Oil Stocks: What to Watch in 2018

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It seemed like every day in 2017 was full of despair for oil investors, as morning after morning went by with oil prices stubbornly stuck around $50/barrel. Then, toward the end of the year, prices began rising, and with it, hopes for -- finally! -- an industry turnaround.

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Now, it looks like every day in 2018 is going to be a nail-biter for oil investors as they check to make sure the price of oil doesn't start heading back down again. Here's what savvy investors will want to keep an eye on in 2018 as they look into independent oil and gas drillers like ConocoPhillips (NYSE: COP), refiners like HollyFrontier (NYSE: HFC), and integrated majors like ExxonMobil (NYSE: XOM).

Producers: watch the price

No sector of the oil industry is as dependent on oil prices as E&Ps, the insider name for independent oil and gas exploration and production companies. Because they directly sell the crude oil they produce, E&P stocks tend to be the first ones affected when the price of oil changes: They drop first (and often farthest) when oil prices go down, but they also tend to rise more quickly when oil prices go up.

Take ConocoPhillips, the largest U.S. E&P. Between June 2014, when the oil price dropped, and the end of the year, Conoco's stock took a 17% hit, while ExxonMobil's lost a more modest 10%. By the time oil stocks hit rock bottom in January of 2016, Conoco's shares had lost 59% of their value, while Exxon's were down less than half that, at 28%.

However, the opposite is also true. Since crude oil stocks began steadily rising in August 2017, Conoco's stock has appreciated more than 30%, while Exxon's has gone up less than 10%. So, the thing to watch when looking at E&Ps is where the price of oil seems to be headed. If it's on the rise, or at least stabilized at current levels -- both Brent Crude and WTI crude are comfortably above $60/barrel now -- E&P stocks should do well. But if the price starts dropping, don't be surprised to see some panic selling in the market, and be prepared to snap up shares while they're cheap.

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Refiners: watch the crack spread

No, the "crack spread" isn't some weird new sandwich topping; it's what the industry calls the difference between the purchase price of crude oil and the selling price of refined petroleum, and it's how oil refiners make their money.

Low oil prices can actually be good for petroleum refiners, because if demand stays high for refined petroleum, the crack spread can get very wide indeed. In fact, that's just what happened to HollyFrontier in 2017, as a busy summer driving season followed by Hurricane Harvey-related supply disruptions pushed the crack spread for WTI Crude to above $30/barrel, up from a range of $6 to $17 in 2016. Holly took advantage by running its refineries at 102% of capacity, and its stock reaped the benefit, rising more than 50% for the year.

However, the rising price of oil is putting pressure on the crack spread, which is unlikely to match its 2017 levels in 2018. Not to mention, there's a limit to how much capacity a refiner can squeeze out of its facilities, and many refiners were operating at peak capacity in 2017. Those refiners will now be facing tough comparable year-ago quarters in 2018, so it's unlikely they'll have the banner year they had in 2017.

Integrated majors: watch everything

The integrated majors -- the largest of the oil companies -- combine exploration and production activities with refining and also selling of refined products. During the oil price downturn, those profitable refining and selling operations were subsidizing the oil majors' underperforming exploration and production activities. Some oil majors even had to resort to offering scrip dividends -- paying dividends in shares instead of in cash -- to fund their payouts.

Cost-cutting measures also helped, as most oil majors were able to push their breakeven points -- the per-barrel oil price at which they would turn a profit -- below $40/barrel. With costs still low and the price of oil now edging higher, some companies are ending their scrip dividend programs and even eyeing costlier and riskier deepwater investments.

ExxonMobil is one such oil major. With a low breakeven point and a healthy balance sheet, the company has made extensive offshore investments in Guyana that seem to be paying off. But it isn't ignoring onshore opportunities, either. In fact, Exxon recently announced it expected to triple its Permian Basin production by 2025.

The combination of higher margins thanks to rising oil prices and cost-cutting should allow many oil majors to expand their operations, pay down debt, make acquisitions, raise dividends, and generally benefit shareholders. Each individual company, though, is likely to prioritize something different. For oil majors, investors will have to keep an eye on the whole package rather than just one or two elements in isolation.

A sector to watch

Analysts are expecting good things from the oil sector in 2018 as higher oil prices combine with successful cost-cutting measures to give a boost to companies across the industry. However, there's some concerns that the stock market in general looks expensive right now, which may lead to a broader market pullback. If that happens, oil stocks could get caught up in an overall downtrend.

The best thing to do, though, is to invest in quality companies with good prospects. And keeping an eye on oil prices, crack spreads, and the overall performance of the integrated majors is a great way to figure out which parts of the oil sector will give you the best bang for your buck.

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John Bromels owns shares of HollyFrontier. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.