Big Oil on big discount

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Oil prices have been in a tailspin much of this year leading to a steep drop in WTI prices with Brent Crude sinking in March to its lowest since 2003. Hit by the one-two punch of lower demand from the global coronavirus lockdown and an all-out price war between Saudi Arabia-led OPEC and Russia, the oil market is on the ropes with no recovery in sight.

As travel grinds to a near standstill and global economy on its knees, observers expect oil prices to remain low and market bearish for the foreseeable future. Moreover, when OPEC+ production cuts expire at the end of March, Saudi Arabia and Russia could ramp up oil production pounding oil prices some more.

Not surprisingly, the S&P 500 Energy Index has cratered nearly 60% for the year to date, twice as much as the 30% drop for the S&P 500 index for the same period, as of March 24. These developments have put a spotlight on leading energy producers whose stocks are trading at a large discount to their fair value, providing a margin of safety. This may be an opportune time for investors looking to boost or build some energy exposure and generate some dividend income to get them through these uncertain times.

The second-largest oil company in the U.S., Chevron (CVX) engages in exploration, production, and refining operations across North America, South America, Europe, Africa, Asia, and Australia.

Chevron, with its robust balance sheet, can withstand financial shocks and benefits from an oil-leveraged portfolio that has led to peer-leading margins and returns on capital. “We expect it to maintain its edge as it moves into the next phase of growth, which is centred on leveraging its large Permian Basin position,” says a Morningstar equity report, pointing out the firm aims to deliver a 3% annual production growth through 2024.

Cost-cutting and the addition of higher-margin volumes should lead to greater free cash flow during the next five years. “Given its low debt, we continue to see Chevron as the safest dividend play in the group, as it has ample balance sheet capacity to ride out an extended period of low prices, making its nearly 10% yield not indicative of the dividend’s safety,” says Morningstar sector strategist, Allen Good.

The integrated energy company is also focused on curtailing capital spending and recently announced a 20%, or US$4 billion, reduction to its 2020 capital program. However, Good recently lowered the stock’s fair value from US$115 to US$111, arguing the benefit of lower capital spending would be offset by lower oil prices.

Leading integrated oil and gas company,ExxonMobil (XOM) explores for, produces, and refines oil in North and South America, Europe, the Middle East, North and sub-Saharan Africa, and the Asia-Pacific. The company is the world’s largest refiner and one of the world’s largest manufacturers of commodity and specialty chemicals.

“We continue to rate Exxon as one of the highest-quality integrated firms, given its ability to capture economic rents along the oil and gas value chain,” says a Morningstar equity report.

Unlike its peers, ExxonMobil is planning to ramp up capital spending to double its earnings and cash flow from 2017 levels by 2025. “While investors have been clamoring for greater capital discipline from integrated oils, Exxon’s view is it holds a host of high-return projects that can leverage its superior integrated model and thus warrant investment,” says Good.

The historical returns support the contention that Exxon is the highest-quality integrated and its downstream and chemicals segments are key differentiators. “It stands to reason it should invest to maximize those advantages,” says Good, who recently lowered the stock’s fair value from US$85 to US$76, to reflect near-term lower oil-price assumptions.

The decision to increase investment during the next five years, however, is also likely to narrow the gap in returns with peers, cautions Good, adding lower long-term oil and natural gas prices could mean also lower returns.

European oil major, Royal Dutch Shell (RDS.B) is an integrated oil and gas company with production and refining operations across Europe, Asia, Oceania, Africa, and North and South America.

“Like the rest of the integrated group, Shell has reduced its cost base, which had become bloated, in part by reducing headcount and improving its supply chain,” says a Morningstar equity report.

In the wake of the recent oil-price rout, Shell is taking steps to cut capital spending and crimp operating expenses. “Shell plans to reduce cash capital expenditures to US$20 billion from a planned US$25 billion in 2020 and reduce operating expenses by US$3 billion-US$4 billion from 2019 levels over the next year,” the report says, adding the company will also discontinue its share repurchase program after completing the current US$1 billion tranche.

The move will boost free cash flow, although the sharp decline in oil prices may impede its plans to improve returns and cash flow by 2025 while returning US$125 billion in cash to shareholders.

The company is expected to put share repurchases on hold, but “we do not expect a dividend cut as Shell has the capability to lean on its balance sheet until commodity prices improve, cut capital spending or, if necessary, reintroduce a scrip dividend,” says Good, who pegs the stock’s fair value at US$67, accounting for lower near-term oil and gas prices.

British oil behemoth, BP PLC (BP) explores for, produces, and refines oil around the world.

The company reached a US$23 billion settlement with the U.S. government, for the 2010 Deepwater Horizon accident, eliminating a key element of uncertainty. “The company should be able to meet its liabilities with proceeds from targeted asset sales of US$15 billion through 2019-21,” says a Morningstar equity report.

Strategic divestitures, cost cuts, and curtailed capital spending should help BP compete in a world of lower oil prices. The measures will allow the company to “cover its dividend at US$55 per barrel of oil,” says Good, adding that “break-even levels [could] continue trending downward to below US$50 by 2021.”

The company’s cost reduction steps have already realized US$7 billion, or 20%, from 2014 levels. “With the firm already one of the lower-cost producers of its peer group, cost reductions will improve margins further,” says Good.

On the other hand, organic capital spending will fall to US$15 billion-US$17 billion per year until 2021, sharply lower than US$25 billion in 2013. “At this level, BP will continue to invest the least among the peer group for its level of production,” says Good, who recently reduced the stock’s fair value from US$52 to US$47, incorporating lower oil prices.

That said, he adds, BP will continue to grow through a mix of projects already under construction or nearing completion.