Published May 28th, 2018 by Aristofanis Papadatos
Energy sector stocks are famous for their high dividends. This makes the sector a favorite of income investors looking for potential high yield investments.
Energy sectors stocks have become even more popular lately thanks to the strong rally of the oil price since last summer. While the price of oil remained suppressed for three years, it has enjoyed an impressive rally and is now trading near a 3.5 year high thanks to the support of OPEC and Russia.
The supply glut of oil has been eliminated and investment cuts from most large producers in recent years will continue take their toll on the global supply. The price of oil is likely to remain strong for the foreseeable future because of this.
Nevertheless, as some stocks have already priced most of the expected earnings growth of the upcoming years, investors should be particularly careful in their choices.
In this article, we will rank the six oil super majors from best to worst, based on their expected 5-year returns. In order to calculate their 5-year returns, we have assumed that all the stocks will revert to their 10-year average P/E ratios within the next five years.
#1 Super Major Oil Stock: Total (TOT)
Total is the 5th largest oil and gas company in the world, with a market cap of $161 billion. Like the other oil giants, it is a fully integrated company and thus operates in three segments; upstream, downstream (mostly refining) and marketing.
Total exhibited much better performance than its peers during the 3-year downturn of the oil market that began four years ago. During this period, in which the oil price plunged up to 70%, the EPS of Total fell only 49% whereas those of Exxon Mobil and Royal Dutch Shell plunged 75% and 87%, respectively, and Chevron and BP posted losses in 2016.
The key factor behind the resilience of Total was its superior refining segment. During the rough years of refining (2008-2013), the upstream segment was generating about 90% of the total earnings of all the oil majors. Consequently, the other oil majors sold many of their refineries during that period, failing to see that their refining segment was their hedge against a potential plunge of the oil price. Total maintained almost all its refineries and hence it has reaped the full benefit from the high refining margins that have prevailed in the last four years.
Total also has another competitive advantage when compared to its American peers. It produces only a minor portion (less than 10%) of its natural gas in the U.S. and hence its average selling price of gas is much higher than the price of Henry Hub. Moreover, while all the oil producers drastically cut their production costs during the recent downturn, Total managed to reduce this cost to 5.4 $/bbl, which is nearly half of the production cost of most of its peers.
Source: Investor Presentation
Like most of its peers, Total failed to grow its production during 2010-2014. However, the company has returned to a solid growth trajectory lately. It grew its output 5% last year and expects to grow it by 6% this year thanks to the start-up of 8 major projects. Moreover, it expects to continue to grow its output by 5% per year for at least the next four years. Therefore, Total is properly positioned to enjoy a double boost in its results in the upcoming years; higher output and a strong oil price.
Given a 5% annual growth in its output and at least a 2% annual rise in the oil price, Total is likely to grow its EPS by at least 7% per year, without taking into account its leverage on the oil price, which will boost its results even further. As the stock is currently trading at a P/E ratio of 11.9, which is equal to its 10-year average P/E ratio, the stock is likely to offer a 12.0% average annual return over the next five years thanks to 7.0% annual EPS growth and its 5.0% dividend. It is thus likely to offer the highest return in its group with the lowest risk, given its impressive resilience in the fierce recent downturn
#2 Super Major Oil Stock: Exxon Mobil (XOM)
Exxon Mobil is the largest publicly traded oil company in the world, with a market cap of $340 billion. You can see Exxon Mobil’s smaller competitors (and all energy sector dividend payers) by downloading the spreadsheet below.
In the downturn of the oil market, which began in 2014, Exxon Mobil saw its EPS plunge 75%, from $7.60 in 2014 to $1.88 in 2016. This performance was much better than that of Chevron, BP and ConocoPhillips, which posted losses in 2016, and Royal Dutch Shell, which saw its EPS plunge 87%. Thus Exxon Mobil proved that it is more resilient than most of its peers during downturns thanks to its more integrated structure.
On the other hand, Exxon Mobil has greatly underperformed its peers in production growth. Its current production level around 4.0 M barrels/day is the same level that the company was producing a decade ago. During this decade, the management has repeatedly pledged output growth but it has not delivered so far. This is the main reason behind the pronounced underperformance of the oil giant relative to its peers during the ongoing recovery of the sector.
However, its management recently announced a drastic increase in capital expenditures in order to finally restore production growth. More precisely, it intends to boost capital expenditures from $24 billion this year to $28 billion next year and about $30 billion per year during 2023-2025. In this way, it aims to raise the output by approximately 25% within the next 7 years, from 4.0 million to 5.0 million barrels/day. It also expects to grow EPS by 135% over this time frame if the price of oil averages $60 in 2025.
Source: Investor Presentation
On the one hand, the management has proven too optimistic in the recent past. On the other hand, the assumption of an oil price around $60 is too conservative given the elimination of the supply glut and the sustained efforts of OPEC and Russia. Therefore, it is reasonable to expect the oil giant to approximate double its EPS by 2025. As it takes several years for oil projects to start bearing fruit, most of this growth will probably come towards the end of the 7-year period. Therefore, it is reasonable to expect EPS growth around 50% over the next five years or 8.4% average annual EPS growth during this period.
When the company announced the drastic increases in its capital expenses, the market panicked and punished the stock with a 3% loss on that day. However, this move was certainly essential to restore production growth and is likely to prove a game changer for the stock in the long run. The stock can offer a 9.7% average annual return over the next five years thanks to 8.4% average annual EPS growth and its 4.1% dividend, which will be partly offset by a 2.8% annualized P/E contraction as ExxonMobil is trading a bit above its historical average P/E ratio at current prices.
#3 Super Major Oil Stock: BP (BP)
BP is the 6th largest oil and gas company in the world, with a market cap of $152 B. It is a fully integrated company and thus operates in two segments; upstream and downstream (mostly refining). BP has gone through extreme challenges since its major accident in 2010. It has paid $62 B for this accident so far. Even worse, when the oil giant began to recover in 2014, the price of oil began to collapse and the oil major incurred another fierce downturn.
However, the worst is certainly behind the company. After years of lackluster performance due to the above headwinds, BP has returned to a solid growth trajectory. It increased its output by 10% last year and expects to grow it by 5% per year for at least the next four years. It launched 7 major oil and gas fields last year, more than in any other year in its history, while it also expects to start another 6 major projects this year.
Source: Investor Presentation
In this way, the company expects to restore its output to 4.0 milion barrels/day, the same as before its accident in Macondo and much higher than the 3.0 million barrels/day it was producing in the aftermath of the accident due to its unprecedented asset sales.
Moreover, BP drastically reduced its operating expenses in the recent downturn and now invests only in projects that are profitable even below $40 per barrel. As a result, the oil major has reduced its breakeven point to $50 and expects to further reduce it to $35-$40 by 2021.
As BP is likely to grow its output by about 5% per year in the upcoming years and the price of oil is likely to remain strong, the oil major is likely to grow its EPS by at least 7.0% per year over the next five years. On the other hand, the stock is currently trading at a P/E of 14.6, which is higher than its 10-year average P/E of 12.7.
Consequently, if its valuation reverts to its average level in the next five years, the stock will incur a 2.7% annualized drag due to P/E contraction. Therefore, the stock is likely to offer a 9.6% average annual return over the next five years thanks to 7.0% annual EPS growth and its 5.3% dividend, which will be partly offset by a 2.7% annualized P/E contraction.
#4 Super Major Oil Stock: Royal Dutch Shell (RDS.A, RDS.B)
Royal Dutch Shell operates in three segments: upstream, downstream and integrated gas. The company struggled during the downturn of the oil market, with its EPS plunging 87%, from $4.72 in 2014 to $0.60 in 2015. Its upstream segment is highly leveraged to the price of oil and was the reason for the precipitous EPS decline.
However, thanks to the rally of the oil price since last summer, the upstream segment of Shell has significantly improved its performance and the total free cash flows of the oil major have posted an impressive rebound, from -$1.5 billion in 2016 to $14.8 billion last year. Therefore, after two years of negligible free cash flows, Shell can now fully fund its annual dividend of $10.9 B via its free cash flows.
Source: Investor Presentation
It is also impressive that the operating cash flows of the oil giant returned to their pre-crisis levels last year even though the price of oil was still 45% lower than it was back then. Moreover, Shell recently surpassed ExxonMobil in operating cash flows ($35.7 B vs. $30.1 B) for the first time in about two decades.
Shell is currently trading at a P/E of 12.6, which is slightly higher than its 10-year average P/E of 12.0. As it is reasonable to expect the stock to revert towards its average valuation level in the long run, if this occurs within the next five years, the stock will incur a 1.0% annualized drag due to the contraction of its P/E ratio.
On the other hand, the oil giant is offering a 5.2% dividend and has an exceptional dividend record. While it has paid the same dividend for four consecutive years, it has not cut its dividend since World War II. This is certainly a unique achievement, which renders the dividend as safe as it gets.
Moreover, Shell expects significant production growth within the next three years, as several new projects will come online. While the company currently produces 3.76 M barrels/day, the management expects more than 700,000 barrels/day from projects that will start up this and next year. Although the natural decline of the existing fields will partly offset the new production volumes, the net output growth is still likely to be meaningful. As a result, given also the strength in the oil price, Shell is likely to grow its EPS from $5.79 this year to about $6.75 in 2023. Therefore, the stock is likely to offer a 7.3% average annual return over the next five years thanks to the above implied 3.1% annual EPS growth and its 5.2% dividend, which will be partly offset by a 1.0% annualized P/E contraction.
One of the greatest weaknesses of Shell compared to its peers is the level of its oil and gas reserves. More precisely, the company replenished only 27% of its reserves last year and thus its reserves dropped to 12.2 B barrels of oil equivalent. Consequently, given its current production rate, the duration of its reserves has decreased from 10.5 years in 2015 to 8.9 years. This metric is much worse than that of the other oil majors. For instance, Exxon Mobil, Chevron and BP have proven reserves that are sufficient for 14.5, 11.7 and 13.7 years, respectively. Therefore, Shell will have to increase its capital expenses to improve its level of oil and gas reserves. Fortunately, its management seems to be aware of this issue, as it recently stated that it would increase the capital expenses from $21 B in 2017 to $25-30 B per year in 2018-2020.
#5 Super Major Oil Stock: Eni (E)
Eni is a major oil and gas producer, which is based in Italy and has exploration activity in more than 40 countries. It operates in three segments: exploration & production, gas & power and refining & marketing. However, as its upstream segment generates 88% of its total operating profit, Eni can be considered an almost pure upstream stock. This is a major differentiation from the other oil majors mentioned in this article, which are much more integrated.
Due to its almost pure upstream character, Eni suffered much more than the other oil majors in the 3-year downturn of the oil market. The company incurred the heaviest losses in its peer group in 2015 and a more tolerable loss in 2016. In addition, Eni has a breakeven point of $57 per barrel and aims to reduce it to $55 this year. This is much higher than the breakeven point of most oil majors, who have cut their expenses and reshaped their portfolios more drastically than Eni. For instance, as mentioned above, BP has already lowered its breakeven point to $50 and aims to reduce it to $35-$40 by 2021.
Nevertheless, thanks to its almost pure upstream character, Eni is properly positioned to benefit from the recovery in the oil price. Moreover, the company expects to grow its output by 3.5% per year until 2021 and by 3.0% per year in the following four years.
Source: Investor Presentation
Therefore, it is reasonable to expect Eni to grow its EPS by at least 5.0% per year over the next five years.
On the other hand, the stock has rallied 50% during the last one and a half year. As a result, it is now trading at a P/E of 14.7, which is higher than its 10-year average P/E of 12.5. As the upcycle of its business unwinds in the upcoming years, it is only natural to expect its P/E to revert towards its average level. If this occurs within the next five years, the stock will incur a 3.2% annualized drag due to the contraction of its P/E ratio over this period.
Therefore, the stock is likely to offer a 6.9% average annual return over the next five years thanks to 5.0% EPS growth and its 5.1% dividend, which will be partly offset by a 3.2% annualized P/E contraction.
#6 Super Major Oil Stock: Chevron (CVX)
Chevron is the third-largest oil and gas super major, with a market cap of $242 billion. It currently generates 61% of its earnings from its upstream segment and 39% from its downstream segment.
While Exxon Mobil, BP and Total produce crude oil and natural gas at approximately equal ratios, Chevron is much more leveraged to the oil price, with a 57/43 production ratio. Consequently, while all the oil majors saw their earnings plunge due to the downturn of the oil market, Chevron was the most affected integrated oil major. It posted losses of $0.27 per share in 2016 and its EPS last year were 63% lower than those of 2014.
Chevron has extensively invested in growth projects for years but has failed to grow its output for a whole decade. Oil projects take several years to start bearing fruit. However, Chevron is now in the positive phase of its investing cycle, as it is growing its output thanks to past investments while it has now reduced its capital expenses.
Thanks to the ramp-up of a series of major projects, the company grew its output by 5% last year. Moreover, it expects its Permian production to approximately double by 2021, from 181,000 barrels/day in 2017 to 300,000-400,000 barrels/day in 2021. Overall, it expects to grow its output by 4%-7% this year and by 2%-3% per year for the next five years.
Source: Investor Presentation
Considering this expected output growth and a further appreciation in the oil price in the next five years, it is reasonable to expect Chevron to grow its EPS by about 30% over this period, from $7.31 this year to $9.50 in 2023.
On the other hand, the stock is currently trading at a P/E of 17.3, which is higher than its 10-year average P/E of 15.1. Therefore, if the stock reverts to its average P/E ratio within the next five years, the stock will incur a 2.7% annualized drag due to P/E contraction. As a result, the stock is likely to offer a 6.2% average annual return over the next five years thanks to its 5.4% annual EPS growth and its 3.5% dividend, which will be partly offset by a 2.7% annualized P/E contraction.
Eni is the most leveraged oil major to the oil price, so it benefits the most from the rally of the oil price. However, this has led the stock to trade at a much higher P/E ratio than its historical average. Consequently, a reversion of its valuation towards the mean in the upcoming years will significantly trim its return.
Very similar observations apply to Chevron as well, which is the integrated oil major with the highest sensitivity to the oil price. In other words, the market has priced future growth too fast in the two stocks that benefit the most from higher oil prices. As a result, these two stocks seem to have the lowest potential for future returns from their current level.
On the other hand, Total seems to have the potential to offer the highest 5-year return. Moreover, as it is the most integrated oil major, it has proven the most resilient during downturns. Therefore, investors can invest in the stock at its current price and expect an approximate 12.0% average annual return over the next five years while the stock also offers significant downside protection in the event of a downturn.
Finally, Exxon Mobil seems very attractive at its current price. As the stock has failed to grow its output for a whole decade, it has been punished to the extreme by the market and has thus dramatically underperformed its peers in the last two years. However, the company recently changed its strategy in order to return to a growth trajectory. This shift in its policy is likely to prove a game changer for the oil giant in the long run. Therefore, those who invest in the stock right now are likely to be highly rewarded in the upcoming years.