Navigating the Energy Sector When Oil Prices Drop

Navigating the Energy Sector When Oil Prices Drop

Oil. Black gold. It’s the lifeblood of the global economy. As essential as sunlight is to plants, so too is the world dependent upon oil to function.

Around 80% of the world’s total energy usage stems from fossil fuels like oil. As it stands today, without oil, the ability to power a city or transport goods becomes impossible.

For investors, a product like oil has built in demand which helps to prop up prices making it the most heavily traded commodity in the market. Take a look at Exxon Mobile’s (XOM) chart over the past 10 years to get a sense of how valuable oil really is. Its price more than doubled over that time, providing investors with plenty of profits over the years. Figure in its dividend yield and an investor would’ve made over 2 ½ times their original investment.

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As such, the energy sector has been dominated by oil companies and offshore drillers. Other energy plays like solar, coal, and nuclear have had periods of dominance, but none have oil’s longevity. The reason is simple – the cost per kilowatt hour. In other words, it all comes down to the cost of generating electricity.

At $100 a barrel, the cost of oil per kilowatt hour is roughly $0.06 while solar is about $0.38. However, government subsidies and regulation has brought alternative energy sources like solar closer in alignment with oil. Even still, solar is priced between $0.12 and $0.30 per kilowatt hour making it inferior from a cost-efficiency perspective to oil.

Rising oil prices and a continued reduction in cost to generate electricity from alternative sources has led to a revolution in green energy nevertheless. Take a look at First Solar’s chart in comparison to Exxon Mobile’s.

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Despite far more volatility, an investor who bought in 2007 would be up nearly triple today. That’s more than they would’ve made in Exxon despite First Solar’s lack of dividends. Green energy has done quite well over the past few years, helped in part by high oil prices.

Recently however, oil has begun a trek downward.

Oil Today

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As a traded commodity, oil is finicky. OPEC (Organization of the Petroleum Exporting Countries) governs the majority of the world’s oil production and supply and can directly impact oil prices by choosing to release or restrict the flow of oil. Interestingly enough, 2 of the 3 top oil producing countries in the world, The U.S. and Russia, are not members of OPEC.

Because of the governing authority over oil, the price is not dictated by pure economic supply and demand, but rather how much supply is actually released by the organization. Despite their best efforts to keep prices high, oil production is now well above usability.

Softer Chinese demand and higher oil storage supplies have taken oil below $100 for the first time in 16 months. Geopolitical concerns around Russia and Islamic extremists have done little to lift the price since supply is so abundant. Combined with a rising U.S. dollar, oil prices could fall as low as $70 a barrel and stay well under $100 for an extended period of time.

U.S. oil production expectations have been raised as well. Shale oil drilling has raised production estimates by 250,000 barrels for 2015 and the U.S. Energy Information Administration projects worldwide oil energy usage to increase 38% by 2040. Domestically, the revamped production will help reduce import costs by 21% – a level not seen since 1968.

The price of oil is often looked at as a gauge of economic growth. Higher costs point to higher growth expectations and tends to serve as a sort of leading business cycle indicator. Lower cost energy though generally means a slowdown as the global economy weakens and future demand lessens. The impact of lower oil on the marketplace could be the end of the 5-year bull run.

Meanwhile, investors are left scratching their heads trying to figure out the next play in the energy market. Green energy had been gaining momentum along with shale oil when prices were high, but an oil oversupply could have an impact across other industries.

Cheaper Oil’s Impact on the Energy Sector

The transportation sector is heavily tied to the price of oil. From commercial trucking to airlines to cargo ships, the price of oil makes or breaks these industries. Without this sector, goods are unable to be distributed and growth stagnates.

One of the biggest expenses these companies have is fuel.  Margins tend to be very slim; trucking companies average a profit margin of under 6%. When the price of oil drops, these companies have more cash on hand and report higher revenues.

In the energy sector, persistently depressed oil prices can have a big impact.

Green energy companies will see a hit due to its relatively higher cost per kilowatt compared to suddenly cheaper oil. While subsidies and new technology continue to bring costs down, the sector is still a decade away from being a viable alternative cost contender.

The effects of lower oil will serve to bring down the majority of energy stocks across the board. Nuclear, coal, natural gas, solar, and all other types of energy companies will find themselves in a difficult competitive position. Some companies may not survive a prolonged period of stagnate oil while others may get bought out by competitors.

Even oil drillers will have a hard time finding worthwhile investment projects when the price per barrel drops below a certain point. Offshore drilling costs average between $70 and $80 a barrel making them huge money pits when oil dips below those levels. Extraction costs in the industry are high and without higher oil prices to support financing these projects, these companies will do their best to close up facilities, seek out tax deductions, and look for cost reduction initiatives in order to hit earnings expectations.

Energy Companies That Will Benefit

The only energy companies that will actually profit will be those that aren’t tied to energy extraction costs. Companies engaged in the processing, refining, and distribution of petroleum products should do quite well in an environment where oil prices are low.

Refiners operate by taking advantage of the spread between the cost to purchase oil and the revenue generated after refining it. Refining costs are relatively stable, but the input cost of oil can change. When the price drops, margins expand, giving refiners plenty of room to negotiate higher prices and drive up revenues.

Oil refiners aren’t known for rapid growth, but rather for their stable business models and reliable income streams. There is a very high barrier to entry into the refining business due to large start-up costs.  This results in the industry being controlled by a small handful of large companies.

Here are 3 stocks that should do well when oil is cheap:

  • PowerShares Energy Exploration & Production Portfolio (PXE)

This ETF’s name is somewhat misleading considering that 3 of the biggest refiners, Phillips 66 (PSX), Marathon Petroleum (MPC), and Valero (VLO) account for 15% of the fund’s total portfolio weight. While there currently isn’t a pure-play oil refinery ETF, refinery stocks make up more than a quarter of the fund’s total investments.  Thus making it one of the best options for investors, who want energy exposure when oil prices drop.

PXE is up 4.5% year-to-date but could be looking at a sustained rally in the near-term future as oil prices continue to decline. If oil drops toward $70 a barrel, this ETF could rise as high as $42 – a 20% gain.

  • Marathon Petroleum (MPC)

Marathon is one of the largest transportation fuel refiners in the U.S. with around 8,300 miles of pipeline. The company reported a 44% increase in earnings in its latest quarter and the stock looks primed for a breakout thanks to lower oil prices. Trading at 10 times future earnings with a long term EPS growth rate of 12.5%, Marathon could be undervalued.

Like most refiners, Marathon offers investors a dividend yield. It currently offers a 2.27% yield and pays $2.00 a share annually, an amount that has been raised 150% since 2011. This stock could be worth $115 per share which would represent a 29% discount based on its current price.

  • Phillips 66 (PSX)

A spin-off of ConocoPhillips, Phillips 66 is a giant $47 billion petroleum refiner with more than 63,000 miles of pipeline. Like Marathon, this company is also set to benefit from the rising tide of lower oil prices. The stock trades at 11 times future earnings with a long term EPS growth rate of 10%, making it a fast growing company in an industry otherwise known for value.

Phillips 66 pays a dividend yield of 2.3%; slightly higher than Marathon. However, since 2012, Phillips 66 has increased its dividend by 150%; one year faster than its competitor. Based on the stocks growth rate, it is fairly valued at $92 – a 10% discount.

Oil Won’t Stay Cheap Forever

While short term macroeconomic effects such as oversupply, a strong U.S. dollar, and a waning global economy may have dragged down the price of oil, it is unlikely to stay below $90 for more than a year.

If Chinese or European economic data comes back higher than expected, that could help to lift oil prices globally if investors assume the slowdown was less severe than previously thought. OPEC will likely continue to pare down supply in order to bring back oil prices as well while the International Energy Agency (IEA) reports that oil demand is at a 2 ½ year low.

Oil prices fluctuate on a variety of influences and could reverse direction as severely and unexpectedly as before. Investors are cautioned against selling under-performing energy stocks as a knee-jerk reaction to oil’s movement but should take precautions by hedging positions. Refiners are the clear winners of black gold’s sudden decline in worth and could be primed for a breakout if oil closes below $90.

Fariba Ronnasi
CEO, Elite Wealth Management

Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions on the companies mentioned through stocks, options or other securities.

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