Is it time to turn bullish on oil stocks?

The last year has been another appalling for oil stocks. The average oil producer in the ETF SPDR S&P Exploration and production of oil and gas plunged 38%. Meanwhile, the oil AND F is down over 55% over the past three years. While the fall in oil prices is partly to blame – West Texas Intermediate, the main benchmark for oil prices in the United States, has lost about a third of its value during this period – oil producers have spent billions of dollars in capital by drilling wells to increase production at all costs.

However, 2021 has started much better for oil. WTI rose more than 10%, topping $ 50 a barrel for the first time since February. This has already pushed up the SPDR oil ETF by more than 20% this year. This rally may be just the start, given how crucial $ 50 crude is for some oil producers.

Image source: Getty Images.

The Case for an Uptrend in Oil Stocks

Most oil producers have spent the past year focusing on cutting costs to survive lower oil prices. One of the tools that many have used is to increase their scale through mergers. Oil giant Chevron (NYSE: CVX) kicked off the current wave of mergers and acquisitions by acquiring Noble Energy last year for $ 13 billion. The main driver of the deal is the hope that the combined company can achieve $ 300 million in annual savings. Many peers followed this plan by acquiring a rival to cut costs. Devon Energy (NYSE: DVN) recently completed its merger of equals with WPX Energy in a deal that will increase its annual savings from $ 300 million to $ 575 million by the end of this year. During this time, ConocoPhillips (NYSE: COP) is in the process of completing its acquisition of Concho Resources (NYSE: CXO) this year, which should enable it to capture $ 500 million in annual cost and capital savings by 2022.

As a result of these deals, oil producers were on track to generate more cash in 2021 at lower oil prices than last year. Because of this, they can produce an even bigger spurt now that crude oil is in the $ 50 range. For example, ConocoPhillips estimated that by partnering with Concho Resources, it could generate between $ 7.5 billion and $ 7.8 billion in operating cash flow at $ 40 of oil, which is enough to fund the capital in order to maintain its current production rate and dividend with leeway. . Meanwhile, at $ 50 worth of oil, the combined company could produce an additional $ 3 billion in cash this year. Devon Energy only needs an average of $ 33 a barrel of oil to fund its dividend and production maintenance program. For this reason, it is on track to produce over $ 500 million in free cash flow from $ 40 of crude oil and over $ 1.5 billion if oil stays around $ 50 a barrel this year.

Usually, oil producers immediately reinvest their additional cash flow at higher oil prices to speed up their drilling programs and increase production. However, having been burned by this approach in the past, most growers plan to keep production flat this year even though oil prices continue to rise. If they do, they will generate huge amounts of excess cash that they can use to pay down debt and return money to shareholders. Devon has already pledged to pay special dividends of up to 50% of its excess cash this year, while ConocoPhillips will likely continue to buy back its shares.

The bear’s case for oil stocks

While the oil market improves, it is still in poor shape. There is a delicate balance between supply and demand. While consumption is set to improve this year, the pandemic could continue to affect how quickly it rebounds. If the vaccines are rolled out quickly, people will be able to go back to their offices and travel a lot more this year, which will drive demand for gasoline and jet fuel. However, if the rollout stops due to production issues or lukewarm demand, oil consumption may not meet expectations, causing crude oil prices to fall.

Meanwhile, supplies are set to increase this year as OPEC and many of its partners restart some of their production at slow speed. If they are rising too quickly, or if US producers start to get greedy, it could put pressure on oil prices, although Saudi Arabia is doing everything in its power to curb global supply.

If oil prices lost their grip on the $ 50 a barrel, oil stocks would likely give up much of their initial gains. Meanwhile, a drop to around $ 40 a barrel would put significant pressure on financially weaker oil producers, potentially triggering a new wave of bankruptcies in the sector.

Cautious optimism

If oil prices continue to rise, oil inventories could be doing very well this year. This is especially true for those who have taken steps to cut costs, as they are on track to produce free cash flow this year if oil stays in the $ 50 range. Given their commitment to keeping production at a stable level, many will return this boon to shareholders through share buybacks and special dividends, which could push their stock prices much higher.

However, downside risks remain, which is why investors should remain cautious by focusing on producers who can thrive even as oil prices cool.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

Source link

Felix J. Dixon