How to Handle Energy Stocks as Oil Prices Drop

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As most of you are aware, oil prices have decreased significantly since hitting a high in June 2014. Low oil prices have reduced earnings projections for energy companies and depressed share prices. Many dividend investors are wondering what to do in this situation. I generally operate under the belief that if prices rebound, earnings will go up, and dividends will continue growing as well.

gas prices

So, lets focus mostly on risks and how to mitigate the potential impact.

The goal of a dividend investor is not how much a company can earn today but whether it can earn more over time. Oil companies earn more by finding and producing more oil or if prices increase over time. Before we dig further, there are several risks which are discussed, concerning energy companies these days.

Risks in Energy

The first risk is that demand for oil and gas will be drastically less in 20 – 30 years due to it being replaced by green energy sources such as wind and solar. However, renewal energy sources are intermittent, which means that there will always be a need for fossil fuels. Plus, our modern economy is based on oil as it is the base for things like plastics, pharmaceuticals and countless other things.

Renewable energy sources will take a tremendous amount of time and investment in infrastructure before replacing current energy sources. For example, most cars these days run on oil and some run on natural gas. Very few cars run on electricity alone. In order for all cars to run on fuel that is not gasoline, but something else, we need time, money and effort to build out refueling stations, replace millions of existing cars and not make any more new cars that run on traditional fuels.

Additionally, as global economies keeps expanding and hundreds of millions of people join the middle class, the demand for oil and gas will almost definitely increase. As poor countries become less poor, they will need to manufacture more goods and deliver more services, which should only increase demand for energy. Thus, I would expect worldwide energy needs to increase over time.

Another risk that somewhat goes along with this first one is the notion that oil and gas companies will somehow end up with reserves in the ground, which they won’t be able to tap because of concerns related to greenhouse gases. I agree that global warming is an issue, and the world needs to be more effective in remedying the issue. However, I find it hard to believe that the world will stop using conventional energy sources within the next 20 years. I also find it hard to believe that all countries in the world will act together while foregoing their short-term economic and policy needs.

Furthermore, the technology might be here to harness sun and wind energy, but the technology to store energy is not here. So, I would say energy companies will be fine for the next 20 years.

The other risk is due to oversupply we are facing today. Governments such as Russia and Venezuela depend on crude as their major export. If crude prices go down, they need to sell more in order to maintain revenues from falling, which further depreciates prices. When a country’s main export is a commodity, its budget is under a lot of pressure to keep selling even more, especially if the price of that commodity drops a lot quickly.

In addition, if prices for oil and gas stay low for longer periods of time, companies like Exxon Mobil Corporation (XOM), Royal Dutch Shell plc (ADR) (RDS.B), Total SA (ADR) (TOT), Chevron Corporation (CVX) and ConocoPhillips (COP) will slash their E&P budgets, since would not be economically viable to produce oil and those lower prices for the commodity. This would be a self-correcting mechanism, which will ensure that supply of oil drops below a certain price.

Therefore, a low price is a self-correcting mechanism which reduces supply from higher cost producers and also reduces the incentives to invest in more fields that will bring more supply a few years into the future. The problem of course is that this process takes a few years to work itself out.

Strategies for Risk-Free Investing in Energy

Oil prices are volatile, but it is also important to not get too focused on short-term fluctuations. Investors should not be scared by scattered results because the pendulum swings both ways. While earnings-per-share is not going to be as smooth for an energy company as that of a Brown-Forman Corporation (BF.B), patient investors with long-term horizons could be pretty well compensated for the risks they took 15 – 20 years ago. EPS and revenues in oil and gas companies are going to be more volatile than those for Procter & Gamble Co (PG), Johnson & Johnson (JNJ) or PepsiCo, Inc. (PEP).

The first line in defense against the aforementioned risks in oil and gas is to own energy companies in the context of a diversified dividend growth portfolio.

Secondly, investors should consider what types of energy companies to own. For example, some energy companies handle pipelines, which are not dependent on prices of oil and gas. Those energy companies are dependent on volume of oil and gas transported throughout their vast networks. The volume is generally stable and not volatile like the prices of underlying commodities. Many of these energy stocks could be temporarily knocked down by program selling where some heavy hitter wants to get out of “energy” exposure.

The third strategy to mitigate risks in oil and gas is to acquire positions in those energy companies that have managed to maintain and increase dividends for several decades. If a company has managed to maintain dividend payments and even increase them in the 1980s or 1990s, when energy prices were mostly flat, they get gold stars in my book. Those companies include Exxon Mobil Corporation (XOM), Chevron Corporation (CVX) and ConocoPhillips (COP).

Companies that are facing some weaknesses today, might be in a tougher positions, since lower prices are putting an extra squeeze on the situation. Therefore, quality blue-chip energy stocks with demonstrated staying power in earnings and dividends during previous difficult times for oil and gas prices are best.

Lastly, the key is acquiring stakes in those blue-chip energy stocks slowly in case one does not get the timing right. For example, if energy prices keep sliding from here, many energy companies might not only have to report much lower earnings, but they might also have to have big one-time impairment expenses. Writing down assets is one of the major reason why ConocoPhillips lost money in the fourth quarter of 2008.

Full Disclosure: Long COP, XOM, CVX, PEP, JNJ, PG, BF.B.


Article printed from InvestorPlace Media, https://investorplace.com/2014/12/energy-stocks-oil-gas-exxon-mobil-conocophillips-chevron/.

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