Top Stocks in Oil

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The oil business fuels our everyday lives. If you have driven a car, used anything plastic, walked on an asphalt road, or taken certain pharmaceuticals, you've used an oil-derived product. For close a century it has been the lifeblood of the global economy. While there have been numerous efforts to replace oil in its many uses, nothing has yet to unseat it, and it looks like it will likely stay that way for the foreseeable future.

A lot of people take the wrong approach to investing in oil. Too many focus on the aspects they have no control over rather than digging into the companies in which you can invest. So let's look at some of the segments within the oil industry, explore some of the traits you want from a stock within that subsector, and discuss a few top stocks for your portfolio.

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The candidates

There are a lot of subsectors within the larger world of oil and gas, each of which has its own investing merits. We could be here all day looking at companies involved in the oil and gas industry, but for now let's focus on a smaller subset: Companies where their respective businesses actually touch oil. That excludes oil services companies and rig companies. Also, the integrated majors -- aka big oil -- have a finger in just about everything related to this business and deserve their own evaluation. That leaves us with three subsectors worth considering: independent exploration and production; pipelines, processing, and logistics; and refining.

We all know that oil is a commodity, and as a commodity, it goes through cycles on a routine basis. The thing that makes oil unique from other commodities, though, is that consumers have a direct connection to it, which makes everyone much more acutely aware of changes in oil prices. This link to oil prices means that a lot of people are armchair speculators, with theories on future OPEC policy or the effect of a strong dollar on consumption. They all sound like smart or sound arguments, but the unfortunate truth is that there are hundreds of factors to consider at any given moment, and any theory is probably going to be upended by some "unknown unknown."

Investing in this industry based solely on where oil prices are going will likely generate the same kinds of returns as dumping diesel on a stack of cash and tossing a match on it. That said, this is a business where investors can make a decent return. To do so, you have to think about it a little differently. It's not just the going rate for a barrel of oil, but also what kind of return a company can make on that price of oil.

There are, of course, the things that every company needs to do to succeed -- e.g., strong balance sheets, sound capital allocation -- but there are certain industry-specific things that companies need to do well to be a viable investment, so let's look at each and why these 10 companies stand out in this regard.

The producers

Exploration and production is by far the hardest way to make money in the oil business. When selling oil you've pumped out of the ground is your only source of revenue, you're at the mercy of oil prices to make your hay. Companies can do a few things to try and insulate themselves from price swings, such as selling futures contracts for production at set prices -- much like what farmers do with their crops. However, if there is a prolonged slump in prices like we saw from 2014-2017, those contracts will get used up and leave the company exposed to low oil prices.

The most important thing for companies in the exploration and production business is their breakeven cost. This is the per-barrel cost it takes for a company to deliver a barrel of oil to market and generate enough of a return to cover expenses and capital spending to replace that extracted barrel. Granted, that per-barrel cost can be influenced by how much of a company's production is oil versus gas, but the overarching theme is the lower, the better.

Five years ago, the cost to deliver a barrel of shale oil to market and generate an OK return for an independent producer was in the $90-a-barrel range. If that were still the case today, no one in their right mind would ever consider buying oil producers because their cost structure is out of whack with the market. Since that time, though, many companies have drastically lowered the per-barrel cost at which they break even. Apache, EOG, and Encana have made budget plans that show them being free cash flow-positive with a barrel of oil at $50. That drastic reduction in cost makes these companies much more viable as potential investments today.

The thing that sets these three apart from the hundreds of other oil and gas producers is their superior balance sheets and the ability to generate decent returns on capital invested during this recent downturn. If an oil producer can produce returns throughout this tough oil price environment, then it should be in relatively good shape for the future.

The middlemen

The pipelines, processing, and logistics business is a unique beast in that it is the part of the oil and gas value chain with the least exposure to commodity prices. Most companies in this area elect to charge fixed fees for the use of pipelines or storage facilities, and typically they try to lock customers in with some form of minimum volume commitment. This ensures that their assets are used to maximum capacity and generate the most amount of revenue possible. Enterprise, Magellan, and Pembina make more than 80% of their revenue from these fixed fees. This business model means that they are considered much less volatile than other parts of the industry.

Also, the capital needs of this business segment are wildly different than other parts of the industry. Once a pipeline or storage facility is up and running, the maintenance capital requirements are minimal. The challenge is spending on new projects, which is highly capital-intensive and can require long lead times for construction. As a result, these businesses tend to have higher debt loads to cover those initial expenses but will throw off lots of operating cash flow for decades. That's why so many companies in this business pay outsized dividends, which is what makes this segment so attractive to investors.

That doesn't mean, however, that these companies are fail-safe investments in oil. Since it costs a lot of money to get new projects up and running, capital spending on growth is high. So management teams need to strike the delicate balance between spending on an adequate amount of future growth, paying a generous dividend that grows steadily over time, and not becoming overly reliant on outside capital to meet those needs. The thing that has sent so many companies in this business reeling is relying too much on debt and equity to fund future growth. When the markets aren't buying what you are selling anymore, it makes it impossible to pay the bills.

The one trait Enterprise, Magellan, and Pembina share that separates them from the rest of the industry is their propensity to fund a decent portion of their growth using retained cash from operations rather than relying on outside sources. This is why these companies have some of the better financial metrics in this industry and have been able to generate double-digit returns over the past decade.

A more refined bunch

Refining falls somewhat in the middle of these two businesses. It requires much less capital to maintain current operations than exploration and production, but certainly more than it does for pipelines, processing, and logistics. Also, the refining business relies heavily on oil prices, but its reliance on prices is much more nuanced than producers.

An oil refiner's profits rest on the difference in price between its feedstock -- crude oil -- and the price of its refined products. Most of those products are either gasoline or diesel, but it also includes jet fuel, asphalt, paraffin waxes, and lubricants. Most major refiners' output is more than 80% gasoline and diesel, so those are the ones worth following. For the most part, the price movements of crude oil and refined products are mostly out of the hands of refiners. So as an investor with a longer view, it's not worth fussing about. The two things that are important for a refiner is to run its facilities at high utilization rates as much as possible and to exploit the small inefficiencies in the oil market.

Oil refining is a business with a lot of fixed costs. It takes just about the same amount of money to operate a refinery at 60% capacity as it does to run it at 95% capacity. If a company can run its facility at high rates, it can spread those operating costs over more product produced and therefore reduce per-barrel operating costs. So companies that run their facilities at high rates tend to do better in the long run.

Exploiting the inefficiencies in the market comes down to a few things, such as geographic location and the types of crude oil a facility can process. For example, gasoline and diesel are much more expensive overseas, so refiners in the Gulf Coast region with export terminals can get higher realized prices for their product than landlocked refiners. On the feedstock side, there are lots of different types of crude oil with unique characteristics that require particular refining processes. Each kind of crude has a different price. For example, the cost of oil sands from Canada is typically several dollars less than U.S. crude because it is hard to refine. So refineries that can refine that particular crude tend to have lower feedstock costs and bigger margin as a result.

Also, there isn't a lot of growth in the refining business. Total refining capacity in the U.S. has grown at a rate of 0.5% annually for the past 30 years. That means companies in this industry need to rely on other ways to generate returns for investors. For most of these companies, that means paying generous dividends, buying back loads of shares, or a combination of both. While some people may be turned off by no growth industries, this strategy has thus far proven to be an effective one for generating a rate of return for investors.

Both Marathon and Valero benefit immensely from their size and their operations on the Gulf Coast that allow them to export considerable amounts of refined products. Marathon also has the benefit of its retail filling stations and its pipeline, processing, and logistics subsidiary MPLX. Combined, these two entities generate close to $2 billion in operating income annually. While HollyFrontier is smaller and doesn't have exports capacity, its refineries tend to draw cheaper crude oil, which gives it high margin. With their reasonable balance sheets and propensity to return capital to shareholders through dividends and buybacks, these are great stocks in the refining business.

What a Fool believes

When investors go into the oil industry with the right mindset, returns can be had. Instead of focusing on companies that will ride higher on rising oil prices, focusing on companies that will be resilient throughout the market cycle is much more likely to generate long-term returns. After all, oil is just like any other commodity and is subject to wild price swings.

Oil may not be around forever. Further development of battery technology and electric vehicles could take a big bite out of oil demand in a few decades. That said, we are still some time from the oil market being entirely upended by an alternative transportation fuel (not to mention all the other needs for petrochemicals). So investors looking at a decade or two out should still seriously consider oil stocks as a part of their portfolio.

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Tyler Crowe owns shares of Enterprise Products Partners and Magellan Midstream Partners. The Motley Fool recommends Enterprise Products Partners and Magellan Midstream Partners. The Motley Fool has a disclosure policy.