How to Profit From the Oil Crash

Two bucks buys you a gallon of gas in many parts of the country these days. But if you think that’s a bargain, check out the deals on energy stocks, which haven’t looked this attractive since the mid 1980s, when Dallas’s J.R. Ewing was scheming to crush his enemies and expand his empire.

Collapsing crude prices have vaporized energy-company profits, pushing down stocks in the sector by 12% in the past year. But the sell-off may have gone too far. Today, stocks of large energy companies trade at an average of 1.6 times book value (assets minus liabilities). That’s 33% below the sector’s 30-year average price-to-book-value ratio of 2.4, according to Bank of America Merrill Lynch. (The situation is similar to the mid 1980s, when a supply glut pushed the price of a barrel of oil to less than $10.) If book values return to normal, Merrill Lynch says, energy stocks could climb about 50% from here.

Granted, oil won’t miraculously jump back to $100 a barrel tomorrow. Kiplinger forecasts that West Texas Intermediate crude will fetch $45 to $55 a barrel in 2016, up only slightly from the current price of $40. Producers are simply pumping too much oil for global economies to absorb. And even with demand at record highs, global oil stockpiles recently hit a record 3 billion barrels—a “massive cushion” that won’t be relieved soon, according to the Paris-based International Energy Agency.

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Yet it doesn’t take a leap of faith to see prices gradually recovering. Companies are drilling far fewer wells in North America. U.S. oil production has slumped from a peak of 9.6 million barrels a day last June to an estimated 9.2 million in November. Companies have also scaled back sharply on drilling and exploration in high-cost areas, such as the Arctic and deep-water regions of the Gulf of Mexico. The upshot: Supplies aren’t likely to increase as fast in the future, bringing the market closer to equilibrium and supporting higher prices.

Even if oil doesn’t recover to $80 a barrel or more, many energy companies can fare well. Below are our seven top picks, starting with the biggest producers, followed by smaller oil drillers and other players in the energy patch, such as refiners and gas-pipeline stocks. As a bonus, all but one of our picks deliver above-average dividend yields. Clean-energy companies, such as solar-panel makers, didn’t make our cut because the businesses still look too speculative. (All prices are as of November 30.)

1. ExxonMobil (symbol XOM, $82, yield 3.6%) Exxon, the supertanker of energy stocks, earns money from both oil-and-gas production, known as the upstream part of an energy company, and such downstream businesses as refining and gas stations. By the time the books are closed on 2015, revenues are expected to have tumbled by 38%, to an estimated $255 billion. But Exxon is getting leaner, slashing operating costs and trimming its budget for new projects to help shore up profits. Exxon is also one of only three publicly traded companies with a higher credit rating than Uncle Sam (though Standard & Poor’s says it may trim the firm’s triple-A rating within the next two years).

Exxon’s oil-and-gas production isn’t rising as fast as that of smaller companies. But Exxon still aims to boost 2017 production by 5% from 2015 levels. The business has historically earned higher returns on capital (a measure of profitability) than major rivals. And Exxon’s financial strength gives it flexibility to buy distressed companies with assets that could boost its bottom line.

Exxon also pays investors to wait for a rebound with a dividend that’s sacrosanct. Even with profits expected to plunge 46% in 2015, the company hiked its payout by 5.8% in April, pushing its streak of annual dividend increases to 33 years.

2. Chevron (CVX, $91, 4.7%) Chevron, another colossus, made some massive bets in recent years, plowing more than $107 billion into projects ranging from a liquefied natural gas plant in Australia to oil wells off the coast of West Africa. With several of those projects now up and running, the payoff to investors should be on the way. Chevron expects to boost oil-and-gas production by 13% to 15% in 2016 and in 2017, propelling earnings from an estimated $3.32 per share in 2015 to $6.04 in 2017.

In the near term, Chevron isn’t making enough money to fully cover its dividend. But CEO John Watson says his priority is to keep payments intact and raise the dividend over time. To bridge the funding gap, the company is scaling back on natural-gas drilling in the U.S. and on other projects, and it’s cutting its budget for oil-and-gas development from an estimated $35 billion in 2015 to no more than $28 billion in 2016. Those moves should help shore up its finances until 2017, when Chevron expects free cash flow (cash flow minus the capital expenditures needed to maintain or expand the business) to cover its dividend. Chevron’s strength remains its “steady plan” to engage in projects with high profit margins, says Deutsche Bank, which rates the stock a “buy.”

3. Occidental Petroleum (OXY, $76, 4%) One of the largest domestic energy companies, Occidental is like a “mini major,” with a mix of oil-and-gas production, pipelines and chemical refineries. Its balance sheet is relatively healthy, with $6.8 billion in long-term debt offset by $2.5 billion in cash. Moreover, although most domestic drillers are spending more on capital projects than they are generating in cash flow simply to keep production flat, Oxy should be able to both boost production and deliver robust levels of free cash flow, says BMO Capital Markets.

Underpinning its business, Oxy owns a deep inventory of wells in the Permian region of Texas and New Mexico, one of the areas in the U.S. that is most conducive to the economic production of oil. If oil manages to stay above $60 a barrel—a price at which it becomes profitable to drill a lot more wells—Occidental estimates that it has 27 years’ worth of production in that region alone. Occidental also owns a 40% stake in a natural-gas production business in the United Arab Emirates, and it’s expanding into chemical production with a new ethylene plant slated to start up in 2017.

Oxy’s stock isn’t the cheapest—at 1.9 times book value, it trades above the industry average. But the company is one of the best positioned to weather a long period of low oil prices, making the stock compelling, says BMO, which recently raised its 12-month price target from $75 to $85. Oxy should also be able to keep hiking its dividend, which it has raised 13 years in a row.

4. EOG Resources (EOG, $83, 0.8%) EOG may not make much money if oil stays in the $40s. But the domestic U.S. producer has some key advantages that could make it a home-run investment if the commodity rebounds.

EOG owns some of the premier oil-shale locations in the U.S., says Barclays, with vast acreage in areas such as North Dakota’s Bakken region, as well as the Permian and Eagle Ford basins of Texas. EOG runs a tight ship, too. It isn’t laden with debt, so it has the ability to buy assets. And it’s well managed financially, earning an 8.8% return on invested capital, compared with an industry average of 4.8%.

Low oil prices are forcing EOG to slash spending on exploration, and Wall Street expected the company to post a loss of $3.5 billion in 2015, largely due to some big asset write-offs. Yet rather than pump more oil at rock-bottom prices, EOG is waiting for a rebound before completing 320 of its wells. Moreover, EOG can make money with oil in the $50s: Its “best and largest” well opportunities generate 40% after-tax returns with oil priced at $50 per barrel, according to Barclays, which rates the stock a “buy.”

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5. Valero Energy (VLO, $72, 2.8%) The world’s largest independent refiner, Valero is raking in profits these days. Falling prices for crude oil and natural gas (its primary “feedstocks”) have boosted profit margins on its refined products. And with demand running strong, Valero reported net income of $1.4 billion in the third quarter of 2015, up 30% from the same period a year earlier. Valero also hiked its quarterly dividend by 25%, to 50 cents a share, bringing its total payout increase for 2015 to a whopping 82%.

One of Valero’s big advantages is the prime location of its refineries, which are along the Gulf Coast of Texas and Louisiana and not far from oil fields in the region. Valero also looks well positioned to export more refined products to Latin America and other areas where demand is climbing, says Robert Thummel, a fund manager at Tortoise Capital Advisors, an investment firm in Kansas City, Kan., that specializes in energy.

Valero’s good times would end if oil rebounded to $70 a barrel; profit margins would shrink, and demand for various fuel products could slump. Yet Valero has other revenue streams to help it stay afloat. It controls Valero Energy Partners (VLP), a master limited partnership that owns pipelines as well as storage and logistics businesses. Valero also sells fuel at more than 7,000 gas stations and operates 11 ethanol plants. Even if oil prices rise modestly, says Thummel, the stock “should continue to be a strong performer.”

6. Spectra Energy Partners (SEP, $42, 5.9%) As a master limited part­nership, Spectra shells out most of its available cash to investors every three months. Its 5.9% yield isn’t the highest among MLPs, which pay 8.5% on average. But Spectra has hiked its distribution for 32 quarters in a row, and it shows no signs of ending the streak, with plans to raise its distribution at an annual rate of 8% to 9% through 2017.Fueling growth are plans to spend $20 billion on new pipelines and other projects. Spectra already owns key pipelines in the Marcellus/Utica shale regions of Pennsylvania and Ohio, where gas production is thriving. Plans are under way to expand the network to deliver more gas to customers in the Northeast and Canada, along with manufacturing plants in the South, where demand for the commodity is high. Moreover, low gas prices aren’t a problem for Spectra because 95% of its pipeline capacity has been booked in advance, and customers pay by the volume of gas shipped, not the price.

All told, Spectra has “one of the most visible slates of opportunities” in the business, says Credit Suisse analyst John Edwards, who rates the stock a “buy,” with a 12-month price target of $61. (Keep in mind that MLPs have tricky tax consequences; consult your tax adviser before investing.)

7. Schlumberger (SLB, $77, 2.6%) There’s no sugarcoating the fact that things look bleak for Schlumberger, the world’s largest energy-services company. Customers are cutting spending on drilling and exploration, the industry has excess capacity, and prices are being squeezed. Yet business won’t stay this bad forever. Spending on oil-and-gas projects is likely to revive in 2017, fueling a rebound in sales, says RBC Capital Markets. Paris-based Schlumberger bought oil-well equipment maker Cameron International in 2015, expanding its suite of services. Even before that deal, Schlumberger had industry-leading technologies to help drillers squeeze more oil from wells and trim production costs. The firm’s non-U.S. business should improve, too, boosted by drilling projects that may not make money here with oil at $50, but can do so overseas.

Betting on Schlumberger won’t pay off if oil prices stay in the tank. But analysts see sales climbing 12% from 2016 to 2017, reaching $36.4 billion, with profits jumping 34% (after slumping in 2015 and 2016). At its current share price, Schlumberger’s “upside opportunity” beats the downside risk, says RBC analyst Kurt Hallead, who sees the stock hitting $92 within 12 months.

Funds for playing the recovery

Picking stocks isn’t the only way to play a recovery in oil. funds can get the job done, too. One way to keep it simple: Stick with a passively managed exchange-traded fund, such as Energy Select Sector SPDR ETF (symbol XLE). Tracking the energy stocks in Standard & Poor’s 500-stock index, the ETF recently held 38% of its assets in three global giants: ExxonMobil, Chevron and Schlumberger. The fund yields 3.0%, but that didn’t prevent it from losing 12.5% over the past year. Its annual expense ratio is just 0.15%. (Returns are through November 30.)

Another worthy unmanaged fund is iShares U.S. Oil & Gas Exploration & Production ETF (IEO). Focusing mainly on domestic producers, the ETF had 27% of its assets in re­finers, such as Phillips 66 and Valero. These businesses make more money when oil prices are low, giving the ETF some support if the commodity stays depressed. The fund, which charges 0.43% annually, lost 12.0% over the past year.

If you prefer an actively managed fund, consider Fidelity Select Energy Portfolio (FSENX). The fund, which lost 10.8% over the past year, beat 92% of its rivals over the past five years. Manager John Dowd says he’s focusing on high-quality domestic drillers with “prime acreage” in major U.S. shale regions—stocks that should climb sharply if oil prices eventually perk up. Annual fees of 0.79% are reasonable.