Smart Energy Investing When Oil Is Cheap

Does the huge drop in the price of oil provide an opportunity for contrarian investors to cash in? Or are we in for a long period of cheaper oil, which would be great for consumers but poisonous for shareholders of many energy companies? Unfortunately, history doesn’t offer a simple answer. Starting last summer, the price of a barrel of oil fell from more than $100 to less than $50 in the space of about six months. Oil fell roughly the same amount during the 2007–09 recession, as well as during the downturn of the early 1980s. The previous declines were triggered by significant global slowdowns. In other words, the price dropped because demand—the desire of people and businesses to buy—dropped.

3 Energy Stocks to Buy Now

The latest decline is the result of a combination of factors. Demand is sluggish in Europe and Japan (both are barely expected to avoid recessions this year) and in China, where growth in gross domestic product in 2015 is projected to be about three percentage points less than it was a few years ago. But increased production in the U.S., thanks to advances in drilling technology, is also playing a major role by boosting supply. Then there is the desire of Saudi Arabia, the leader of the OPEC cartel, to squash oil-producing companies that can’t survive with a low price—and perhaps punish its oil-producing enemies, Iran and Russia. When the Saudis turn on the spigot, the supply rises and the price falls.

But how long will oil stay low? The past is no help. The rebound after the most recent recession was sharp. From a low of about $34 a barrel in February 2009, West Texas Intermediate crude was back above $100 two years later. The second half of the 1980s and the 1990s were another matter. Except for a quick spike during the Gulf War, prices bounced between $10 and $20 nearly the entire time.

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I have written many times that individual investors should avoid direct purchases of commodities; they are just too volatile and unpredictable. But what about stocks of companies in the oil and gas business? When you buy their shares, aren’t you also betting on a commodity’s price?

Certainly. But the exposure of those firms to oil and gas prices varies. Especially vulnerable to lower oil prices are energy-services companies, such as Halliburton (symbol HAL), which provide the rigs, analytic equipment, and other implements for extracting crude from the ground. The number of rigs operating in North America (a good measure of the amount of drilling) fell from 2,403 at the peak last year to 1,597 by the end of February. It’s no surprise that shares of Halliburton dropped by half between July 23 and January 15. Analysts on average expect the company to earn $1.78 per share in 2015, down 56% from what it made in 2014. Based on that estimate, Halliburton’s price-earnings ratio is 24, which is high but, because earnings are depressed, not especially worrisome. If oil prices rebound, then the stocks will rise sharply.

Ravaged sector. The same is true for battered exploration and production companies—the firms in the risky business of looking for oil and gas and pumping it out of the ground. Noble Energy (NBL), which has operations around the world and 1.4 billion barrels’ worth of proven reserves, saw the value of its assets cut in half as oil prices plummeted; its share price fell by the same proportion in just six months. The story is the same for most other E&P companies. An investment in these stocks is pretty much a bet on the price of oil.

Integrated energy companies are different. They make their money from both production (known in industry parlance as the upstream side of the business) and refining, chemical manufacturing and selling to consumers at gasoline stations (downstream operations). When the price of oil falls, these companies, such as Chevron (CVX, $104), ExxonMobil (XOM, $86), Netherlands-based Royal Dutch Shell (RDS-A, $61) and France’s Total (TOT, $51), receive less revenue from selling crude. But because crude is the key input for the production of petrochemicals and gasoline, they earn more in their downstream businesses. (Prices, yields and returns are as of March 6.)

It is this balance that keeps integrated companies on a relatively even keel. Shares of ExxonMobil, for example, peaked last summer at $104 but never got below $86 as the price of a barrel fell by half. The stock’s P/E of 23, based on estimated 2015 earnings, looks rich, but Exxon and the other big integrated companies have something else going for them: They’re large enough, and their balance sheets are solid enough, to buy struggling production companies—or even integrated ones—at good prices. Oil prices will go back up; they always do. In the meantime, these companies will pay you a nice dividend. Exxon’s current yield is 3.2%, and Chevron’s is 4.1%. Total, a smaller and dicier proposition, yields 5.4%.

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I like these integrated companies, even though they aren’t screaming bargains. If you want to speculate on an excellent E&P company with a strong balance sheet (rated A– for financial strength by the Value Line Investment Survey), I would turn to Pioneer Natural Resources (PXD, $156). Its shares are 33% below their peak last June of $233. The company, based outside Dallas, focuses its operations in Texas and the western U.S. With a market capitalization of $23 billion, Pioneer could be a takeover candidate.

Be careful investing in energy funds. The sector covers a lot of territory, so you need to know what you’re buying. One of my favorites is Energy Select Sector SPDR ETF (XLE), an exchange-traded fund. It gives you a dose of integrated majors: At last word, 16% of its assets were in Exxon and 13% in Chevron. Schlumberger is 7% of the portfolio, and Kinder Morgan (KMI, $40), a pipeline company whose price has been relatively stable and whose yield is an attractive 4.5%, rounds out the top four holdings.

Vanguard Energy (VGENX), a 31-year-old, actively managed mutual fund, lost 16.3% over the past 12 months, but the fund has a stellar long-term record. Over the past 15 years, it returned an annualized 11.6%, beating Standard & Poor’s 500-stock index by an average of 6.9 percentage points per year. The fund is heavily weighted toward the integrated companies, but it is leavened with such stocks as Pioneer, Halliburton and EOG Resources (EOG, $89), an E&P firm that is heavily invested in the Eagle Ford shale field in Texas and the Bakken formation in North Dakota and Montana.

My view is that lower oil prices could last for a while—maybe three years. Demand will eventually revive, but there is a vast amount of supply that can sop it up. Still, even with a level or slowly rising price, there’s a lot of money to be made in the energy business as companies get smarter about cutting their extraction costs. The history of oil drilling has seen constant improvements in efficiency, and I would expect the trend to continue, allowing companies to make more profits from oil selling for $50 to $60 a barrel.

What about alternative energy? Solar and wind are expensive sources of power to begin with, and lower oil and gas prices won’t help them. We’re still living in a world in which we get nearly all of our energy from fossil fuels, and, as an investor, you would be foolish to ignore that fact when building your portfolio. But, please, proceed with caution. Don’t bet the ranch on oil rebounding to $100 anytime soon.

James K. Glassman is a visiting fellow at the American Enterprise Institute. His most recent book is Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence.