Global markets oftentimes react overly hard to news and situations that will only have a short-term impact. This is especially true for oil markets, where short-term issues, such as the attack on the Aramco (ARMCO) oil facilities last fall, can lead to massive price movements -despite the fact that there basically was no lasting impact on Saudi Arabia’s oil output. On the other hand, overreactions to the downside occur as well, and one such case is the current panic over the coronavirus outbreak that is so far mainly centered on Wuhan, China.
Oil prices have declined rapidly over the last two weeks, and the stocks of many oil-related companies have suffered a lot during that time frame, as markets had already been jitterish due to factors such as climate change protests and BlackRock’s (BLK) decarbonization moves.
In the long run, the coronavirus will most likely not result in a meaningful change in global oil consumption, thus the market’s current overreaction allows investors to scoop up shares of many energy-related companies at highly attractive prices. In many cases, this goes hand in hand with compelling initial dividend yields for investors that buy right here.
Source: Seeking Alpha’s image bank
What Will The Coronavirus Outbreak Mean For Global Oil Markets In The Long Run?
It is not possible to forecast what the coronavirus will do exactly, but we can look at similar outbreaks in the past, and at the impacts these past outbreaks did have on the global economy.
The current coronavirus outbreak is oftentimes compared to the SARS outbreak at the beginning of the current century. Said SARS outbreak reduced China’s GDP by an estimated 0.8% in 2003. The economy recovered quickly, though, and equity markets in China regained their lost ground in just 6 months back then. As the Chinese government is doing a lot to stop the outbreak, and as it has already started to inject additional liquidity into markets and taken measures to boost its economy, it is unlikely that the impact of the current virus outbreak will last for a very long time, and it is indeed plausible that this will, just as the SARS outbreak, be a near-term problem only, with no long-lasting impact.
Once the outbreak is under control, which will most likely happen in a couple of months at most, flights to and from China will resume, cruise lines will operate as they did before the outbreak, and international trade will get back on track. In short, oil demand should go back up towards the level where it was before the outbreak.
On top of that, additional demand will come to the market over the next couple of quarters and years, from economic growth, rising consumer spending (especially in countries with a fast-growing middle class such as India), etc. The EIA forecasts that global oil consumption will rise by 2.7 million barrels daily this year and next, with growth accelerating meaningfully from the level set in 2019.
The coronavirus outbreak will thus most likely get under control in the very near term and should not hurt oil demand in the long run, while other factors lead to sizeable consumption growth over the next two years. It, therefore, seems unlikely that oil prices will remain at the very low levels they are at right now for long:
It seems likely that oil prices will reclaim the $60-mark eventually, possibly rising much higher than that due to ongoing demand growth and the potential for supply disruption in countries such as Venezuela, Libya, and Iran. Despite the fact that the long-term outlook for oil prices is thus not too bad, many oil-related companies have seen their share prices get devastated, which allows investors with a long-term view to scoop up shares at bargain prices:
We witness share price declines for the whole energy industry, as the Energy Select SPDR ETF (XLE) trades 21% below its recent highs, driven by price declines across different sub-sectors, such as oil and gas production (which includes companies like Shell (RDS.A)(RDS.B)) and refining (which includes companies such as Marathon Petroleum (MPC)). The whole industry looks oversold right here, but some companies look especially attractive at the current price.
Risks For Oil Prices And Oil Stocks
The rate of new coronavirus infections has slowed down over the last couple of days, and experts believe that the outbreak will be dealt with by April, if not earlier. There is still some risk that the outbreak will have a longer duration than what experts are forecasting right now, which could result in a steeper decline in global oil demand over a longer period of time, which would mean that oil prices could remain at a low level for a while.
Oil prices could also come under pressure over a longer period of time in case the global economy gets into a recession or major economic slowdown. The IMF forecasts accelerating growth for 2020 (3.3% rise in global GDP, versus a 2.9% increase in 2019), thus a downturn does not look very likely right now, yet such a development should also not be ruled out completely.
Another risk for oil companies with a large asset base in the US could come from politics. Elizabeth Warren is a pronounced opponent of shale oil production; in case she becomes president, US-focused oil companies could get into trouble, as their growth would likely grind to a halt. Right now the forecasting website predictit.org gives Elizabeth Warren a chance of winning of around 2%, thus an Elizabeth Warren presidency is not a very likely outcome. Nevertheless, investors should still keep in mind that political decisions can have a large impact on both global oil prices, as well as on the fate of specific oil companies.
If either of these risks materializes, which does not seem overly likely, but which cannot be ruled out, my outlook on oil prices and on oil stocks would be less bullish. The five stocks I cover more closely in this article would most likely still not falter away completely, though, as they generally are large players with healthy balance sheets that do not belong to the riskiest investments in the industry.
First Stock That Is A Great Deal: Exxon Mobil
Exxon Mobil (XOM) is the biggest oil company in the US, with a strong long-term track record, delivering about 8,000% total returns since the 1970s (per YCharts). Over the last decade, on the other hand, Exxon Mobil’s performance has not been strong at all: Its share price actually declined by 7% during that time frame, and shares have fallen to 10-year lows over the last couple of weeks.
Now when a company with a positive long-term track record suddenly trades at a very low price, this can be a great time to accumulate, as it is not unlikely that the factors that were responsible for the strong performance of the past will allow for solid returns in the future, too.
In Exxon Mobil’s case, one such factor is its dividend. The current yield is 5.8%, the highest on record – buying while the initial dividend yield is high is a great way to boost long-term returns. Even if Exxon Mobil managed to generate share price growth of just 2-3% annually going forward, investors would still be looking at attractive total returns in the 8-9% range. Due to Exxon Mobil’s plans to boost production to at least 5 million barrels a day by 2025, there is significant free cash flow upside:
Source: Exxon Mobil presentation
The company plans to generate more than $60 billion in annual cash flows by 2025, which should allow for free cash flows in the $30 billion range, assuming capital expenditures remain around $30-35 billion. Annual free cash flows of around $30 billion, or even more if oil prices rise to a higher level, should allow for share price gains over the coming years, as Exxon Mobil is valued at just $250 billion right now.
Second Stock That Is A Great Deal: BP
BP (BP) is, like Exxon Mobil, a member of the so-called supermajors, a group of leading oil and gas companies with vast, diversified, upstream and downstream operations. Following the Gulf of Mexico disaster that happened a couple of years ago, BP had to pay dozens of billions in compensation, and the company was forced to sell many of its assets. The impact of the GoM disaster is dealt with now, though, and the company can focus on the future.
BP generates, relative to its market capitalization of just $125 billion, strong free cash flows, and rewards investors with a very attractive dividend yielding 6.8% right now, following a dividend raise a couple of days ago.
The company generated operating cash flows of $26 billion over the last four quarters, which means that shares are valued at below 5 times annual cash flows right here, which looks like a very inexpensive valuation. With capital expenditures of around $15 billion, the company has more than $10 billion that is available for dividends, share repurchases, or debt reduction, which means that BP’s dividend is well-covered.
BP expects that free cash flows will rise to an even more attractive $14-15 billion by 2021. When we put a free cash flow multiple of just 10 on that amount, there is upside potential of around 20% for BP’s shares over the next two years, in addition to its juicy dividend yielding almost 7%, which could easily result in double-digit total returns going forward.
Third Stock That Is A Great Deal: Phillips 66
Over the last couple of months, Phillips 66 has seen its shares decline from $120 back to around $90. This 25% cut in its price has made shares significantly less expensive and has resulted in a much higher dividend yield. Right now shares are trading with a dividend yield of 3.9%, and it is very likely that the company will increase its dividend in the near future: The dividend has, over the last couple of years, always been raised in May, and thanks to a 5-year dividend growth rate of 13% investors can count on another sizeable increase in just three months, which should bring the company’s dividend yield to more than 4%.
Phillips 66 sports return on equity and on capital employed of 19% and 10%, respectively, despite a weak environment for the refining industry over the last couple of quarters. In a more supportive environment, these returns will be even higher. On top of that, Phillips 66 is also performing well in another category Buffett cares about, which is payouts to the company’s owners. Through its market-beating dividend and steady share repurchases, shareholders benefit from a shareholder yield of close to 11%.
Even without the impact of new projects coming online, and excluding the potential for multiple expansion, dividend reinvestment and the impact of buybacks alone could result in double-digit annual returns from the current level, which makes Phillips 66 look quite attractive at its current price.
Fourth Stock That Is A Great Deal: Energy Transfer
Energy Transfer (ET) is a leading pipeline company that has seen its share price come under pressure over the last couple of quarters. Over the last month alone, Energy Transfer’s share price declined by close to 10%, which has made its dividend yield jump to a massive 9.4%. Energy Transfer issues a K-1, which is one of the reasons why some investors have shied away from the company in the past, as peers that issue a Form 1099, such as Kinder Morgan (KMI), make tax season a lot easier for retail investors.
Despite a more complicated tax situation relative to some peers, Energy Transfer still offers a very high dividend yield and share price upside potential from the current level. The dividend yielding more than 9% would be attractive all by itself, but on top of that Energy Transfer also has generated significant distributable cash flow growth in the past, while its low valuation allows for multiple expansion tailwinds over the next couple of years.
Source: Energy Transfer presentation
The company was able to grow its EBITDA by almost 20% annually between 2015 and 2019, which is quite extraordinary, although it should be noted that this growth was partially driven by acquisitions.
Another reason investors have shied away from Energy Transfer is its debt, which has grown to $47 billion over the last three years:
This sounds like a lot, but investors should not look at debt in a vacuum, but rather focus on debt relative to the cash flows that the company generates. For Energy Transfer, which generates about $10 billion in EBITDA a year, the leverage is not too high, at ~4.5 times annual EBITDA. For a company with reliable cash flows that has long-term contracts with its customers, a leverage ratio in the 4-5 times range is not unreasonable at all. Debt is not a major problem for Energy Transfer, but many retail investors nevertheless don’t want to invest in Energy Transfer due to its balance sheet.
The positive is that this allows other investors to buy shares at a very low price, as Energy Transfer trades at just 6 times distributable cash flows, while its 9.4% dividend yield is covered at a ratio of 1.9. This means that the risk of a dividend cut is not high, and the company’s potential to invest huge surplus cash flows into growth projects, debt reduction, or share repurchases should result in meaningful share price appreciation over the next couple of years.
Over the last year, the average price target has moved down a bit, but its upside potential is still very large, at more than 55%. Even if just a fraction of that upside potential materializes, investors would still be looking at total returns in the 10%+ range, which is quite attractive.
Fifth Stock That Is A Great Deal: Chevron
Chevron (CVX) is, behind Exxon Mobil, the second-largest US-based oil and gas company. It has, like many of its peers, seen its share price fall to new 52-week lows over the last couple of weeks, which has made its dividend yield climb to 4.7%, the highest level in years.
Chevron has generated free cash flows of $13 billion over the last four quarters, which results in a free cash flow yield of 6.5%. This easily covers Chevron’s dividend payments. On top of paying out dividends that provide a return of almost 5% all alone, Chevron also has started to buy back shares again, with the buyback pace standing at $5 billion a year, which equates to 2.5% of its float being repurchased every year.
On top of that, Chevron will continue to benefit from a large recent growth program, with major projects such as Gorgon and Wheatstone providing huge cash flows over the coming years and decades. Chevron also plans to increase its Permian basin oil production to as much as 900,000 barrels daily by 2025, which should help drive the company’s cash flows and earnings upwards over the next couple of years.
Due to Chevron’s growth investments and the impact that its buybacks will have on its earnings per share growth rate, it is not surprising that analysts are forecasting long-term earnings per share growth rates of around 7%:
This forecasted long-term growth, coupled with a dividend that yields close to 5%, could easily result in double-digit annual returns from the current level. Upside potential in the near term is not bad at all either, as analysts believe that shares are undervalued by well above 20% right here.
Buying when others are fearful has allowed for market-beating returns in the past, and it seems opportune to assume that the same will be true in the future as well. It seems unlikely that the coronavirus will lead to lower energy demand in the long run, thus the current panic allows long-term oriented investors to buy shares in quality companies at attractive prices.
There are many stocks to choose from, but the large and high-yielding companies shown in this article are a good starting point for investors interested in benefiting from the recent market worries by buying quality stocks well below fair value while locking in attractive dividend yields at the same time.
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Disclosure: I am/we are long RDS.A, PSX, ET. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.