Drillers or Pipelines: Which Oil Stocks Would You Rather Own for the Next 25 Years?

By Markets Fool.com


Source: Flickr/katscool.

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The energy sector has gone through a huge amount of turmoil in recent months, as plunging oil prices have put some companies in jeopardy of suffering through a painful period of losing money. Drillers have taken the biggest immediate hit, being the most directly affected by falling prices. But some investors also worry about the prospects for pipeline companies, especially if dramatic production cuts reduce the need to transport energy products.

To look at which oil stocks might be best for long-term investors right now, we asked three Motley Fool contributors to weigh in with their arguments for respective portions of the market. Take a look and decide for yourself which course makes the most sense for you.

: For some reason, whenever investors talk about pipelines, the term "boring" always comes up because the whole business model is based around fixed fees. I really hate this label. Last time I checked, there are no bonus points for revenue that's exciting or sexy. If I wanted "sexy" earnings, I'd invest in lingerie. If I want a solid return on my investment, then I'm buying pipelines.

When it comes to generating a return, it's hard to argue that producers or integrated majors are a better proposition. Sure, pipelines may have more upfront costs, but once that pipeline is in the ground it can be a steady income stream for 20 to 30 years. Compare that with producers, which need to constantly plow capital back into the business just to maintain current production -- this also applies to integrated majors, since all of them generate more than 75% of their earnings from production. Also, pipelines aren't exposed to the risk of drilling dry holes. Instead, the smart pipeline companies only allocate capital for a new project once enough producers or refiners have signed up for long-term take or pay contracts to guarantee a certain return on that investment.

Don't believe me? Then let's look at the numbers. Both ExxonMobil and EOG Resources have some of the best returns in the integrated majors and independent producer industries, respectively. Yet when we compare these two with pipeline company Magellan Midstream Partners on a return-on-equity and return-on-asset basis, Magellan drinks ExxonMobil's and EOG's milkshake.

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MMP Return on Equity (TTM) Chart

MMP Return on Equity (TTM) data by YCharts

When you translate those return figures into total return prices -- share price appreciation plus dividends -- it becomes even clearer what the better investment is:

MMP Total Return Price Chart

MMP Total Return Price data by YCharts

So go ahead and worry that all you get from pipelines is a boring income stream, I'll take boring with superior returns any day of the week.

Dan Caplinger: The energy bust has left drilling stocks harder hit than pipeline stocks, since many exploration and production companies have seen their profitability slashed by lower oil and natural gas prices. Yet the magnitude of their drop makes drillers a more promising play right now for long-term investors seeking bargain entry points.

The reason I prefer drillers has to do with their business model compared to pipeline companies. Pipelines look a lot like utilities, with massive capital expenditures to build energy infrastructure that produces predictable but generally unexciting revenue prospects over the long run. It's true that pipeline MLPs have seen monumental growth lately, but that's because of the one-time opportunity for profits from building up new pipeline assets. Once those pipelines get built, those companies turn into income plays.

Source: Flickr/Lindsey G.

By contrast, many drillers are priced right now as though their businesses are doomed. Admittedly, some drillers have overleveraged their balance sheets to try to maximize short-term profits, and those moves will likely backfire if oil doesn't cooperate by rebounding quickly. Yet for healthier drilling companies, surviving the current drop in oil prices should eventually give way to cyclical recoveries that will send share prices back up to more typical levels. Add in regular dividends from production, and the growth potential from your typical driller looks stronger than the pipeline industry's long-term prospects.

Jason Hall: Even though it might seem like I'm taking a "Goldilocks" approach, I'm going with "neither." Actually, it's really "both," since I'd rather own an integrated major like ExxonMobil or -- a personal favorite -- Phillips 66 than a pure-play pipeline or driller for 20 years.

The reality is, the oil and gas industry is cyclical in nature and exposed to massive swings in prices with a lot of factors that can drive that volatility, including both geopolitical and macroeconomic issues. Producers tend to be the most volatile oil stocks, because of their typically large direct exposure to oil prices. Pipeline operators, on the other hand, are less exposed to commodity prices, but they have massive fixed costs and are typically geographically exposed to connecting specific areas of production to demand centers or storage facilities.

While one could say that an integrated major is exposed to all the risks but with less of the upside, the reality is, the majors are typically better prepared to weather the inevitable price collapses that can destroy producers, or high costs and limited long-term upside of pipelines.

The reality is, the integrated majors are built to stand the test of time, while pipelines and producers, frankly, are just more exposed to certain risks. Drillers are "too hot," while the pipelines are "too cold"? I guess that makes the integrated majors just right for the long term.

The article Drillers or Pipelines: Which Oil Stocks Would You Rather Own for the Next 25 Years? originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. Jason Hall owns shares of Phillips 66. Tyler Crowe owns shares of Magellan Midstream Partners. The Motley Fool recommends Magellan Midstream Partners. The Motley Fool owns shares of EOG Resources, Inc. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.