Best oil stocks to watch in 2020
We explain the oil and gas industry, how to analyse the market and outline the top oil and gas stocks to watch.
Understanding the oil industry
Oil and gas is key to powering the world economy. Oil is predominantly used to fuel road, sea and air travel, but is also used in a wide range of applications including the production of petrochemicals and plastics.
Gas is mostly used to generate electricity or heating for residential, commercial and industrial use, while also being used to create plastics and other chemicals.
Not all oil and gas is equal, and the characteristics and quality can vary depending on where and how it is produced. For example, most of the oil produced in the shale-rich regions of the US is known as West Texas Intermediate (WTI), whereas many other countries produce a slightly sweeter product known as Brent oil.
There are two main aspects to most of the big oil and gas players: upstream and downstream. Upstream concerns the extraction of oil and gas while downstream handles the refining activities that turn those raw products into an array of other goods, such as petroleum, gasoline, diesel, kerosene or jet fuel.
The oil and gas industry is built on a foundation of supply and demand, which in turn dictates the price of oil and gas. The price of these commodities is key because it decides the value of their production as well as the oil and gas that is still in the ground. As always, when supply outstrips demand then prices will fall, whilst higher prices tend to come when demand is higher than supply.
At first, you would assume that the entire oil and gas industry would want prices to be as high as possible. However, there are fierce rivalries. For example, some countries where it is extremely cheap to produce oil sometimes drive the price lower to make the activity unprofitable for rival countries with higher costs.
There are three big players in terms of geography in the industry. The first is the Organization of Petroleum Exporting Countries (OPEC), a group of countries predominantly in the Middle East and Africa that is led by the largest producing nation in the world, Saudi Arabia. The second is Russia, which is one of the largest individual producers, and the third is the US, where the shale industry has taken off over the last ten years. The industry is highly exposed to geopolitical events, which can be a key driver to prices.
The industry is also highly cyclical, which means it experiences prolonged periods where the industry is booming as well as lengthy downturns. Despite going through these cycles for decades, you still find most major oil and gas companies expand and spend when times are good, only to find they are bloated and unprofitable when the next downturn comes.
Production is what brings money through the door, but it is equally important for the industry to ensure it has a long-term future by discovering new sources and developing new projects to replace existing operations when they finally run out of oil or gas.
This requires companies to explore for new oil and gas, and to develop them into reserves and resources which can be produced at a later date. There are many different types of projects that differ in complexity, ranging from conventional onshore discoveries to offshore projects pumping from deep in the ocean.
How to analyse oil stocks: what drives their performance?
Below are some of the key considerations to take into account when evaluating the major oil and gas stocks:
- Production: The amount of oil and gas a company produces, which is often measured in barrels of oil equivalent (BOE).
- Commodity prices: The price of oil and gas dictates what these companies can sell their product for, which goes toward deciding on the margin it makes on each barrel.
- Costs: The other driver to margins is the cost of extracting the stuff out of the ground. Low costs are key, especially when prices are low, as this can be the deciding factor behind whether a company is profitable or not during a downturn.
- Cash flow: Oil and gas companies have a lot to pay for. They have to maintain their huge operations, invest in new projects and exploration, and keep shareholders happy by paying dividends. Generating cashflow is how they must pay for all of this if they are to avoid using debt.
- Dividend and buybacks: Many investors flock to oil and gas companies because they are known for generous payouts compared to many industries, while some also reward investors with additional share buybacks.
- Resources and reserves: The amount of oil and gas they have in resources and reserves can play a large part in deciding the value of a company. This is the same as taking the value of excess stock of a retailer into account. It also needs sufficient resources and reserves if it is o continue producing over the long-term, as otherwise it would have to lower output or purchase new projects.
- Exploration and prospects: Resources and reserves are found by exploring new prospective areas for oil and gas. Exploration is risky and expensive, and often doesn’t pay off, but it is essential for the industry and a solid track record in delivering new projects is key.
Top 5 oil and gas stocks to watch
Investors are not short on choice when it comes to oil and gas stocks. There is choice between junior exploration companies to mid-cap producers to the major oil and gas giants. Below we focus on five of the largest oil and gas stocks in the world.
ExxonMobil was founded in 1859 and has evolved from a kerosene producer in the US into a global behemoth that is now predominantly focused on upstream production. Producing oil and gas, as well as significant volumes of liquified natural gas (LNG), contributed 83% of net income in 2019 before central eliminations, with 13% coming from downstream and the rest from its chemicals division.
Its operations in Asia are by far the biggest contributor toward revenue, accounting for over one-third of the total, followed by the US and then the rest of the Americas.
ExxonMobil has proven to be a reliable dividend payer in recent years, having grown at an average annual rate of 6.2% over the last 37 years, and it has pledged to maintain payouts during the coronavirus crisis.
Royal Dutch Shell
Royal Dutch Shell is the largest oil and gas company listed in London. Its origins trace back to importing from the Far East in 1833, but its venture into oil and gas began in the 1880s. Today, it has four main businesses including an upstream and a downstream division, which sit alongside its more distinguishing segments focused on integrated gas and alternative, cleaner energy.
The integrated gas division, which manages its LNG, fuels and other products, means Shell is more exposed to gas than other major producers. Shell is onboard with the world’s ambition to move to cleaner forms of energy, but it believes gas is key in bridging the gap in the meantime. Still, it isn’t the biggest driver of Shell. Downstream operations accounted for the vast majority of revenue last year.
Royal Dutch Shell offered a reliable dividend to investors but payouts hadn’t grown for years and it utilised share buybacks to reward shareholders instead. But that came to an end in 2020 as the coronavirus crisis prompted it to cut its dividend for the first time since the Second World War and utilise the flexibility that buybacks offer.
Chevron is another big US-listed oil and gas major. It began life as the Pacific Coast Oil Co when it was formed in 1879. Today, the company operates a more traditional model of upstream and downstream, which equally contributed toward earnings in 2019.
The company has consistently increased its dividend for 32 consecutive years and has committed to paying investors during the coronavirus crisis, marking a huge difference in attitude between US oil majors and their European counterparts. However, this is partly due to the fact they entered a troublesome 2020 with better debt to equity ratios than most of their international peers.
Total is a French giant that was born in 1924 and today it is operating in over 130 countries and it believes its geographical spread is a differentiator for the business. Currently, Europe, the Middle East and Africa are key hubs for the company, but it recognises areas like the Americas and Asia will play a bigger role in the future.
Total has pledged to become carbon neutral by 2050 and has been making large investments into renewable energy, such as a recent investment in a UK North Sea wind farm.
In 2019, Total’s downstream division generated nearly half of all revenues before eliminations, while its trading division contributed about one-fifth. Its upstream division only accounted for 16%, while its integrated gas and renewable energy unit contributed the rest. However, upstream contributed the most in earnings, followed by downstream.
In terms of its dividend, Total currently sits in between its European and US counterparts. It has maintained payouts during the crisis so far but also committed to a more aggressive drive toward cleaner energy. It has, however, stopped buying back shares.
BP is the other major listed oil and gas giant listed in London. Currently, it is split into three key areas that operate in 87 countries worldwide: upstream, downstream and a third one representing its 19.75% stake in Russian giant Rosneft. Downstream was the biggest contributor to both revenue and earnings last year.
BP has unveiled the most ambitious plan of all the major oil and gas giants to move toward cleaner energy and away from fossil fuels, and believes the coronavirus crisis will only accelerate the move toward renewables and other sustainable forms of energy.
BP’s new chief executive Bernard Looney has wasted no time rewriting the strategy and is now aiming to become net-zero by 2050 or sooner.
However, its ambitions are not cheap and it is adding to the financial pressure that the coronavirus crisis is already applying. It has so far resisted adjusting its dividend and has sold off some assets to bolster its balance sheet but there are concerns whether it can afford to transform itself and keep shareholders happy.
How to trade oil stocks
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