Avoid Big Oil — Here’s a Better Option

$138 billion — that’s the enormous sum earned by the five largest oil companies back in 2008 when crude oil prices surged to all-time highs near $150 per barrel. Exxon Mobil (NYSE: XOM) alone earned more than $45 billion, a figure which now stands as the record for profit earned by any U.S. corporation in history.

But that’s the past, and as any seasoned investor is well aware, markets are forward-looking. What matters isn’t the $150 oil price of 2008 or the $85 price of today, but rather the price several months or even several years down the line, depending on your investment timeframe.

With that in mind, there are many reasons to believe oil prices will be higher in the future than they are today. But I’m not here to repeat the bullish oil thesis that some of my colleagues and I have already made. Instead, I want to explain why an investment in the largest oil companies is one of the worst ways to profit from a move higher in crude oil prices.

At first glance, this may seem counterintuitive. How could a company that produces a lot of oil be a bad way to cash in on rising oil prices? To understand why, investors need to consider that bigger is not necessarily better in the oil industry. In fact, it is a handicap in a world in which oil reserves are becoming scarcer.

Let me explain. As oil companies produce crude, two things happen: reserves are depleted and overall output declines. This phenomenon is often referred to in the industry as a treadmill in which companies must continuously drill more wells to maintain production, while finding new reserves to replace depleted reserves.

When oil is abundant and easily accessible, this is no problem. But in today’s environment, when companies have to look in some of the most volatile regions of the globe to find new oil reserves, this becomes a real burden — and the bigger the oil producer, the bigger the burden.

In the past several years almost all of the oil majors have struggled to replace their reserves and maintain output levels. The best performer, Chevron (NYSE: CVX), has seen its production grow by an average of +1.9% in the past five years. Exxon Mobil, by contrast, has seen production fall by an average of -1.8%.

Big oil has responded to this problem in several different ways. In many cases, companies have shifted a greater proportion of their capital to natural gas production, but that has the consequence of reducing leverage to rising oil prices. Firms in the energy industry typically combine their oil and natural gas output to come up with an “oil equivalent” headline figure that is calculated on the basis of energy equivalency — thus what may seem like growth on the surface may actually be masking declines in oil production.

Acquisitions are another way big oil has attempted to replace reserves and grow. As is the case with any acquisition in any sector, the price paid plays an enormous role in determining whether the purchase ends up creating value for the acquiring company. If oil prices rise, the cost of any acquisition will also rise. It becomes very easy for a company to overpay for an acquisition in a “seller’s market.”
#-ad_banner-#The challenge big oil faces with regard to reserves and production is not the only reason investors should avoid these companies. Another is the fact that these companies are vertically integrated, which is economic jargon for saying a firm is engaged in the whole supply chain — from the upstream production side of the business to downside marketing.

The upstream segment is the one that benefits from rising oil prices. The profitability of the downstream segment on the other hand, is determined primarily by refining margins.
During 2003 to 2007, refining margins increased in step with oil prices as decades of underinvestment in the sector combined with strong demand for refined products, such as gasoline and diesel, made for a bullish recipe. As oil prices continued to spiral ever-higher in 2008, however, demand began to falter. The economic downturn that took vicious shape around the same period was the nail in the coffin for refining margins, which plunged and haven’t recovered since.

Looking forward, the outlook for the refining space continues to look dismal. Furious investment during the boom period of the last several years has once again created overcapacity in the sector– and not just in the United States. China’s Sinopec (NYSE: SHI) says the country may have refining capacity of 10.2 million barrels per day by the end of this year, well above this year’s estimated demand of 9.2 million barrels per day. India has also aggressively expanded refining capacity, becoming the largest exporter of petroleum products in Asia.

Action to Take –> Investors who are bullish on oil prices and want an investment that will generate attractive returns as the commodity rises should avoid the big integrated oil companies. While they generate tremendous cash flow and are currently offering attractive dividend yields, big oil faces many headwinds — and these are headwinds that only get stronger the higher oil prices go.

Instead, consider an investment in much smaller, independent exploration and production companies. Pioneer Natural Resources (NYSE: PXD) is an oil and gas producer that will grow production +15% annually in the next two years. Importantly, much of that growth will come from crude oil, where output will increase +20% annually. Whiting Petroleum (NYSE: WLL) is another solid investment opportunity. More than 80% of the company’s production is made up of crude oil, with output set to grow +16% this year.

Both Pioneer and Whiting generate most of their production onshore in North America. And while they are much smaller than big oil firms such as Exxon, Chevron, and the like, they are by no means tiny, speculative companies. Both have market capitalizations between $6 billion and $9 billion. Finally, neither Whiting nor Pioneer has any refining capacity, which makes them perfect candidates for investors looking for direct exposure to rising oil prices.