural gas prices. And here you see a completely different picture compared to these we've seen with XOM above. To wit, its operating income shows little correlation with both crude oil and also natural gas prices. As seen from the first chart below, the correlation coefficient with crude oil prices has been essentially 0 on average in the long term (meaning no correlation at all). Do not be alarmed by the current positive correlation of 0.262, which is a very mild level of correlation, and also it's totally within the range of random fluctuation.
As seen from the second chart below, the correlation coefficient with natural gas prices is equally weak with a long-term average of essentially zero also. And currently, the correlation stands at 0.088, also weak and squarely within the range of random fluctuations.
Under current conditions, pipeline stocks are good choices for more conservative investors, especially with a need for current income, for several reasons.
Firstly, their insensitivity to oil and natural gas prices as just mentioned. Furthermore, their assets and operation are located in North America and shielded from the Ukraine/Russian situation. ENB has some international operations. But its operation exposure is concentrated in Canada and North America in general. It operates the world's longest crude oil and liquids pipeline system primarily located in Canada, and it owns and operates Canada's largest natural gas distribution company. Its most important service areas are Ontario, Quebec, New Brunswick, and New York State.
Secondly, their generous and safe dividend yield provides a further hedge for income-oriented and less risk-prone investors. Currently, the dividend for ENB is about 6.51%. To put things under historical perspective, the dividend yield for ENB has fluctuated in the past decade between 5.0% and 7.5% with an average of 6.32%. Therefore, its current dividend yield is quite attractive in absolute terms and also relative terms. For example, it is almost 2x higher than XOM's 3.81% current yield and slightly above its historical average of 6.32%.
Lastly, ENB (and together with other pipeline stocks) are currently valued reasonably (or even at a small discount) providing a margin of safety. As you can see from the following chart, in terms of dividend yields, ENB is yielding 6.53% currently. It is about 3% above its historical average of 6.32% (in relative terms), signaling a small 3% valuation discount. The picture for other pipelines such as EPD is similar. EPD is yielding 7.18% currently, almost exactly on par with its historical average of 7.36% (2.5% lower to be exact).
Although as aforementioned, the above positives come at a price too. The negative side is that pipeline stocks would not enjoy too much price appreciation in the case of an upward oil and natural gas price rally either. And you can see this clearly from the chart below. As seen, the large oil and NG prices rally YTD has resulted in a 57% total return for XOM and 37% for CVX. But in comparison, pipeline stocks like ENB and EPD only delivered a fraction of the total return (and a good part of the return is in the form of dividends during the same period).
Now we move on to the refineries, such as Phillips 66 (PSX) and Valero Energy Corporation (VLO). We feel that they face a mixed situation and hence we have a neutral view on them for the following considerations:
Lastly, service players, such as Schlumberger Limited (SLB) and Halliburton Company (HAL), are the higher-risk-higher-reward stocks. If the likes of XOM and CVX benefit from the first-order and second-order effects of oil and NG price rises, then the service stocks benefit from the third-order effects. Hence, they are more like a leveraged play. As you can see from the chart below, they tend to fluctuate more violently than both the integrated players and the pipelines. In terms of annual standard deviation (as highlighted in the orange box below), SLB's annualized standard deviation has been 33%, and HAL even higher at 41%, about 2x higher than XOM and ENB (both around 19%) and about 3x higher than the overall market (about 14%)
More risk-prone investors may find these service stocks appealing under current conditions. They will benefit more sensitively when the producers (such as XOM and CVX) expand on their CAPEX spendings, which is very likely to happen given the cash earned by producers and the energy shortage created by ongoing Ukraine/Russian situation. Take XOM for example. It now has plenty of cash to reinvest in future growth. It has just set annual capital spending through 2027 at $20 billion to $25 billion, a substantial boost from its already whopping $16 billion CAPEX spending this year.
Finally, there is another benefit to these stocks given their third-order response to energy prices. Due to their different responses, both in terms of magnitude and also in terms of timing, to oil and NG prices, these stocks show a relatively low correlation against other energy stocks. Therefore, they could provide an effective diversification among your energy holdings. As highlighted in the red box in the chart above, their correlation to the integrated stocks like XOM is in the 0.58 to 0.64 range, and only 0.35~0.36 to the pipelines like ENB. To put things under perspective, the entire energy sector's correlation to the overall market is on the order of 0.65. In other words, these service stocks are LESS correlated to other energy stocks than the energy stocks themselves are to the overall market.
Throughout the article, I have mentioned various risks facing each stock (geopolitical risks, sensitivity to oil and NG prices, volatility risks, et al). Besides these specific risks, here let me also point out the risks common to all energy stocks and also to my above analyses:
To conclude, the Russian/Ukraine war significantly disrupted the global energy supply. Since the war broke out, oil and natural gas prices have not only surged substantially (by 63% and 191%, respectively, YTD) but also gyrated widely. Such extreme gyrations can create enormous uncertainties for energy investors. To make things worse, such gyrations are very likely to continue. And it is the goal of this article to provide a more comprehensive overview of energy stocks so investors can be better prepared. More specifically, my thesis is that:
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This article was written by
** Disclosure: I am associated with Sensor Unlimited.
** Master of Science, 2004, Stanford University, Stanford, CA
Department of Management Science and Engineering, with concentration in quantitative investment
** PhD, 2006, Stanford University, Stanford, CA
Department of Mechanical Engineering, with concentration in advanced and renewable energy solutions
** 15 years of investment management experiences
Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.
** Diverse background and holistic approach
Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities.
I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.
Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.