As tough as the past month and a half has been for all investors, anyone who's invested in oil and gas stocks has experienced an absolutely brutal ride. The writing was on the wall in early February, when the International Energy Agency said it was expecting to see global oil demand fall in the first quarter.
Since then, everything has gotten worse. The coronavirus that was hitting China so hard at the time -- the reason the IEA said global demand would fall -- is ravaging the world. Global commerce and travel has been ground to a halt. Many countries have issued stay-at-home orders, and millions of businesses are closed as a result. It could be many months before the global economy opens back up for business, and global oil demand could fall by as much as Russia and Saudi Arabia's entire daily production over that period.
Image source: Getty Images.
Pouring more oil on the fire
After talks to cut output fell apart in early March, Saudi Arabia and Russia both say they plan to move ahead with production increases in April and May. Saudi Arabia plans to increase its oil exports more than 40% in April, and add even more in May.
In this environment, I've already cautioned investors to step lightly -- if at all -- in the oil patch. A spate of bankruptcies in the sector is expected, with the first casualty Whiting Petroleum (NYSE: WLL), which filed Chapter 11 after reaching a deal with debt holders. Chesapeake Energy (NYSE: CHK), which recently hired a law firm with restructuring expertise, is not expected to be able to avoid bankruptcy either.
Both companies have long track records of massive cash consumption, and have destroyed nearly $20 billion in investor capital over the past half-decade:
They're unlikely to prove the only losers, either. Dozens more are in similar financial condition and on the cusp of insolvency.
A potential winner
There will be survivors, and when we look out a few years, we will realize that today's prices were an incredible buying opportunity for the best companies. Phillips 66 (NYSE: PSX), looks to be one of the likeliest winners, and so far, it's the only oil stock I have bought during the crash.
What sets Phillips 66 apart as worthy of buying in the midst of such uncertainty? It has a powerful combination of balance sheet strength, management that's proven they can navigate downturns, and the right kinds of operations to avoid the worst of the downturn, and find ways to profit.
Here's how Phillips 66 is different
The worst business to be in right now is oil production. These companies are the most-exposed to the current environment, particularly American shale producers, most of which can't make money with oil below $40 per barrel, and many that can't even keep the lights on below $35.
Joining the producers in the lineup of "trouble's a-comin'" oil stocks are the pure-play companies that drill oil wells, supply supply frac sand or steel pipe. As cash flows collapse at the producer level, these companies will see their cash flows get cut off. The spate of spending cuts by producers is already affecting this group.
That's why, as a group, these companies have taken it harder than the majors or even the oil producers. Here's how the sectors have done this year, as measured by the SPDR Oil & Gas Equipment & Svcs ETF (NYSEMKT: XES), SPDR Oil & Gas Exploration & Production ETF (NYSEMKT: XOP), and Energy Select Sector SPDR ETF (NYSEMKT: XLE):
The biggest and strongest, companies in the oil and gas industry, like ExxonMobil (NYSE: XOM) and Royal Dutch Shell (NYSE: RDS.A)(NYSE: RDS.B), and Phillips 66 have an advantage over their pure-play peers. They have diverse operations that are better able to handle severe shocks to the oil market, and also tend to have much stronger balance sheets and better access to capital.
Phillips 66 is different than even its big-oil peers in one important way: It doesn't produce oil. While ExxonMobil and Shell have diverse operations similar in some ways to Phillips 66, they have massive exploration and production segments. In good times they count on those downstream operations to generate massive cash flows; but the downside is when oil prices collapse, their earnings suffer greatly.
Why that's a massive advantage
Phillips 66 won't have to deal with the burning dumpster fire that is paying $30 to $40 to pump oil you can only sell for $25 in the current environment. Managing these downside risks are far more important than looking to capture potential upside from an oil price recovery.
Billions of dollars of wealth will be destroyed in the weeks and months to come because too many investors tried to buy oil stocks based on what they could be worth when oil prices recover, and didn't realize many of those companies won't survive to see the recovery.
Image source: Getty Images.
Built to survive now and thrive later
As the oil war and ongoing recession play out, I will identify other oil stocks to buy. But until there's more clarity on Saudi Arabia's plans to drown out the competition, and signs of an economic recovery, I'll avoid the pure-plays tied to oil production and tread lightly everywhere else. We haven't, I don't think, seen the worst of the 2020 oil market.
Even Phillips 66 will feel a pinch. Demand for refined products is falling sharply, and even its top-tier refineries will struggle to generate positive cash flows. But a very strong balance sheet with $900 million in cash, almost $6 billion in available low-cost liquidity, along with a profitable petrochemicals business and a midstream sector that's more exposed to natural gas than oil, it's in better shape than even the biggest of the integrated majors.
I've already bought shares, and it's at the top of my list to buy more of if the price falls further. But I'm in no hurry to take action anywhere else in the oil patch. This downturn could persist much longer than anticipated, and Phillips 66 should prove one of the best-built to survive if that happens.
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