“Avoid At All Costs”: Why Oil Stocks Will Be Worth Nothing In The Long Run

“Avoid At All Costs”: Why Oil Stocks Will Be Worth Nothing In The Long Run

over 3 years ago4 mins

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What’s going on here?

Last month, NextEra Energy – the world’s biggest producer of wind and solar power – saw its market value overtake that of oil giant ExxonMobil, once the planet’s largest public company.

If that isn’t indicative of the times we live in, then consider this: according to investment bank Oppenheimer, the value of the still oil-and-gas-dominated energy sector as a whole is currently at its lowest level relative to the S&P 500 index since 1931.

US energy versus S&P 500
Source: CNBC

While there may be buying opportunities in certain parts of the sector – as discussed in our Pack on Investing In Oil & Gas – this analyst reckons you should avoid one area like the plague: “upstream” oil exploration and production companies (E&Ps), popularly represented by the XOP exchange-traded fund.

What does this mean?

E&Ps, as the name suggests, search for oil reserves and extract them once found. They’re the firms actively drilling wells and often hydraulically fracturing (or “fracking”) the hydrocarbon-rich bedrock thus reached – the latter process, like this Insight, being more specific to E&Ps in the US. Once the oil’s out, it’s sold at prevailing market prices to “downstream” companies which convert it into usable products such as fuel, plastic, and petrochemicals.

There are two main issues with US E&Ps. First, the fracking process is highly complex and relatively expensive. Second, the oil wells created via this method suffer from steep “decline rates”. They produce a lot of oil in the first few months – but their output subsequently drops off rapidly. After a year, a fracked well is producing just a fraction of what it was during its first month.

Taken together, these two things mean that American E&Ps have to constantly spend large amounts of money drilling new oil wells to offset the declining output at previous ones. Just maintaining a stable level of production requires a lot of capital spending, and growing production is even more costly. That’s why it shouldn’t come as a surprise that the E&P industry as a whole never makes any positive “free cash flow” (FCF): the amount of cash generated after all necessary reinvestments back into a business. Negative FCF has to be offset by external financing – either borrowing money, issuing new shares, or both.

Oil companies' free cash flows
With oil prices collapsing this year due to the pandemic, you can expect a big red bar for 2020...

Why should I care?

Owning shares of a business that generates FCF every year and dishes some of that profit out to you via either dividends or share buybacks is like owning a hen. The hen produces eggs, and their sale more than covers the cost of chicken feed, bedding, and securing the coop against foxes.

Owning an E&P is more like owning a turkey: you have to constantly fork out to fatten the bird up, and there’s no guarantee there’ll be that much meat come Thanksgiving. E&Ps have to constantly outspend to grow production, with the idea being that at some unspecified point in the future they’ll cool off and start distributing FCF to shareholders. An E&P’s value today is pretty much entirely made up of its terminal value “discounted” back to the present.

But this relies on one massive assumption: that the price of oil will still make producing it worthwhile well into the future. And that assumption, like the E&Ps themselves, has numerous holes. For starters, oil demand is heavily concentrated in transport fuels, and electric vehicles are increasingly displacing the need for gasoline and diesel. The major oil-producing nations collectively known as OPEC have also made drastic supply cuts this year in a bid to prop up prices – but the plan is that these will eventually be reversed. It doesn’t take a Finimizer to figure out what happens when falling demand meets increasing supply.

Picture a scenario where E&Ps keep borrowing money and selling new shares over the coming decade to fund their spending. In ten years’ time, when they can’t grow any larger, they’ll still need to spend money offsetting the steep production declines of older wells. But if oil prices are then sat at $20-$30, it’s hard to see how E&Ps could generate any FCF. How do you value a business that plausibly won’t generate any FCF in its entire lifetime? Zero. And that’s why this analyst, at least, thinks that giving upstream oil a miss is a savvy idea.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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