Mega-cap energy stocks might not be particularly exciting, but anyone who has been invested in this group in the past five months has a lot to celebrate. Since the market touched bottom on Oct. 3, Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP) have produced total returns of 19.2%, 22.4% and 26.6%, respectively.
As these stocks continue to trade near their 52-week highs, it’s time to take a closer look at what might be in store for large-cap energy in the months ahead. While the story isn’t perfectly clean — as highlighted by Exxon Mobil’s news that this year’s production would come in 3% lower than 2011 levels — on balance, these three names continue to offer more pros than cons.
The Case Against Mega-Cap Energy
Let’s start with a look at the three major reasons these stocks are saddled with low valuations.
First, as the “easy” oil gets pulled out of the ground and the marginal cost of extracting each new barrel rises, energy companies are forced to take on higher costs or make expensive acquisitions to maintain the same level of production. This argument is well-known, but it moved back into the headlines following Thursday’s Exxon news. Notably, CEO Rex Tillerson said, “An unprecedented level of investments will be needed to develop new energy technologies to expand supply of traditional fuels and advance new energy sources.” Not what investors wanted to hear.
The second reason the energy giants fail to get traders’ juices flowing is their low-beta nature and history of underperformance during rising markets. The past five months serve as the most recent example. While these stocks have all registered hearty gains, they have lagged the 36.6% return of the United States Oil Fund ETF (NYSE:USO) and as a group haven’t performed appreciably better than the 24% gain of the S&P 500 Index. However, low beta actually might be a strength at this stage of the rally.
The third knock on the mega-caps is their slow growth. While 2013 earnings estimates have moved higher in the past 90 days, the growth outlook is tepid at best. Exxon is expected to experience a year-over-year earnings decline of -1.4% in 2012, while analysts are calling for 3% and 4.5% drops for Chevron and Conoco. The estimated five-year growth rates also are nothing to write home about — while Exxon is expected to grow at 8.7% annually, Chevron and Conoco are on track for growth of just 4.4%.
The growth issue is somewhat balanced somewhat by valuations, as Exxon, CVX and Conoco all are trading at price-to-earnings and price-to-book ratios below their five-year averages despite their recent gains. And dividends are nothing to sneeze at, either, as the three stocks sport forward yields of 2.2%, 3% and 3.5%, respectively.
The Key Positive: Mega-Cap Energy Provides a Hedge Against ‘Tail Risks’
Alone, valuations and yields aren’t enough to make a case for these names. Instead, the most compelling argument in favor of the mega-cap energy stocks is their ability to weather two of the most important risk factors facing the market right now.
First, with the European debt crisis becoming less of a market mover with each passing week, the situation in Iran has taken over as the leading factor that could derail the markets with a negative surprise. While the issue of Iran’s nuclear program and a possible Israeli response has lurked on the periphery for well more than a year now, it remains an important “black swan” to factor into the current outlook. It’s true that in the event the Middle East blows up, large-cap energy stocks would be more likely to track the stock market lower than to follow the oil price higher. Still, it’s a group that almost assuredly would outperform the broader equity market if a worst-case scenario unfolds in Iran.
The surge in unleaded gas prices — and the potential impact this might have on the nascent economic recovery — is another issue that could pressure the markets as summer driving season approaches. In contrast to the various segments of the market that might begin feeling the heat from rising prices at the pump — consumer stocks foremost among them — integrated energy producers are much more likely to outperform in this scenario.
The technical picture also makes a compelling case in favor of these three energy names, as Exxon, Chevron and Conoco are all trading within striking distance of new high ground. As of Thursday’s close, the three stocks were 6%, 1% and 4%, respectively, from their 52-week highs.
While the charts of XOM and COP remain vulnerable to the development of “double-top” formations, CVX has printed a very bullish pattern that indicates some meaningful upside potential if crude keeps climbing from here. In this way, the mega-caps can outperform if oil weakens (due to their low-beta nature) or if it continues to rise.
The Bottom Line
The energy mega-caps have come a long way in the past five months, but they continue to offer a compelling set of attributes. Be mindful of the potential for a short-term pullback, especially if CVX fails here and XOM and COP begin to look like they’re putting in a double top. But if this takes place, consider it an opportunity to own three of the energy sector’s most reliable stocks.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.