Oil Prices Are Down, But Oil Stocks Are Worse—Why?

Art by A.Richard Allen

For the past five years, energy stocks have been the S&P 500’s biggest loser, the worst performing sector during earnings season. Oddly, the price of oil, the key product that the energy firms like ExxonMobil sells, hasn’t done as badly.

The companies have suffered from tepid earnings and revenue growth since 2015, and so their stocks lagged. From the start of 2018 until now, oil industry stocks have slid 17%, as measured by the exchange-traded fund that best mirrors their S&P 500 energy listings, the Energy Select Sector SPDR.

Nevertheless, the price of oil is down just 12% over the past two years, reflected by the United States Oil Fund ETF. Certainly, the vagaries of commodities trading render oil’s price volatile, yet the general direction is clear. We used the past two years because both crude and the stocks had a brief rise in 2017, then settled back into the downward trend. Just not as bad as the stocks. The reasons for the gap is instructive about where fossil fuels, oil in particular, are headed.

There’s a sound argument that this low-lying situation for crude and oil stocks is temporary. Oil will remain central to the world’s rising energy needs for decades to come. So now, the thinking goes, is a good buying opportunity for oil stocks, as they are cheap. Carbon-based fuels, said Shawn Reynolds, a portfolio manager at Van Eck Securities, “will be around for a long time.”

Known as “black gold,” oil has been vital to modern prosperity, helping power America to its perch at the world’s largest economy and creating a lot of wealth. The same good fortune visited the petro states that came to the fore in the 1970s: Of the richest 25 nations recently, in per capita terms, five are oil producers (excluding the U.S., at No. 19). 

The richest person ever, by the assessment of the MeasuringWorth research service, was John D. Rockefeller, founder of Standard Oil, the monopoly that at one time controlled almost all of this nation’s refineries. When he died in 1937, his fortune was 1.5% of the US’s gross domestic product, three times that of Amazon’s Jeff Bezos, the current richest individual. These days, to be sure, the balance of power, in terms of market capitalization, belongs to technology, not an industrial commodity like oil.

Mismatch in the Oil Patch

Well, what explains the divergence between crude prices and oil company stocks? It all stems from the glut in oil that took hold in the middle of the last decade. The prices of crude and energy company stocks are linked, even if their correlation is skewed.

By late-2014, the world’s economic recovery had finally kicked in, and the price per barrel exceeded $100. The Organization of the Oil Exporting Countries, or OPEC, was opening the spigots to meet demand and take advantage of the high crude prices. US oil production doubled from 2008 levels, owing to huge improvements in shale fracking.

The spiraling production spawned the present glut. As prices dwindled, OPEC and other oil producers like Russia scrambled to reverse course. In 2017, they agreed on voluntary output cuts and deepened them last year, but the over-supply has persisted. That’s thanks to willy-nilly production from American frackers, a disparate bunch that isn’t under a government’s control, like many of the producers elsewhere.

Corporate stocks are different from commodities. A company has many moving parts and is more difficult to understand than a contract for a barrel of oil. Exxon, for instance, is into oil drilling and exploration, refining it, shipping it, and selling it at gas stations—going far beyond how to get the gunk out of the ground. The large integrated companies like Exxon and Chevron also traffic in natural gas, chemicals, and by-products like motor oil. Energy company operations run up a lot of costs in many areas. Similar company-commodity divides are found in some other commodity-centered industries, such as between gold miners and bullion.

For oil companies, the damage from plunging crude prices was immediate. Sales and profits sank rapidly. Exxon, the largest US oil major by revenue (and No. 5 globally), garnered $310 billion in revenue in the first three quarters of 2014, and just $192 billion in 2019’s comparable period, off by 38%. Earnings were cut in half, to $51 billion for last year through Sept. 30. (The energy giant is expected to report 2019’s fourth quarter results on Friday.)

These downbeat developments soured Wall Street on the energy sector. Since its mid-2014 peak, Exxon’s share price has skidded by a third. Since more oil drilling was out of the question, companies curtailed their capital expenditures. Lower cap ex allowed them to shrink their debt, and to return cash to shareholders via stock buybacks and fattened dividends. “While this appeased investors” to a degree, said Mike Morey, CIO of Integrity Viking Funds, “sentiment didn’t improve.”

Also hurting energy stocks is their cellar-dwelling status among S&P 500 sectors. The psychology is: If the sector looks like a loser, it’ll stay a loser, so keep away. Energy makes up just 4.5% on the index in terms of market cap. Energy may be cheap, but being a value play these days is out of fashion. “Investors essentially take on excessive risk by being overweight on energy,” Morey said.

Adding downward pressure on oil stocks is the booming movement to divest portfolios of fossil fuel exposure. As of December last year, 1,176 institutions, ranging from pension plans to philanthropies to religious organizations, representing $12 trillion in assets, had pledged to divest.  New York City’s pension program is the latest to look at dumping its energy stocks. An Oxford University study found that the divestment drive may “materially increase the uncertainty surrounding the future cash flows of fossil-fuel companies.”

In the wings is the possibility that renewables will replace carbon-based fuels. Although that day likely will come, it’s decades away, since oil and natural gas are much cheaper than the alternatives.

The Case for Carbon-Based Companies

An odd aspect of the company-commodity price mismatch is that, when crude takes a sudden plunge, energy company stocks benefit, at least momentarily. Futures for West Texas Intermediate crude (the most prevalent variety in the US) dropped 17% to start out January—a development that may portend higher stock prices.

In seven out of the nine times that WTI has slumped to start the year, energy stocks rose, for a median increase of 15.2%, according to the Bespoke Investment Group, a research house. Why would this happen? One theory is that the oil companies can take advantage of suddenly cheaper crude and sell it for more later when the commodity’s price rebounds. And canny investors reward such moxie.

The point of this fun fact is that oil and its purveyors aren’t locked in a death spiral, and that daylight lies above, albeit invisible now.

Worldwide demand is growing for oil, despite green consciousness and the Paris Accord, which most nations support (except the US) to shrink carbon use. Estimated oil demand last year reached a record high of 101.3 million barrels per day, the International Energy Agency reported. And the demand comes despite 2019’s US-China trade war, a slowing of the oil-hungry Chinese economy, and higher American interest rates—a policy the Federal Reserve reversed starting last August).

Another possible boost for oil stocks: The industry’s lower capital spending will make financial statements look better and better. “Free cash flow will increase because of the reduced cap ex,” predicted Brian Kessens, a Tortoise portfolio manager.

Improved infrastructure is also a plus. An increase in pipeline capacity is making transporting oil cheaper, Kessens noted. In the Gulf Coast region, the focus of much US refining and energy shipments, nine new pipelines are planned or under construction, all slated to be operating by next year. They can handle an extra 5 million barrels of oil daily, the US Energy Information Administration estimated.

Black Gold to Retain Its Shine

The choke hold that OPEC has over oil is gone. With the US as the largest producer, and now an exporter of oil, political disruptions in the Middle East don’t have the same punch as they did in the past. In 1973, outraged by the US’s support for Israel in the Yom Kippur War, Saudi Arabia led an OPEC embargo that threw America into a recession.

Any scare these days is temporary. When a US drone killed an Iranian general, Qassim Soleimani a few weeks ago, oil prices jumped, as if there would be a re-run of the oil embargo. The drone-driven price climb proved to be short-lived.

True, some people in the investment sphere seem to think that oil is going the way of the dodo. “Everybody’s assuming the world’s not going to use oil for the next 20 years, or five years, or next year,” Peter Lynch, the master fund manager at Fidelity Investments, marveled to Barron’s. But until the glorious age of solar and wind arrives, the world will need oil. Odds are this will increasingly dawn on energy-company skeptics.

Meanwhile, supply will surely be present to support demand. The concept of peak oil, where the world’s petroleum reserves begin to dwindle, has been oft-predicted, although the decline has sure taken its sweet time appearing. New technology has managed to detect underground and often undersea oil deposits previously sequestered from easy discovery.

Last year, Chevron, Royal Dutch Shell, and others located a large new field in what’s called the Perdido Corridor in the Gulf of Mexico. Other large finds have been made in waters off Guyana and Brazil, and in the Russian Arctic.

One thing to keep in mind: The stock market is cyclical. In the century’s first decade, oil shares did well. Stands to reason that they will again.

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