Don't Miss Energy's Next Bull Run

Nick Lanyi's picture

Friday, July 15, 2016 - 12:30pm

by Nick Lanyi

In today's market, the energy sector is an enigma.

On the one hand, oil and gas prices have rallied mightily since hitting historic lows in January -- a strong data point for those who believe the multi-year energy cycle has turned northward. On the other hand, energy prices are down more than 10% since early June, providing fodder for those who argue that energy will remain in the doldrums a while longer. 

The ambiguity derives in part from the economic backdrop. In the United States, the world's largest consumer of oil and gas, the economy is growing steadily though slowly, with employment rising and personal incomes starting to inch up. That's a bullish sign for consumption of oil and gas. But around the world, economic indicators are flashing yellow, not green. China, Brazil, Japan, Europe? Don't look for strong demand growth there. And the UK's shocking exit from the European Union has only made analysts more jittery.

But economic factors explain only part of what drives energy prices -- and the related, but not identical, earnings of energy companies. As with any commodity, energy prices tend to move in cycles that are driven not only by demand but by supply. The current energy downcycle occurred in large part because of booming supply -- in the United States, where oil and especially natural gas production has exploded, and also from the need for other oil-producing countries to boost their economies by producing more.

Russia, Saudi Arabia, Brazil, Iraq and Iran could have put a floor under oil prices by cutting back on production. But their short-term economic imperatives drove them to keep pumping. Even now, after two years of a sustained bear market in oil prices, worldwide oil inventories are sky-high. It's this worldwide glut in crude oil, not a collapse in demand, is the reason energy prices have remained so low.

However, there is reason to think the boom-and-bust cycle for energy prices is going to change in the second half of the year. First, OPEC may be shifting policy back toward its historic stance of supporting oil prices by strategically limiting production. Saudi Arabia's oil minister hinted at such a shift just last week. Second, low fuel prices around the world are encouraging drivers, shippers and airlines to use more -- a welcome demand increase for the industry. And third, many high-cost producers have dropped out of business -- in some cases, for good. The supply reduction is good news for oil and gas prices, and ultimately will benefit lower-cost producers who have waited out the downcycle.

One of the best ways to participate in the coming upcycle is to buy shares of an integrated energy company that will profit from higher energy prices but isn't devastated by low prices because of its diversified operations. The best is ExxonMobil (NYSE: XOM). I recommended the stock in January, and it's up 30% since then. But despite the huge gains, it remains attractively valued and a great way to participate in energy without assuming an enormous amount of downside risk should oil prices head further south.

ExxonMobil's earnings are somewhat hedged against lower prices because it combines exploration & production operations with so-called "downstream" businesses for which oil is an input: refining, chemicals and gas stations. In addition, the company was smart and/or lucky enough to ease back from a long cycle of capital investment in 2014, just before energy prices plunged, so unlike some other energy companies it has not been forced to follow through with as many expensive projects in development during the downcycle. Instead, it has enjoyed falling capital expenditure budgets while still generating solid cash flows from downstream operations. The company also has moved out of lower-margin operations while investing in research & development of new resources that can be produced at lower cost.

When energy prices move higher, ExxonMobil will capitalize from its status as the world's #1 oil exploration and production company and its rock-solid balance sheet. The stock yields 3.2% and trades at 33 times analysts' expected earnings per share for 2016 -- an expensive price/earnings ratio on the surface, but if energy prices rise, earnings estimates will shoot higher.

Risks To Consider: ExxonMobil shares may not move much higher if oil prices drop and/or remain low. The company also faces negative publicity from an ongoing investigation that alleges that it deliberately misled the public about the risks of climate change. While energy companies deserve criticism for climate change denial, these past actions are unlikely to have much impact on their operations.
    
Action to Take: Buy ExxonMobil below $98.

Editor's Note: There's more than one way to invest in the future of energy. Tesla CEO Elon Musk is building a large battery array in Hawaii to store energy from island sunshine. It's just his latest move to build his energy storage business. Here are three little-known energy companies riding Tesla's huge 10-bagger technology wave.

Nick Lanyi does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.