Oil and gas prices are cyclical in nature. The recent downturn in energy prices that started in 2014 has pushed energy stock prices, earnings and dividends lower. The question on the minds of many investors is what to do with their energy investments. I believe that studying history should provide some perspective on the situation.
Over the past 60 – 70 years, oil prices have generally moved up. However, this was not a gradual increase each year. It was rather a series of violent moves up and down, in order to confuse the maximum number of participants. For example, in the 1970s, oil prices move up a lot. During the 1980s, oil prices were mostly flat, with the occasional spike and bust ( like in 1986). The 1990s started out strong with the spike around the time of the first gulf war, only to keep sliding all the way down to multi-decade lows achieved in 1998.
Commodity producers are price takers – readers who read my analysis of BHP Billiton Limited (ADR) (NYSE:BHP) in 2013 hopefully learned that lesson, and avoided buying this company. There is very limited product differentiation between different types of crude for example, which is not sufficient to warrant a price premium that is immune to downward pressure in oil prices in general.
Cyclical companies are flush with cash and earn record profits at the top of the economic cycle. This is when high profits and high earnings per share result in very low P/E ratios. This is referred to as the peak earnings trap. For example, back in 2012, Exxon Mobil Corporation (NYSE:XOM) earned $9.70/share and sold at $86.55/share. This translated into a P/E ratio of 8.90. The company paid $2.18/share in dividends in 2012, which appeared to have very good coverage from earnings. Chevron Corporation (NYSE:CVX) on the other hand earned $13.32/share in 2012 and paid out $3.51/share in dividends. The stock price at $108.14/share looked cheap with a P/E ratio of 8.10. While I knew about the peak earnings trap, I viewed energy companies as better investments than other commodity plays such as metal companies.
At the bottom of the cycle however, profits are low. Given low earnings per share, P/E ratios look extremely high. Dividends look unsustainable. The bottom of the cycle is a trying time for investors, because it tests their patience. Investors’ patience is tested, because the fundamentals look terrible.
For example, Chevron Corporation (NYSE:CVX) closed 2015 at $89.96/share. The stock appeared very expensive with a P/E ratio of 36.70, if you are using the 2015 earnings of $2.45/share. Those earnings do not even cover the annual dividend of $4.28/share. In the case of ExxonMobil, the stock closed in 2015 at $77.95/share. The company earned $3.85/share in 2015, and paid $2.88 in annual dividend income. this translates into a P/E ratio of 20.20. The dividend is covered by earnings, and was recently increased. Chevron on the other hand is on track to lose its status of a dividend champion if it doesn’t raise dividends this year. I am on the record as stating that ExxonMobil’s dividend is possibly the only safe dividend in the energy sector today. This is why I am looking to adding to my position if we get further weakness in valuations.
At the end of 2015 there were 68 investors tracked by Insider Monkey with long stakes in Exxon Mobil valued at $3.08 billion, which amounted to just 0.9% of its float. That same pool of investors owned an identical 0.90% of Chevron’s float, as 44 investors had holdings worth a combined $1.48 billion. Thomas Bailard’s Bailard Inc opened a position in both stocks during the first quarter.