Now is the time to buy oil stocks?

Oil prices have been volatile in recent days as investors fear the omicron variant of the coronavirus could lead to widespread economic shutdowns. It could very well happen, but the whole picture for energy stocks will not materially change, even if it does. Here’s why now might still be a good time to buy oil stocks, and why you need to be careful about which ones you choose.

Inherently volatile

Oil is a cyclical industry, with demand tending to fluctuate with economic activity. And since oil is essentially a commodity, there is little that energy companies can do to differentiate their products. Thus, the industry’s financial results tend to rise and fall with the highly variable price of oil. This is how the sector works. Notably, when demand fell sharply due to economic shutdowns used to slow the spread of the coronavirus in 2020, energy companies suffered, as did their inventories. Although demand has returned, the new omicron variant has investors once again worried about closures. And, therefore, the volatility of oil and energy prices is high.

Image source: Getty Images.

But the long-term picture here hasn’t changed. For starters, carbonaceous fuels like petroleum will lose shares in the wider energy space in favor of cleaner alternatives in the long run. However, over the next two decades, increasing global demand for energy will likely offset this and lead to increased demand for oil and natural gas in absolute terms. This suggests that the still strong demand for oil will continue for years to come, bolstering the activities of the companies that produce it.

ExxonMobil (NYSE: XOM) CEO Darrin Woods summed this up recently in a company update, noting that, “Where there are no practical alternatives, people will continue to need the products we make for. decades to come. And so we will continue to responsibly meet the energy needs of people, consumer products and other advanced materials. ” But in that statement is the big divide that investors need to be aware of in the field of energy.

Support the right horses

Exxon and American counterpart Chevron (NYSE: CVX) have been relatively slow to tackle the clean energy transition that is taking place today. They essentially see a long trail for oil and are moving slowly to change their business. Both are industry giants, with integrated business models that span from upstream (drilling) to downstream (refining and chemicals). For most investors, this inherently diverse approach to the industry is probably a better option than a pure driller, who will likely see performance rise and fall more dramatically with the price of oil. Indeed, if you think oil is still important and will continue to be, then Exxon and Chevron should be on your shortlist as relatively pure bets on space.

Notably, both have historically high dividend yields backed by companies that have proven their commitment to sustaining their dividends over decades. It’s also worth noting that these two industry giants also have very strong balance sheets, with debt ratios near the bottom of their integrated energy peer group. This gives them the flexibility to get through tough times while still paying their dividends.

XOM debt-to-equity ratio chart
Data by YCharts.

However, it is not clear when the entire energy industry will switch to clean energy and when the demand for carbon fuels will begin to decline in absolute terms. Exxon and Chevron, and those who invest in them, bet the time is far away. Companies like PA (NYSE: BP), Shell (NYSE: RDS.B), and TotalEnergies (NYSE: TTE) take a slightly different approach. They are all now working to build clean energy companies using cash flow from their oil and gas operations to fund necessary investments. It’s sort of a middle-of-the-road approach that allows investors to own oil stocks with a clean energy safety valve, if you will.

There are still some important differences here. For example, BP’s balance sheet is heavily indebted compared to its peers. This helps explain why he cut his dividend to help fund his efforts to invest more aggressively in clean energy. Most investors are likely to want to avoid BP given the other alternatives in the integrated energy space.

This brings Shell and TotalEnergies. Shell has also reduced its dividend by redefining its business priorities to include clean energy. However, it has returned to the path of dividend growth, with three dividend increases since its cut in early 2020. The company’s performance is weak relative to its peers, but it is probably best positioned to deliver slow growth. and regular dividends while it changes with the world around it.

XOM Dividend Yield Chart
Data by YCharts.

TotalEnergies’ position has been to support its dividend in the same type of transition. This does mean, however, that the high relative return here is unlikely to be accompanied by steady increases in dividends. Investors are therefore trading a high current yield for lower dividend growth. Nonetheless, if you are looking to maximize the income you generate, this might be the perfect fit for you.

Is it time to buy oil?

As with so many things in investing, the answer to buy or not to buy in the oil space today is: it depends. The industry is likely to benefit from strong demand for years to come, so there is no reason to avoid it per se. So the fears of the omicron variant could be a buying opportunity. That said, for most investors, it makes more sense to stick with the biggest names in the space, which are the integrated energy giants highlighted above. But within this group there are different stories. Exxon and Chevron are basically pure games, with the intention of sticking to their oil goal as long as possible. BP, Shell and TotalEnergies are starting the shift towards clean energies, but are taking different paths. BP’s leverage is worrying, Shell has reduced its dividend but is growing it again, and TotalEnergies is trying to balance the energy transition while supporting its current payout.

While all of this means that there are a lot of variations to consider here, it also means that you will likely be able to find an oil name that suits your needs well.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

Steve R. Hansen