Battered Energy Stocks Are Now Alluring

How value investors can distinguish clarion calls for divestment from the reality of world energy demand

John KinsellaghApril 25, 2020

1 minute read

There is not a lot of good news surrounding the energy sector these days. Many have shunned the entire industry as a form of investment, and in terms of public relations, the group has become something of a pariah for institutional investors and fund managers due to increasing awareness and demand for action surrounding climate change.

Last year was a particularly painful year for energy stocks, which returned just 5% against a 28% return for the S&P 500. The past month has been particularly brutal on the already hard-hit sector. During the fourth quarter, profits were anemic, including an eye-popping 70% drop in Exxon Mobil’s (NYSE:XOM) operating earnings. The energy sector has trailed the S&P 500 for seven of the past eight years, and the group is already down 10% in 2020 compared to a 3% rise in the S&P 500.

With all the bad news that has plagued the industry for the past several years, what makes the sector so attractive currently? Who in their right mind would want put their money in these companies, whose shares have been heading on a persistent downwards trajectory for over the past five years?

Precisely because of the difficult times suffered by the energy stocks over the past few years, there is now a noticeable disconnect between energy and the overall market, which ascended to new highs recently while the battering of the trailing energy sector continued.

This mismatch has now reached the point where it is so glaring that the energy industry looks appealing from a valuation perspective. Additionally, energy stocks have been further depressed recently on fears of economic fallout from the new coronavirus.

In addition to the dramatic drop in oil prices from 2014 to 2016, and more recently in 2018-19, some of the depressed share prices can be attributed to political factors such as heightened concerns about climate change, now currently in vogue among many institutions. Adopting these moral standpoints to attract more capital has led to a fair amount of investing firms divesting themselves of energy stocks.

The dividend yields on many energy stocks are now considerably higher than any fixed-income yields available. The yield on the benchmark 30-year treasury bonds fell to a record low

of 1.889% last week. By comparison, energy stocks are currently yielding 4% and above.

The abundance of crude oil has depressed oil companies’ stock prices as well as the price of oil. Investors can now obtain relatively high dividend yields that far exceed the meager return on most fixed-income investments. At today’s rock-bottom prices, investors may have an opportunity to lock in substantially higher returns.

Indeed, there may even be the prospect of modest price appreciation for some of the energy stocks. Should stock prices begin to revert to the mean in the near future, I estimate that investors could expect single digit price appreciation in some selected stocks.

The following are some candidates for consideration; all of these stocks sport relatively high yields in the 3% to 6% and above range. Two European energy stocks, particularly cheap due to climate change disfavor, are British Petroleum (NYSE:BP), currently selling at $31.77 and carrying a 7.7% yield and Royal Dutch Shell at $45.13, yielding 8.1% and selling below its book value per share price of $47.17. Royal Dutch Shell has a current price-earnings ratio of 11.6, while BP has a price-earnigns ratio of 27.

Chevron (NYSE:CVX), which trades at $96.66, has one of the industry’s best balance sheets, stable cash flow and a yield of 5.1% after a recent dividend increase. It should also be noted that Chevron’s dividend yield is approximately twice the rate of its 10-yrear debt, which represents one of the widest stock/bond yield gaps in the oil industry.

Investors can also participate in the bargain hunting through the Energy Select Sector SPDR Exchange-Traded Fund (XLE), which owns the energy stocks in the S&P 500 index and has about 40% of its assets in Exxon and Chevron. It yields a generous 7.6% dividend and currently trades slightly above its 52-week low of $45.31.

Those who want a more speculative play might consider SPDR Oil & Gas Exploration & Production ETF (XOP), which is trading at $15.13 (near its 52-week low of $14.43). The fund’s largest holdings include Apache, Occidental Petroleum and EOG Resources.

Integrated companies, meaning those involved in not just the production but also the refining, storage and transportation of energy products, may be best positioned to withstand oil price and competitive pressures. Some of these oil companies have ancillary businesses such as producing chemicals and plastics and raw materials. Many integrated companies that are in the transportation as well as the storage chain in the overall energy sector industry are sporting attractive yields. Some bargains within the sector are listed below.

Total (TOT), whose shares yield 5.4%, and Marathon Petroleum (NYSE:MPC), which yields 4.4%, are companies that specialize in transport or storage. This group also includes Kinder Morgan (NYSE:KMI), which is currently yielding 4.9%.

In addition to the rock-bottom prices, the industry itself has changed. Responding to investor pressure, many energy companies are exerting capital discipline and boosting returns to shareholders by way of share buybacks or dividends. Many oil companies are now putting less money in the ground and more into stockholder’s pockets.

The oil sector provides a propitious opportunity for investors looking for undervalued stocks that are heavily out of favor by the overall market . Despite the highly publicized divestment movement, astute investors should note that the fervent wish of many to move out of carbon-based energy sources to wind and solar goes against where the available profits are. Renewables currently still supply only a fraction of the world’s energy demand. The world economy will continue to rely heavily on oil and gas for at least the next twenty to thirty years.

This article appeared in Gurufocus — a value investing site

Disclosure: I have no position in any of the securities referenced in this article.

About the author:

John Kinsellagh

John Kinsellagh is a financial writer, former financial advisor and attorney, with over twenty-years experience in civil litigation and securities law. He completed the Boston Security Analysts Society course on Investment Analysis and Portfolio Management.

He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

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