- Oil prices have gained significantly from this year’s lows, but there is likely more pain in store for energy investors.
- Investors should remain cautious and stick with the highest quality name – Exxon Mobil.
- The company benefits from a large portfolio of downstream assets, peer leading credit rating and a massive war chest for acquisitions.
The market sentiment for oil seems to be improving, pushing a number of energy stocks higher. The SPDR Energy Select Sector ETF (XLE), the benchmark fund for this sector, has reported gains of 10.2% this month. But I believe investors should remain cautious and stick with the highest quality name – Exxon Mobil (NYSE:XOM).
Oil prices have climbed more than 40% after touching this year’s lows of less than $27 a barrel in January. The markets are pinning their hopes that the large OPEC and non-OPEC producing nations might agree on some sort of price support. Saudi Arabia, Russia, Qatar, UAE and Venezuela have all shown their willingness to freeze production. Alexander Novak, Russia’s Energy Minister, is expecting a meeting of the major producers between March 20 and April 1 to take this discussion forward. The International Energy Agency’s recent report, in which it said that oil prices may have bottomed, has also fueled optimism.
But even if the major producers agree on capping output, they will still likely continue producing near-record quantities of crude. Iran, on the other hand, which has recently started selling oil to international buyers after years of economic sanctions, has publicly said that it is not going to freeze output. US output, on the other hand, has been declining and is projected to fall to 2013 levels next year, according to the US Energy Information Administration.
But nobody knows how the massive quantity of oil that is held in storage all over the world is going to play out. The US alone is home to 521.9 million barrels of stockpiles which are currently at their highest level in more than 80 years. Concerns regarding weak global demand is also a major overhang. These factors will likely continue to weigh on oil prices going forward.
This means that there’s likely more pain in store for the energy companies. The rating agencies have been busy slapping downgrades on dozens of oil and gas producers over the last couple of months, limiting their access to debt markets. Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B), Exxon Mobil’s closest rival in terms of market cap, has already been slapped with a downgrade by S&P and Fitch. Others, such as the Canadian producers Cenovus Energy (NYSE:CVE) and Encana (NYSE:ECA) have seen their ratings reduced to junk. Among the major North American oil and gas producers, Chesapeake Energy (NYSE:CHK) has been the hardest hit. The second largest US gas producer faces the greatest bankruptcy risk in its peer group.
But in this turmoil, Exxon Mobil is an island of safety. The company benefits from having a large portfolio of downstream or refining business which usually performs better when oil prices are weak. The refining assets act as a natural hedge in the downturn. They offset the negative impact of cheap oil on the upstream or exploration and production business, allowing the company to remain profitable, even as oil prices collapse.
This was evident last year when Exxon Mobil reported 74.2% drop in upstream earnings from 2014 to $7.1 billion, but downstream earnings more than doubled to $6.56 billion. Total earnings dropped 50% to $16.16 billion, but if it weren’t for the refining business, the drop would have been more severe.
Exxon Mobil is widely regarded as the most financially sound oil and gas producer. It is the only energy company in the world with a perfect credit score, which was recently reaffirmed by Moody’s. Now Moody’s has changed Exxon Mobil’s outlook to negative from stable. The company is facing a significant risk of losing its coveted rating, but that will likely happen only when the rating agencies have downgraded every single publicly listed oil and gas producer that they cover. Exxon Mobil will remain the highest rated energy company.
On top of this, Exxon Mobil, which so far has stayed on the sidelines in terms of M&A activity, could use its massive war chest to swoop in and buy a major oil and gas producer on the cheap. The company has recently raised $12 billion in its largest ever bond sale which, it said, could be used for acquisitions. In addition to this, Exxon Mobil also holds 3.8 billion of treasury shares worth $278 billion, as per third quarter estimate. Theoretically, Exxon Mobil can deploy these funds to buy any oil and gas producer, even Royal Dutch Shell or Chevron (NYSE:CVX) with market caps of $191 billion and $182 billion respectively.
Although the broader energy industry will likely remain under pressure this year, as discussed earlier, I believe Exxon Mobil could outperform if it makes a big bolt-on acquisition.
The company’s sound financial health and a vertically integrated business model have bolstered the stock’s safe haven appeal. Investors will likely flock to Exxon Mobil stock as we head deeper into the downturn and the entire energy sector comes under additional pressure. This, coupled with an acquisition, could fuel a rally in Exxon Mobil stock. Exxon Mobil stock could end up beating not only the energy sector but the S&P-500 as well.