The point of buying a commodity producer - say, Exxon Mobil Corporation (NYSE: XOM ) stock - is to gain leverage to the price of that commodity. To use an overly simplistic example, imagine "ABC Oil Exploration" has $10 million in corporate costs, a cost at the wellhead of $35 per barrel, and is producing 1 million barrels a year.
With crude at $50, ABC earns $5 million a year ($50 million in sales, less than $35 million in wellhead costs and $10 million in corporate expense).
At $60, however, the company earns $15 million a year. Profits triple based off a 20% increase in the commodity price. With rising prices, investors in ABC stock (or Exxon stock in a real-world example, perhaps) get much better returns buying the stock than simply buying oil.
That's a double-edged sword, of course. With crude at $40, ABC swings from a $5 million profit to a $5 million loss - through little fault of its own. Admittedly, this example ignores multiple factors in oil and gas (depletion, land cost, royalties, etc.). But it highlights the underlying cause of what happened to so many wildcatters over the past decade as the boom in U.S. shale, in particular, turned to a bust.
Crude oil prices have stabilized somewhat, with West Texas Intermediate around $51. Oil stock prices have stabilized in turn, at least for those stocks that managed to avoid bankruptcy as crude oil prices crashed. And many investors believe that oil prices will continue to rise, as U.S. producers pull back on rig counts and cash-starved OPEC nations avoid (or break) production limits.
One might think that the best way to play rising oil prices would be to buy Exxon stock. XOM, after all, is the third-largest oil producer in the world (it trails Russia's Rosneft (OTCMKTS: RNFTF ) and PetroChina Company Limited (ADR) (NYSE: PTR )). It's a seemingly safe play, with a reasonable balance sheet: In fact, it has the same credit rating as the U.S. government. Exxon stock even pays a dividend, with a 3.5% yield, providing income.
That's actually not the case, however. XOM stock might be a good investment for a diversified portfolio, given the yield and safety. But for investors betting on higher oil prices, there are two key reasons why Exxon Mobil stock is not a good choice.
Not All of Exxon Mobil's Benefits Are From Higher Oil Prices
The first key reason is that higher oil prices won't be good for all of Exxon's businesses. Certainly, the well-known exploration and production business would benefit, and overall that would be a net positive for XOM stock.
But Exxon Mobil also has businesses "downstream" - notably, a large refining operation - and in petrochemicals. Those segments actually benefit from lower oil prices. In refining, spreads are more important, and it's generally easier to get higher spreads when prices are falling. (There's lag between the wellhead and the pump, and traditionally it's difficult to increase gasoline prices at a quick rate.) In petrochemicals such as ethylene, product prices increase as the price of oil inputs rise, which hurts Exxon's profit margins.
The downstream and chemicals businesses thus act as a "hedge" against lower oil prices - one key reason why XOM stock held up better in the oil bust than most. In 2015, for instance, according to the Exxon 10-K, lower oil prices took a whopping $18.8 billion off earnings in the company's upstream (exploration) business. But margin increases - mostly from the same lower oil prices - added nearly $5 billion to profits in Downstream and Chemicals. That offset some of the profit losses from the oil bust - and helped protect XOM stock.
That occurred, somewhat ironically, after calls for Exxon Mobil to divest those downstream businesses to fully capture $100+ crude, as Fortune wrote last year. Other companies, such as Marathon, did split into Marathon Oil Corporation (NYSE: MRO ) and refiner Marathon Petroleum Corp (NYSE: MPC ). And without that hedge, shares of MRO stock fell about 80%, as crude hit $35 early last year. The downstream and chemical businesses are part of why Exxon stock has held up reasonably well, but they're also why an investor bullish on oil should look elsewhere.
There Are Better Options Than Exxon Stock
If an investor expects crude to go to $60 or $80, a "pure play" like MRO is a much better (if more aggressive) way to play those gains than XOM stock. That's because those upstream-only stocks should appreciate more, without the offsetting pressure in other businesses. Indeed, that's what happened so far: Exxon stock is one of the weaker performers in O&G since oil bottomed last February.
XOM stock has gained about 16% over the past year. MRO is up 120%; Oasis Petroleum Inc. (NYSE: OAS ) and Parsley Energy Inc (NYSE: PE ) have more than doubled. In fact, most O&G stocks have done better than Exxon stock over the past year. And if oil prices do rise, those E&P's as a group almost certainly will continue to outperform XOM stock going forward.
There's another option - literally. Individual investors now can buy crude oil futures and options. It can be more lucrative - and it definitely is far simpler - to bet on crude oil hitting $60 through futures and options than it is to add the messy human factor of management decisions at individual companies. In those markets, investors can get the theoretical leverage to higher oil prices that used to only exist through buying higher-risk stocks.
Of course, buying futures and options, in particular, is a far higher-risk decision than buying XOM stock. For that matter, PE, MRO and other smaller pure plays are much riskier than Exxon Mobil stock as well. But that's the trade-off investors need to understand.
XOM is a mega-cap stock that pays a dividend and gives some, hedged, exposure to oil prices (and thus the world economy, still driven by that oil). That's a good thing for many, if not, most investors. But for investors who believe strongly that oil prices will rise, the size of Exxon Mobil and the inherent hedges in its diversified business mean there are better choices elsewhere.
As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.
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