Oil just hit $60. Should I buy oil stocks now? #Unloved series

It’s hard to find a much more unloved sector than traditional energy BUT with Brent crude oil back above $60, there’s a case for buying oil stocks.

Key takeaways

  • Brent crude oil just hit $60 per barrel for the first time in over a year
  • The latest leg up in the oil price has spurred a rebound in energy stocks
  • But the performance differential between the S&P 500 and a major oil sector ETF is close to 50% in just 12 months
  • Oil stocks are in a multi-year downtrend relative to the broader market
  • OPPORTUNITY: start of commodity super cycle, high dividend yields, possible M&A
  • RISK: Green energy & ESG investment, dividend cuts, oil price topped?

What’s happening with oil?

Brent crude reaching $60 so quickly after falling under $20 less than a year ago was almost unthinkable. Nevertheless it just happened. The oil price has tripled since the low last April.

 

brent crude oil $60

 

Oil is caught up in the big ‘reflation trade’ amid the reopening of the global economy that has sent global stock markets to a record high. As vaccines are rolled out and economies reopen, demand for oil is set to rise.

Oil stocks are hated!

The latest leg up in the oil price finally came to the aid of energy stocks with a 27% gain for the Energy Select SPDR ETF (XLE) in Q4, which out-performed the broader S&P 500.

However despite the solid rebound in the underlying commodity, oil stocks were down 37% in 2020, while the S&P 500 was making fresh record highs with a 16% annual gain. A 50% differential in performance between an index and one of its sub-groups is abnormal and presents a potential opportunity for some ‘catch-up’. The gap is even wider if you look outside the United States to for example the UK, where BP (BP:LON) is 20% worse off than Exxon (XOM) in the past year.

 

XLE oil stocks

 

While oil stocks have already started to close the gap, the underperformance of Big Oil goes back to 2014 when the price of oil first crashed from over $100 per barrel. The chart below shows the energy sector has underperformed the S&P 500 by nearly 80% in the last 6 years.

 

relative XLE vs S&P500

Upside catalyst for oil stocks

We have identified three potential catalysts for a catch-up move in oil stocks.

Commodity super-cycle

Commodity prices go through cycles, roughly dependent on business cycles as well as the amount of exploration. Here the argument goes that an increase in global activity post-COVID potentially coupled with higher inflation will mean greater demand and higher prices for oil as well as industrial commodities. The effect on price from the greater demand could be exaggerated by the lower supply and reduced exploration that has cut into supply.

Dividend yield

Right now the cash flows from the industry do not support the current level of dividends. The expected dividend cuts go a long way to explain why oil stocks are underperforming. Once the dividend cuts actually take place, and investors have greater certainty moving forwards that the dividends are sustainable - the sector will become more attractive given what will likely still be a large gap over US treasuries.

M&A

The rather astonishing story that Exxon and Chevron discussed a merger, which would essentially bring back John D Rockefeller’s Standard Oil is bullish for the industry. Pricing power is already very concentrated but if global exploration is trending lower in the push for alternative fuels, the only way for one energy company to expand its own production is through mergers and acquisitions.

Risks for oil stocks and XLE

The risks for oil stocks are just the current consensus view.

Green energy and ESG investments

Big investors especially are under pressure to make their portfolios more ‘green’ and investing in oil companies is precisely the opposite of that. Norway’s sovereign wealth fund plans to divest itself entirely of oil exploration companies and a discussion as to whether to divest from diversified oil companies like Exxon and BP is ongoing. The more funds that follow suit, the few available buyers there are for oil stocks.

Dividend cuts

As discussed above, the risk that oil companies will have to make further divestments and cut dividends creates uncertainty and hangs over the stocks.

Oil price

There is a perception among many that the price of oil has already run too far to the upside relative to the likely demand recovery for oil in 2021/22. Should the price of oil correct some of the rally that has seen Brent crude triple and WTI return from negative to over $55 per barrel then that weights on the earnings and capex plans for oil companies.

How to play it

Oil ETFs

Energy Select Sector SPDR Fund (XLE)

XLE top 10 Holdings

 

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