Oil stocks offer investors the chance to profit from global economic growth, and that might have you wondering what oil stocks are best for your portfolio today. There are many choices, but these three companies are well positioned to benefit from the current market environment. Read on to learn why oil stocks are worth owning and what makes ExxonMobil (NYSE: XOM), Hess Corp. (NYSE: HES), and Core Labs (NYSE: CLB) particularly compelling stocks to buy.
What is oil?
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Oil is a viscous liquid that can be used as a fuel or lubricant. It exists underground in open spaces in between rock and clay and is formed over millions of years.
It's called a fossil fuel because oil is formed by the remains of plants and animals such as algae and zooplankton. As sediment builds up on top of this organic material, the organisms are subjected to heat and pressure. Initially, the materials turn into a waxy material called kerogen, but over time, they'll form into natural gas or oil, depending on the temperature, the type of organism, and the amount of pressure.
In its raw and processed form, oil and natural gas are referred to as petroleum, which is Latin for "rock oil." Once oil is extracted from the ground, it's distilled into various petroleum products, such as gasoline, diesel fuel, kerosene, and petrochemicals.
Why oil's important
Although oil products have been in use for thousands of years, the use of oil skyrocketed following the invention of the internal combustion engine in the mid-1800s. Industrial combustion engines generate energy by igniting fuel in a combustion chamber to move pistons or blades to create power, and they've become used commonly in cars, trains, planes, machinery, and ships, as well as to generate electricity worldwide.
Oil accounts for about 90% of the fuel vehicles use, and broadly, petroleum represents 40% of total energy consumption. Because oil can be refined into chemical reagents, it's also a feedstock for the production of plastics, solvents, fertilizers, and other chemical products.
The biggest oil-producing countries
According to the International Energy Agency, the United States surpassed Saudi Arabia to become the second largest oil producer behind Russia in 2017, and the United States will overtake Russia to become the world's largest producer as soon as 2019.
In 2017, U.S. oil production exceeded 10 million barrels per day (bpd) for the first time since the 1970s, and according to the U.S. Energy Information Administration, U.S. production could top 11 million bpd later this year. If so, it could be neck-and-neck with Russia, which was reportedly producing 11.06 million bpd as of June 2018.
The increase in U.S. oil production is due to technological advancements that have eased the extraction of oil from tough-to-access formations. Specifically, the use of fracking, which forces open existing fissures to extract oil by using high-pressure injections of liquid, has made accessing oil in shale formations such as the Permian Basin less expensive, which, in turn, has unleashed a flurry of drilling activity among oil and gas producers.
The oil market explained
Supply and demand dictate prices for commodities such as oil. Regulation and legislation can increase or decrease supply, depending on the circumstances, and large oil-producing countries can purposely crimp or expand supply to support higher or lower prices, too.
For instance, the Organization of the Petroleum Exporting Countries (OPEC) is a permanent, intergovernmental organization that oil producers Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela created in 1960 to coordinate oil supply to maintain price objectives. Today, OPEC's 15 member countries produce about 40% of the world's crude oil, and OPEC's oil exports account for roughly 60% of the total petroleum market.
OPEC's decisions to maintain oil supply at existing levels as U.S. shale production grew contributed to a significant decline in west Texas crude oil and Brent crude oil prices between 2014 and 2016. The price decline continued until shale production became unprofitable, resulting in a slowdown in shale output, and OPEC, in coordination with Russia, agreed to cut oil production by 1.8 million bpd in late 2016. Since OPEC's decision to restrict supply, oil prices have increased significantly.
The biggest driver of oil demand is global economic activity. As economies expand or contract, the use of oil to power vehicles and machines and to create energy increases or decreases. For example, the next chart shows the impact that declining oil demand resulting from the Great Recession had on oil prices in 2008.
Companies participating in the oil market are categorized as upstream, midstream, or downstream, or some combination of the three. Upstream companies are involved in the exploration and extraction of oil in the ground; midstream oil companies, such as pipelines, transport oil from upstream producers to downstream companies; and downstream companies refine oil into petroleum products or chemicals, or they distribute those products to consumers.
Key ratios for evaluating oil stocks
Because the oil business is costlier than other industries and oil prices can be volatile, investors shouldn't limit their evaluation of oil stocks to the commonly used price-to-sales and price-to-earnings ratios. P/S and P/E ratios shouldn't be ignored, but they should be considered alongside:
- Return on capital employed (ROCE): measures the earnings on total capital a business uses before interest and taxes. According to YCharts, it's calculated as EBIT (earnings before interest and taxes) / by total assets - total current liabilities. Note that companies can calculate ROCE slightly differently, so check each stock's annual 10K SEC filing for a definition of their calculation before making company to company comparisons. Alternatively, you can rely on a third-party site, such as YCharts, that applies the same formula to every company.
- Return on invested capital (ROIC): shows how much every dollar of invested capital is generating in net income. It's arguably more useful than return on equity, because it includes investments by lenders and it differs from return on assets because it includes investments by shareholders. It's calculated as net income / average invested capital.
- Free cash flow: shows how much cash is being generated for debt payments, dividends, acquisitions, product development, capital investments, and debt reduction. If it's increasing, the company's more likely to meet its obligations and invest in future growth. It's calculated as net income plus depreciation divided amortization + net interest x (1-tax rate) - changes in working capital - capital expenses.
- Price to cash flow: shows how much investors are paying for each dollar of free cash flow per share. Because cash flow is critical to financing obligations, including debt payments, it can help investors see how expensive shares are relative to a company's ability to keep the lights on. It's calculated as price per share / cash flow per share.
- Operating margin: shows the proportion of revenue left over after variable production costs relative to total revenue. A higher operating margin can indicate a more efficient business. It's calculated as operating income / revenue.
The big kahuna
The following table highlights the 10 biggest energy companies by market capitalization. Some of these companies operate upstream, midstream, and downstream businesses, but all of them derive the majority of their revenue from upstream operations.
|2||Royal Dutch Shell (NYSE: RDS-A)(NYSE: RDS-B)||$286 billion|
|3||Chevron (NYSE: CVX)||$223 billion|
|4||Petrochina Co. Ltd. (NYSE: PTR)||$218 billion|
|5||Total SA (NYSE: TOT)||$163 billion|
|6||BP Plc (NYSE: BP)||$143 billion|
|7||China Petroleum (NYSE: SNP)||$107 billion|
|8||Equinor ASA (NYSE: EQNR)||$89 billion|
|9||ConocoPhillips (NYSE: COP)||$84 billion|
|10||Schlumberger Ltd. (NYSE: SLB)||$84 billion|
ExxonMobil, a diversified company with upstream and downstream exposure -- is an oil Goliath. It's also one of my favorite oil stocks to buy now.
Its upstream business was sitting on proven and developed total crude oil reserves of nearly 5 billion barrels and proven undeveloped oil reserves of 3.9 billion barrels as of December 2017. Downstream, it boasts global refining capacity of 4.9 million bpd, including 1.7 million in America, and it operates nearly 21,000 retail gasoline stores under the Exxon, Esso, and Mobil brands. It's also a major producer of chemicals, including olefins, polyolefins, and aromatics.
In 2017, ExxonMobil's crude oil production was 1.67 million barrels per day (mbd), and its natural gas oil-equivalent production was 3.9 mbd. On average, its oil fetched $51.56 per barrel last year, up from $40.39 in 2016, and including its downstream operations, its total revenue was $237.2 billion in 2017, up from $200.6 billion in 2016.
Although the company's total oil production slipped slightly last year because of a 10% decline in Africa and a 1% decline in Asia, its production in the U.S. climbed to 416,000 bpd from 405,000 bpd because of projects in oil-rich shale formations, including the Permian basin in western Texas and the Bakken shale in North Dakota. Overall, ExxonMobil completed 445 net wells in the contiguous 48 states last year.
In terms of profitability, rising oil prices more than made up for the decline in production last year. Net income was $19.7 billion in 2017, up from $7.8 billion in 2016. Its upstream operations contributed $13.4 billion to earnings, its downstream business contributed $5.6 billion to earnings, and its chemicals business contributed $4.5 billion to earnings. Those results were slightly offset by $3.7 billion in corporate and financing expenses. Overall, ExxonMobil's trailing-12-month operating margin has grown from below 2% at the end of 2016 to 6% as of June 2018.
The benefit of expanding margins from oil prices that are climbing faster than expenses is also reflected in ExxonMobil's improving ROCE. As of June 2018, ExxonMobil's trailing 12-month ROCE had expanded from less than 3% exiting 2016 to nearly 8%.
The company's single-digit decline in production shouldn't be ignored, nor should its focus on profit-friendly production. Because its profit is growing faster than its revenue, and investments are under way that could restore production growth, including a 45% stake in a project offshore Guyana (more on that in a minute), I think now is a good time to make this stock part of a core portfolio, especially because its P/E ratio is the lowest in three years, its 3.7% dividend yield isn't too far from its three-year highs, and it's $13.5 billion in trailing 12-month free cash flow through June 30 gives it plenty of shareholder-friendly financial flexibility.
A big payday approaching
If you're interested in smaller companies, you might want to consider Hess because it's executing a transformation that may not be fully appreciated yet and its massive project offshore Guyana with ExxonMobil could begin contributing revenue soon.
In the past, Hess' growth was hamstrung by mature assets that provided stable production but little opportunity for upside. That's changing. Hess is selling slow-growth assets, and last year it created Hess Midstream Partners (NYSE: HESM), a master limited partnership it maintains an ownership stake in that controls Hess midstream assets in the Bakken shale.
This restructuring is already beginning to pay off. Revenue grew 27.6% to $1.6 billion in Q2 2018, because of rising realized prices per barrel, and its quarterly loss improved to $0.23 per share from a loss of $1.46 in the same quarter last year. If not for interest on its debt and costs associated with options to protect itself against a drop in oil prices, its exploration and production segment would've posted a $21 million gain last quarter.
Hess' oil and gas production averaged 247,000 barrels of oil equivalent per day (boe/d) in Q2 2018, and if you back out assets sold during the past year, its production increased 4% year over year, including a 6% increase in the profit-friendly Bakken shale, where Hess' oil production reached 114,000 boe/d last quarter.
Investments in the Bakken should continue driving production growth into next year, too, because Hess added one rig there this quarter and will add another next quarter. With six rigs expected to be operating there by the end of 2018, Hess is guiding for full-year average Bakken production of between 115,000 and 120,000 boe/d in 2018. Management expects its average production across all its assets, including the Bakken, will exceed 245,000 boe/d this year, and that includes the headwind associated with its recent decision to sell its Utica shale interests for $400 million.
The restructuring has already given the company a lot of financial flexibility, and the Utica sale gives it even more wiggle room. Through the first six months of 2018, it bought back $1 billion in shares, and it plans to spend another $500 million on share repurchases before the end of 2018. It's also bought back $500 million in debt this year.
Improving financials puts Hess in an excellent position to profit as its production expands, and production could get a big lift soon, when its Guyana project with ExxonMobil comes online.
Hess has a 30% interest in the Guyana project, and phase 1 of that project is expected to result in gross production of 120,000 bpd in 2020. By 2025, gross production is expected to reach 750,000 bpd, but it's possible that peak production is higher than that. In July 2018, Hess and ExxonMobil boosted their estimate of gross discovered recoverable resources for the Stabroek block of this project to more than 4 billion barrels of oil equivalent (boe), up from prior estimates of 3.2 billion boe.
One knock against Hess is it's losing money. Another is that its price to cash flow has rallied to new highs because investor optimism in its transformation is taking hold. Nevertheless, I think upside in Guyana and the Bakken will get this company back into the black, and if I'm right, then its financial ratios should improve significantly in the coming years.
An oil technology titan
Increasingly, oil companies are embracing technology that allows them to make better exploration and production decisions, and Core Labs is arguably benefiting most from this trend.
Core Labs' technology enables oil and gas companies to maximize well production and boost oil reserves. Its reservoir description business unit generates 60% of its sales from reservoir fluid analysis, and 80% of its revenue comes from international projects. This unit's solutions help oil companies better understand their reserve potential and the impact of development and production activity on reservoir performance.
The production enhancement business helps oil companies complete wells for complex and unconventional projects, such as in shale formations or offshore. Oil companies use Core Labs' solutions in this segment to boost margins by producing higher initial production rates, reducing downtime, and lowering all-in well completion costs.
Because Core Labs can help oil companies generate more production at lower costs, its business didn't drop as much as its oilfield services peers when oil prices fell between 2014 and 2016. Importantly, because Core Labs is an asset-light business, its operating margin is higher than those of its peers. That's particularly good for investors, given that demand is increasing following the rally in oil prices last year. In Q4 2017, Core Labs' operating margin swelled to 19% from 4% the year prior, and despite increased investments to serve its customers this year, Core Labs' operating margin was still 19% in Q2, 2018, up 1.9% from one year ago.
The production enhancement business is driving most of Core Labs' growth. Its big exposure to U.S. shale markets resulted in a 48% year-over-year surge in U.S. land sales. In turn, segment sales jumped 36% year over year to $73.4 million, operating margin improved 8.9% to 26%, and operating income soared 105% to $19 million.
The company's reservoir description business hasn't done as well, because offshore exploration and development hasn't recovered yet, but it's still handsomely profitable. In Q2 2018, its sales were $102 million, its operating margin was 15%, and its operating income was $14.8 million.
Overall, Core Labs' ROIC clocked in at an industry-leading 28% in Q2 -- and that's better than any other similarly sized oilfield services company. As a result, its trailing-12-month ROIC and ROCE have both improved significantly in the past year.
Because Core Labs' operating margin was near 30% before peak oil prices, there could be plenty of potential for even greater earnings upside, especially if offshore activity finally perks up and midstream bottlenecks that are currently hampering production growth in the Permian basin get resolved.
Key risks of investing in oil stocks
Although I think buying all three of these oil stocks in long-haul portfolios can pay off, there's no guarantee that oil prices will cooperate or that equipment and labor costs won't rise because of inflation. If oil prices sink and costs rise because of inflation, then profitability could tumble and take share prices lower. Regulations could change as well, making the oil business less attractive, and global oil suppliers could alter production in ways that hamper domestic oil stocks. In short, investing in oil stocks is risky, and that could make diversifying your portfolios energy exposure across more stocks worthwhile.
Investors interested in diversification may want to consider exchange-traded funds. ETFs pool money from many investors, and they can be bought or sold during the day like individual stocks. One of the biggest oil stock ETFs is the Energy Select Sector SPDR ETF (NYSEMKT: XLE). It doesn't own Core Labs, but ExxonMobil accounts for 23% of its assets, while Hess accounts for 1.25%. Overall, the ETF invests in 31 stocks and charges a reasonable fee of 0.13% of assets.
An eye on the future
A recession is the biggest risk to oil prices, but there's little evidence of a looming recession, even as the Federal Reserve has increased interest rates to control inflation. If rates climb too high, it could stall economic growth, so investors will want to keep an eye on the economy.
As it stands today, ExxonMobil estimates the global population will increase by 1.7 billion to 9.2 billion by 2040, and that economic growth will average about 3% annually over the period. If so, then global energy demand could increase 25%. If they're right, then revenue and earnings at oil companies should head higher, not lower, over the long haul, making now a good time to add oil stocks to portfolios.
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Todd Campbell has no position in any of the stocks mentioned. His clients may have positions in the companies mentioned. The Motley Fool has the following options: short January 2019 $285 calls on SPDR S&P 500 and long January 2019 $255 puts on SPDR S&P 500. The Motley Fool recommends Core Laboratories. The Motley Fool has a disclosure policy.