Stock Investing

A positive industry trend could create strong tailwinds for some energy companies directly exposed to oil.
By Vikram Barhat | 29/11/17

The U.S. energy sector is on course to end up as the second worst performing sector of 2017. On a year-to-date basis, the S&P 500 Energy Index is down more than 7% against a robust 18.4% total return for the S&P 500 Index, as of Nov. 24.

About the Author
Vikram Barhat is a Toronto-based financial writer specializing in investing, personal finance and small business. His experience working in various editorial capacities in digital and print media spans more than a decade across three continents. He has written for CNBC, BBC, The Globe and Mail, the Toronto Star and other publications. He can be reached on Twitter @vikrambarhath.

On a more upbeat note, though, oil prices have bounced back from the lows of the last few years, powered by an OPEC-led supply cut. In fact, this year they have been hovering around two-year highs, and there's expectation that they will continue to tick higher. The recent 2017 OPEC World Oil Outlook (WOO) report forecasts stronger long-term demand for oil, led by developing countries. Such growth is supportive for oil prices, which Morningstar expects to surge in 2018 to reach US$65 per barrel.

The positive industry trend could create strong tailwinds for some energy companies directly exposed to oil. While most of these companies are trading close to or just above their fair value, they are still trading well below their all-time highs -- some are still in the red for the year to date -- which suggests upside potential for long-term investors with some risk tolerance.

The leading oil giants are well-managed and diversified business operations with growing profits and strong balance sheets to provide a cushion during uncertain times. They are well positioned to benefit as rebounding oil prices and demand growth reenergize the market, according to Morningstar equity research.


Total SA ADR
Current yield:4.82%
Forward P/E:16.2
Fair value:US$67
Data as of Nov. 27, 2017

French energy giant  Total (TOT) explores, produces and refines oil around the world. The company operates refineries primarily in Europe and distributes refined products in 65 countries. It also owns a 19% stake in Russian oil company Novatek.

"Total stands to meaningfully improve its cash flow generating power in the next several years through peer-leading production growth and operating cost cuts," says a Morningstar report, noting about 5% volume growth per year through 2022, the highest among its peers. "However, despite a sharp decrease in capital spending, it will still require some help from oil prices to reach cash flow neutrality and achieve its goal of paying a full cash dividend."

Morningstar sector strategist Allen Good warns, though, that production growth won't be without elevated execution risks, given the size and complexity of those projects.

Total is one of the lower-cost operators, and as the firm continues to hack its operating costs, margins should improve. "Total aims to reduce operating costs to US$5 per barrel of oil equivalent by 2018, a 50% cut from 2014 levels," says Good who recently raised the stock's fair value from US$58 to US$67, indicating more than 10% upside potential.

The scale of the cost reduction should help Total save US$4 billion by 2018. In some cases, the company reduced costs by as much as 50%, and dramatically reduced spending while maintaining growth, says Good.


Chevron Corp.
Current yield:3.71%
Forward P/E:25.8
Fair value:US$106
Data as of Nov. 27, 2017

The second-largest oil company in the United States,  Chevron (CVX) owns exploration, production, and refining operations worldwide. The California-based integrated energy behemoth owns refineries in the U.S., South Africa and Asia.

"In recent years, Chevron's oil portfolio has led to peer-leading margins and returns on capital," says a Morningstar report, noting that new production in Mexico, Africa and Australia will "serve as the growth engine for Chevron in years to come, setting it up for peer-leading growth during the next two years."

Improving oil prices, cost-cutting and increased production will be supportive of cash flow which Good expects to rise during the next five years. "Free cash flow should increase as capital spending declines due to Chevron investing in shorter-cycle, less capital-intensive projects like unconventional production in the Permian Basin and brownfield expansions of existing projects, which will also deliver the next stage of production growth," says Good who puts the stock's fair value at US$106.

Chevron's Permian position, he adds, is a "real differentiator to peers", thanks to its size, quality and lack of royalty.

Liquefied natural gas (LNG) and offshore projects and increased investment in the Permian are expected to boost Chevron's production growth in the coming years. "The company expects growth of 4% to 9% in 2017," says Good, who projects natural gas to contribute a greater share of production (about 38%) by 2020, up from 34% in 2014.

He cautions, however, that a significant portion of these volumes will be LNG, whose pricing is linked to oil.


Exxon Mobil Corp.
Current yield:3.76%
Forward P/E:21.9
Fair value:US$78
Data as of Nov. 27, 2017

Integrated energy company  Exxon Mobil (XOM) explores, produces and refines oil around the world. The company is the world's largest refiner and one of the world's largest manufacturers of commodity and specialty chemicals.

"ExxonMobil has set itself apart from the other majors as a superior capital allocator and operator, delivering higher returns on capital relative to peers as a result," says a Morningstar equity report that forecasts Exxon will maintain its lead in returns, albeit at lower than historical levels due to the impact of higher-cost projects and lower oil prices.

While its larger projects such as oil sands and LNG are more capital intensive than legacy projects, squeezing returns, "they produce at plateau levels for decades with little need for reinvestment, thus generating strong cash flows," says Good, adding the company will "lead peers with nearly 50% of production from long-life assets in 2018."

To improve returns and cope with a more volatile oil price environment, Exxon is shifting investment toward projects that can generate free cash flow within three years. "The combination of long-life assets and flexible investment in short-cycle assets should safeguard free cash flow in a volatile oil price environment, leaving Exxon able to cover the dividend at oil prices as low as US$40 per barrel," says Good who appraises the stock's fair value at US$78.

The oil behemoth recently reported a stellar third-quarter performance where its quarterly profit jumped 50%, buoyed by higher oil prices and, to a lesser extent, production growth, of which Good warns "the firm will continue to deliver little."


Royal Dutch Shell PLC ADR
Current yield:5.83%
Forward P/E:15.6
Fair value:US$71
Data as of Nov. 27, 2017

 Royal Dutch Shell (RDS.B) is Europe's largest integrated oil and gas company with worldwide operations. Its acquisition of British rival BG Group in 2016 expanded its footprint in Brazil and Australia, boosting its cash flow and its position to compete in a world of US$60/barrel oil.

Shell, like its peers, is cutting costs by reducing headcount and improving its supply chain. Further, it plans to dramatically slash investments by tightening yearly capital spending to $US30 billion through 2020, from US$50 billion in 2014.

"The sharp decrease should improve capital efficiency, but should not completely sacrifice growth," says a Morningstar report. "While the reduction in spending is in part a function of canceled marginal projects that are no longer economical, it also results from cost deflation, improved performance and design standardization."

The impact is most notable in Shell's future projects in the Gulf of Mexico and Brazil, where break-even levels have fallen to US$45 per barrel oil. Improved economics of deep-water projects, high-return conventional reinvestment opportunities and a large LNG portfolio enable the oil giant to deliver modest growth at reduced spending, the report notes.

"As a result of its collective efforts, Shell should boost margins and improve returns by 2020, leaving it in a better competitive position," says Good, who recently upped the stock's fair value estimate from US$65 to US$71 prompted by strong third-quarter results.

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