Mention the words "cheap oil" to an energy investor right now, and they will probably crawl into a corner and assume the fetal position. The fall in the price of Brent and West Texas Intermediate has dragged down the industry by more than 20% in just over six months while the S&P 500 has been able to generate a decent gain.
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It's not very often that investors in Big Oil have to panic when tough times hit the oil industry. However, oil in the $50 range is certain to take a toll on these industry giants because so much of their earnings is based on exploration and production.
If you are invested in companies like ExxonMobil or Chevron , I have some good news and some bad news for you. The bad news is that most of these companies can't do much to improve earnings, but the good news is that they all have some options to ease the pain on investors. Let's take a look at why these companies will probably take a big hit, but how they have a little wiggle room to shield their shareholders from the worst of it.
Wide right turnsIf there is one major flaw when it comes to big oil companies, it's that they are not exactly nimble organizations that can react to sharp changes in the oil and gas market. With these companies having such large production portfolios, all of them need to take on big projects and access large reservoirs in order to move the needle. These projects, such as deepwater production platforms, LNG terminals, and oil refineries and chemical manufacturing facilities, can be under construction for several years. What this means is that many of these companies' capital expenditures over the next several years are pretty much baked in. So, don't ever expect capital budgets to get slashed to close to zero.
It also means these companies' earnings and cash flow numbers will look pretty rough with oil at these prices. Having refinery and chemical manufacturing business segments will help offset some of the losses from the production side, since cheap oil means cheap feedstocks, but with all of these companies generating more than 75% of earnings from production, it will be hard to make that up.
Juicing shareholder returnsEven though earnings may look dismal under these market conditions, there is a non-operational option these companies can take to help ease the burden on investors: buy back shares. The idea of buybacks is simple. When a company buys back shares and reduces the overall share count, the share of net earnings and free cash flow for each share will be greater.
Not only does this improve earnings per share numbers, but it also frees up a little extra cash that would have gone to paying dividends on those shares, therefore a company can increase their dividend payments faster. This is part of the reason a company like ExxonMobil can continue to increase its dividend per share even when total earnings have been fluctuating for the past 4-5 years.
Source: Exxonmobil Investor Presentation.
For share buybacks to be really effective, the market conditions need to be just right. Fortunately for most of these companies, those conditions exist today.
- Shares are (modestly) cheap: Of course, the most opportune time to buy back shares is when they are trading at a discount -- more shares bought at the same price. Since these companies are the stalwarts of the industry with strong balance sheets, they never really ever go on sale. However, almost all of them are trading at levels close to or below their 10-year median valuations.
- Flush with excess cash: Running the day-to-day operations of these companies takes tens of millions of dollars, so they all have to keep a pretty big war chest lying around to pay the bills. Today, though, there is more than enough cash lying around, as noted by the current ratios of these companies (current ratio more than 1.0 means extra cash left over after current liabilities are paid).
- Low debt leverage: I know what you're thinking. For you or I to take on debt to buy company shares sounds clinically insane. For a company like ExxonMobil, which has a better investment grade than the U.S. government, though, increasing the debt load to reduce equity stake isn't the craziest idea. Since several of these companies have very low debt-to-capital and debt leverage ratios -- net debt/EBITDA -- it might actually make sense to buy back shares on credit.
What a Fool believesIt's pretty obvious that earnings for these big oil players will suffer as long as oil prices remain low, so investors in these companies shouldn't expect much in terms of operational excellence until we see oil prices recover. That being said, almost all of the big five in Big Oil either have enough cash lying around or a debt level that could support a massive share buyback program that could help juice returns for shareholders during the down times -- except for maybe BP, because of, you know, that whole Gulf oil spill thing. As earnings for all of these companies roll around, look to see if management makes any comments about plans to buy back shares by the truckload. It's hard to imagine a better time to do it.
The article Oil Stocks: Is There Anything Big Oil Can Do to Protect Shareholders From Cheap Oil? originally appeared on Fool.com.
Tyler Crowe has no position in any stocks mentioned. The Motley Fool recommends Chevron and Total (ADR). 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.
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