Should You Buy Oil Stocks Now?


Futures for West Texas Intermediate crude oil fell below zero on April 20, bottoming out below negative-$38 per barrel. In other words, traders were paying buyers to take the contracts. And while yesterday’s disaster was partly a bizarre quirk of timing — the contracts were for early May deliveries, and many of the traders didn’t have storage lined up and had to pay others to take the contracts off their hands — it was also an indicator just how incredibly imbalanced the supply and demand sides of the oil industry are. 

Even after yesterday’s bloodbath, oil futures are still very beaten down. June West Texas futures are trading below $14 per barrel at recent prices. Brent, widely considered the most important global benchmark, is down 25% today, with June contracts below $20 per barrel at recent prices. 

Some of the biggest names in the business are taking a beating. Shares of oil producers Occidental Petroleum (NYSE:OXY) and ConocoPhillips (NYSE:COP) are down 74% and 50%, respectively. Oil-field services giant Baker Hughes (NYSE:BKR) stock is down by half. Even integrated giants like ExxonMobil (NYSE:XOM), Royal Dutch Shell (NYSE:RDS.A)(NYSE:RDS.B) and Phillips 66 (NYSE:PSX) have lost more than 40% of their value. 

Two hands holding blocks with letters that spell risk and reward.

Image source: Getty Images.

There are a handful of sayings that investors often repeat during these sorts of troubled times. The two most popular are Warren Buffett’s being “greedy when others are fearful,” and one that’s been attributed to a number of people — “buy when there’s blood in the streets.” Is now one of those times? It sure feels like it. 

Is it time to buy oil stocks? My answer is, in most cases, no. Yes, there is often immense opportunity to profit during times of uncertainty, but the oil and gas industry is a minefield for individual investors at present. Until the risk/reward profile improves, it may be better to stay on the sidelines. 

Unprecedented supply and demand imbalance

Global oil demand has falling catastrophically because of the spread of the coronavirus that causes COVID-19, and it’s far from clear how soon — or how much — that demand will recover. Estimates are pretty broad, but it’s expected that oil consumption could fall more than 30 million barrels per day in April and May, a 30% decline in oil demand. “Unprecedented” simply isn’t a big enough word to describe the repercussions such a dramatic decline in global oil demand.  

As a result, the supply side is in complete disarray. The industry isn’t built to deal with a 5% drop in demand, much less the massive 30% drop we have experienced. We saw that on April 20. When oil traders were left holding contracts for oil deliveries in a few weeks that they didn’t have storage for, they were forced to pay others to take the contracts off their hands. 

April 20 could prove to be the bottom; it’s going to be hard to top (or bottom) a situation where traders are paying nearly $40 per barrel to get out of contracts. But it’s a mistake to assume that the environment will only improve from here. Oil prices are certainly going to improve, but the reality is, oil prices are set to remain far below profitable levels for many oil companies for months to come. 

It won’t get better overnight

Global oil demand is expected to be down 30 million barrels per day or more from levels before the COVID-19 pandemic. And while that’s certainly the biggest reason oil prices have crashed and why so many industry participants are at risk of insolvency, it’s only part of the picture. Since April 1, global oil production has actually increased, following the expiration of a prior production regime between OPEC and Russia. 

That could remain the case until May 1, when the landmark deal to take 10 million barrels per day off the market kicks in. Before that happens, the world will have gone for potentially a full month of production exceeding consumption somewhere between 30 million and 40 million barrels of oil every single day. 

Even when the calendar turns to May, there will still be more oil getting pumped out of the ground than is being consumed. Oil markets are already pricing this expectation in. West Texas Intermediate futures trade below $30 per barrel as far out as February of next year. 

What it means for oil stocks

Let’s start with this reality: Not all of the oil produced in North America trades on futures exchanges, and the prices you see stated aren’t necessarily the prices oil companies get for their production. A lot of oil produced is sold under private contracts and directly by oil producers to customers like refiners. Yesterday is an excellent example of when traders took a beating on oil prices, and not oil companies directly. 

But futures do set the market, and it’s clear that there’s very little appetite for American oil at present. That’s likely to remain the case for many months to come. Even as demand starts to recover as the economic impacts of the COVID-19 recession lessens, there will be months and months of excess oil that the industry will work through before oil producers can start ramping production back up. You can bet that anyone who’s storing oil will get more and more interested in selling it the longer they’re stuck paying for storage. So low prices could remain the norm even months after demand starts to recover. 

And that, plain and simple, could mean it takes far, far longer for any overall economic recovery to show up on the bottom lines of oil companies. Frankly, I expect to see a swath of bankruptcies in the sector as this downturn stretches on. And it’s not just onshore oil that’s at risk. Offshore drilling stocks never really recovered from the 2016 crash, and Diamond Offshore Drilling (NYSE:DO) is not expected to make its next interest payment. That means the company will probably default on all of its debt, a precursor to going bankrupt. 

Are there any oil stocks worth buying?

Investors would do well to stay away from companies too closely tied to oil production. A company like Occidental may look enticing because its stock price is down 75%, but it’s going to spend billions of dollars simply to stay afloat, and it could be 2021 before oil prices have risen above production costs, much less become profitable. Baker Hughes and other oilfield services companies may not sell oil, but they count on producers to make a living. That means they’re going to suffer just as much, while also getting stuck potentially waiting on a bankruptcy court to award them payment from customers that become insolvent. 

If you’re set on investing in oil, the best place to look is the integrated majors. My top two are Shell and Phillips 66. Shell has a large natural gas business that helps offset some of its still substantial exposure to oil production, while Phillips 66 doesn’t produce oil. Both companies will see big losses from their refining operations because of the crash in demand for motor fuels, but between their strengths in natural gas and petrochemicals, along with sizable cash balances, both are built to ride out the downturn and should prove quite profitable when the recovery finally kicks in. 

The big risk here is that the recovery could take a lot longer than investors expect, and at the expense of missing out on better opportunities outside the oil patch. 

 





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