The oil industry can be a challenging one for investors because oil prices are very volatile. In the last five years, crude plummeted from more than $100 a barrel all the way down to near $25 before bouncing back into the mid-$70s by the middle of 2018. That wild ride has caused investors in some oil stocks to lose a boatload of money, while others have unleashed a gusher of profits into their portfolio. Several factors separated the winners from the losers.
This guide will walk investors through the steps of finding oil stocks with the best chance of winning. The journey will lead investors into a better understanding of the critical characteristics found within the oil stocks that have what it takes to survive the industry's ups and downs and thrive along the way.
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Oil stocks 101: What is an oil stock?
The oil industry organizes itself into three segments: upstream, midstream, downstream. Each one represents a link in the value chain that transforms and transports raw crude oil into a more valuable refined product like gasoline.
Companies operating in the upstream segment include both those that explore for and produce oil and gas -- known as exploration and production (E&P) companies -- as well as service and equipment providers that make it possible to drill new wells. Midstream companies, meanwhile, transport the crude that comes out of upstream wells through pipelines, tankers, and trucks. Finally, the downstream segment includes oil refiners and petrochemical producers that transform oil into a more usable form.
Each link in the chain provides a vital cog in getting oil out of the ground and fueling the global economy. Likewise, each section of the value chain offers investors a unique way to invest in the oil industry, complete with its own set of risks and reward potential. While many publicly traded companies operate in each segment, investors can choose the best ones by focusing on the most important factors.
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How to find the best upstream oil stocks: E&P companies
E&P companies are what investors commonly think of when they hear the words oil stocks. That's because they make most of their money by producing oil, which means they have direct exposure to oil price volatility. This linkage makes them riskier than other types of oil stocks while at the same time offering the promise for the greatest reward. Given an E&P company's elevated risk level, investors should focus their attention on three crucial features:
- The strength of a company's financial profile, including its balance sheet.
- The company's oil price breakeven level.
- The way the company allocates capital.
The predominant factor to consider when looking at E&P companies is the strength of their financial profile. That analysis all starts by looking at the company's balance sheet since having too much debt and not enough cash can be the death knell of any oil producer. During the most recent oil market downturn, more than 100 oil companies went bankrupt because of debt-laden balance sheets that they couldn't support when falling crude prices caused their cash flow to dry up. Given the importance of having a strong balance sheet , an ideal oil stock will have an investment grade credit rating -- meaning it has a low risk of being unable to meet its financial obligations -- and low leverage metrics, which is the percentage of debt it has compared to assets or cash flow.
Two key financial metrics for E&P companies are the debt-to- EBITDA ratio (which helps determine a company's ability to repay debt with earnings) and a debt-to-capitalization ratio (which measures the size of a company's debt compared to its market value). Ideally, debt-to-EBITDA for an E&P should be less than 2.5 times while debt-to-capitalization should be below 30%, though the lower these numbers are, the better. One of the balance sheet leaders among E&P's is Pioneer Natural Resources (NYSE: PXD) . The company ended 2017 with a net debt-to-capitalization ratio of just 7% and a debt-to-EBITDA ratio of less than 1.0 times, which supported its investment grade credit rating. In addition to that, Pioneer Natural Resources had $1.8 billion of cash in the bank, which could cover a significant portion of its $2.9 billion capital investment program for 2018 if needed. That strong balance sheet ensures that Pioneer has the financial resources to continue operating should oil prices unexpectedly tumble.
A second factor that's a must for any E&P company is a low oil price breakeven level, which is the oil price where the company can produce enough cash to drill the wells needed to maintain its current production rate as well as fund its dividend if it pays one. This number can vary wildly by company, and many don't share it publicly. However, a good target is to find E&P companies with a breakeven level of less than $40 a barrel since that means an oil producer can survive at a fairly low oil price and thrive when it's higher. Occidental Petroleum (NYSE: OXY) is a great example of an oil company with a low breakeven level since it recently achieved its goal to get this number to $40 a barrel. By dropping its breakeven down to $40, Occidental can now generate enough cash at $50 oil to pay its lucrative dividend and grow production at 5% to 8% annual pace, while generating significant excess above that price so that it can grow even faster and repurchase stock. Most oil producers highlight their oil breakeven level in the investor presentations posted to their website. If the company doesn't highlight this number, it's likely because it has a high breakeven level.
A third factor to focus on is how an E&P company allocates its oil-fueled cash flows. Some oil companies take the "drill, baby, drill" mentality and spend everything that comes in, and then some, on new wells. That approach, however, can lead them to pile on debt, which can be their undoing during the next downturn. That's why investors should look for oil companies that keep spending to within cash flow. Though the best ones spend much less than what comes in, which gives them excess cash that they can return to shareholders via dividends and buybacks. That more conservative approach helps ensure they don't drill their own grave. An excellent example of an adept capital allocator is ConocoPhillips (NYSE: COP) . The U.S. oil giant aims to return 20% to 30% of its cash flow to investors via dividends and share buybacks each year while reinvesting the rest on oil projects that are profitable under $50 a barrel. Because of that more conservative approach, ConocoPhillips will avoid drilling itself into trouble by outspending cash flow on new wells to chase production growth. Many oil stocks provide detailed cash flow analysis on the most recent investor presentation posted to their website.
While there are other factors investors should consider before investing in an E&P company, focusing on these three will ensure that a company has a strong enough foundation to withstand the ebb and flow of the oil market. That's because it's imperative that an oil company survive the down cycle so that it can cash in when prices turn higher.
How to find the best upstream oil stocks: Service and equipment companies
E&P companies are just one way to invest in the production of oil. Another is the so-called "pick-and-shovel plays," which is a phrase dating back to the California gold rush to describe those who made money providing the equipment needed for mining. In the oil industry's case, this encompasses oil-field service companies, equipment makers, and other suppliers. These companies make money by providing E&P companies with the specialized services, products, and equipment they need to find, drill, and produce oil.
Investors have two basic options: large oilfield service giants that act as one-stop shops or smaller niche players that provide specialized services or equipment. Oil service giants Halliburton , Schlumberger , and Baker Hughes tend to be less risky investments because they have strong balance sheets and large-scale operations that enable them to keep costs low so that they can navigate through markets challenges. Niche players, on the other hand, tend to focus on doing one thing well such as producing the sand used in fracking, operating drilling rigs, or providing specialized well services. While that focus can lead to outsize returns during market booms, an oil bust can hit these companies hard. Investors therefore might want to focus on the large oilfield service companies because they tend to be less risky than E&Ps, while still offering investors a fair amount of reward potential.
Image source: Getty Images.
How to find the best midstream oil stocks
Another way to invest in the oil industry is through the midstream segment, which includes the companies that move oil from upstream production facilities to downstream end users such as petrochemical plants or refineries. One thing that separates midstream oil companies from their upstream counterparts is that they have less direct exposure to oil prices because they typically sign long-term, fixed-fee contracts with oil shippers to transport and store crude, which tends to make them less risky investment options.
The best oil midstream companies have three things in common. First, they get a significant portion of their revenue from long-term contracts, with an ideal target being a company that gets more than 85% of its earnings from predictable sources. Second, they should have a solid, investment grade balance sheet, with appropriate leverage metrics. In the midstream sector, an ideal leverage ratio is less than 4.0 times debt-to-EBITDA. While that's much higher than E&P companies, it's an acceptable level for midstream companies because of their steadier cash flow. Finally, since most pipeline companies pay out a significant portion of their cash flow in dividends, investors should look for those that distribute less than 75% of their annual cash flow to investors.
One other factor investors should keep in mind when reviewing midstream options is that some have chosen to structure as a master limited partnership (MLP). While MLPs tend to have higher yielding dividends , or in their case distributions, they also have unique tax implications.
One oil midstream company that meets all these criteria is Plains All American Pipelines (NYSE: PAA) . While the oil pipeline MLP did struggle during the recent oil market downturn, it's working to address those issues, which positions it to deliver better returns for investors in the coming years. Among the problems it's fixing is its balance sheet, with Plains' aim to get its leverage ratio to less than 4.0 times by early next year. Meanwhile, the company has invested heavily in strengthening its portfolio of fee-bearing assets so that long-term contracts now support 90% of its earnings. Finally, Plains only expects to pay out about 60% of its cash flow to support its high-yield dividend in 2018, which is an ultra-conservative level for an oil pipeline stock.
How to find the best downstream oil stocks
The final leg in oil's journey is the downstream segment where companies transform it into usable products like gasoline and plastic. Since downstream facilities consume oil, they tend to benefit when prices are lower. Still, they do have direct exposure to pricing, which makes their earnings more volatile than those of midstream companies. It's therefore imperative that they have a strong balance sheet backed by an investment grade credit rating to help get them through challenging times.
In addition to having a strong financial foundation, investors should also look for downstream companies that have large-scale, diversified operations, both regionally as well by facility type such as owning refineries as well as ethanol plants or chemical facilities. Having scale helps these companies offset the fact that downstream assets tend to require continual maintenance, which can take them offline for quite some time. As such, operating several facilities helps smooth out this impact. Meanwhile, diversification helps offset regional issues such as infrastructure problems -- when a major pipeline goes offline for maintenance, for example -- as well as pricing issues resulting from weaker demand for a certain product.
An ideal downstream company is Phillips 66 (NYSE: PSX) . Not only does it operate a diversified refining portfolio with facilities spread across the U.S. as well as in Europe, but it also owns a stake in a large petrochemical joint venture, manufactures specialty products like lubricants, and has a fuel marketing and distribution business. Furthermore, Phillips 66 has a strong, investment grade-balance sheet backed by low leverage metrics. Those factors position Phillips 66 to make money for its investors in good times and bad.
Why invest in the oil industry?
In 2018, the global economy will consume an average of 99.1 million barrels of oil per day (BPD), which is the equivalent of nearly 55,000 Olympic-size swimming pools for the year. The 2018 demand forecast represents an increase of 1.4 million BPD from the prior year while analysts expect that it will rise another 1.4 million BPD in 2019. In fact, the International Energy Agency anticipates that oil demand will steadily increase all the way through 2040 and that's even after assuming an accelerated adoption of electric cars. A range of factors will drive this increase including emerging markets like China and India, as well as increased fuel demand from the trucking, shipping, aviation and petrochemical sectors.
At the same time oil demand is rising, oil supplies from legacy fields are depleting. On average, production from conventional oil fields around the world has declined at a 7% annual rate over the past decade. Oil companies therefore need to invest hundreds of billions of dollars each year in drilling thousands of new wells to maintain the current production rate and even more to meet expanding global demand. Those investments, however, can generate lucrative returns for oil companies as long as oil prices cooperate.
Given this backdrop, the thesis for investing in oil is that demand should continue growing for the foreseeable future, which will necessitate continued investment in new supplies. That view implies that oil companies will keep drilling new wells, earning an adequate return in the process as long as crude remains above their breakeven point. That activity will provide work for oil service companies, while also driving the need for more equipment and pipelines, fueling growth both upstream and further downstream. In other words, the industry should continue producing profits for years to come.
The oil cycle
While the price of oil can be very volatile, it tends to follow cyclical patterns. When supplies outpace demand, oil prices tumble, which causes producers to cut back on investments in new wells. With demand continuing to trudge higher as the global economy grows, and supplies steadily declining as wells deplete, the industry tends to self-correct given enough time. In fact, more often than not the cure for low oil prices is low oil price because that accelerates demand growth, enabling it to catch up with supplies. That helps lift crude prices out of their doldrums, giving oil companies more money to drill wells. As oil continues to climb, the drilling pace accelerates. That trend continues until oil companies inevitably get greedy and begin producing more oil than the market needs, which causes crude prices to descend, starting the cycle all over again.
Where are we in the oil cycle?
The industry hit its last cyclical peak about four years ago. Global oil production, led by U.S. oil companies focused on drilling into tight shale formations, grew output at a frenzied pace in the preceding years fueled by triple-digit prices and the realization that by combining legacy technologies such as hydraulic fracturing and horizontal drilling they could unlock vast supplies of oil trapped in the shale formations under the U.S.:
US Crude Oil Field Production data by YCharts
However, with demand slowing under the strain of triple-digit pricing, market fundamentals got out of balance, which caused crude prices to tumble. It took the industry several years to right the ship and get supplies back in line with demand, which started to occur in 2017 thanks to the help of OPEC . The organization of several major oil-producing nations , as it has done many times in the past, agreed on a coordinated effort to reduce oil supplies so that the market could use of the excess crude sitting in storage depots around the world.
While it's anyone's guess where crude prices will go in the future, the stage appears set for higher oil prices . For starters, after being inundated with oil in the recent past, supply issues are starting to emerge, which could put upward pressure on prices.
Years of underinvestment also seem to be catching up to the industry as crude supplies are falling around the world. Oil production in Venezuela is in freefall because of the country's economic turmoil. Production has declined from around 2.4 million BPD in 2016 to less than 1.5 million BPD in recent months and could drop by another 500,000 BPD in the coming months. Meanwhile, production is also falling in places like Mexico and China, which are major non-OPEC producers.
On top of those natural declines from underinvestment as legacy fields start drying up, several man-made issues are impacting supply. One of the biggest is President Trump's decision to impose new sanctions on Iran , which could take upwards of 2.5 million BPD offline. In addition to that, civil unrest in Libya and Nigeria have caused production in those countries to ebb and flow. Meanwhile, pipeline constraints in the Permian Basin will halt that region's growth until new lines enter service next year while opposition to new pipelines supporting Canada's oil sands region continues to hold back new oil projects.
These factors lead analysts at the International Energy Agency to estimate that there could be a major supply shortfall in the coming years . In their view, after 2020 the oil industry could struggle to meet growing global crude demand, which could cause prices to spike. That potential surge should make oil stocks very lucrative long-term investments.
What are the risks of investing in the oil industry?
While an investment in the oil industry can be a very lucrative one, the sector isn't without its share of risks. Topping the list is the price of oil, which can tumble without warning, taking oil stocks with it. As noted earlier, the most recent crash in the price of crude oil caused more than 100 U.S. oil companies to declare bankruptcy, which wiped their investors out completely.
Another risk is that growing opposition to the industry stemming from environmental concerns could make it even harder to build new pipelines and drill wells in the future. If the industry can't grow, it will be tougher for oil companies to create value for investors. Meanwhile, the rapid growth of alternative energy sources could disrupt demand for oil at a faster pace than most currently anticipate. In addition to that, a litany of other risk factors can have an impact on the oil industry, including increasing environmental regulations, mismanagement, geopolitical issues, and many others. Needless to say, the sector isn't for the faint of heart.
How to determine the best oil stocks for your portfolio
While those risk factors make oil stocks riskier than other investments, the reward can be well worth it given the world's constant need for more oil. However, investors still need to keep risk in mind when investing in the sector. For some, oil price risk alone might keep them away from owning an E&P company, which is why they might want to opt for the lower risk profile found in the midstream sector. Meanwhile, others might want to pair an E&P with a downstream company to balance out their risk profiles or opt for an integrated oil company that owns both upstream and downstream assets.
Once an investor settles on the part of the oil value chain that best suits their risk tolerance, they then need to seek out companies best suited to navigate each segment's unique risks. The foundation of that search is the balance sheet, followed by a focus on companies with conservative financial and operating metrics. By investing in companies with the financial strength to survive tough times, investors should reap the benefit of the boom years, which appear to be just around the corner.
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Matthew DiLallo owns shares of ConocoPhillips and Phillips 66. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .