The markets are near historic highs, and earnings are rebounding nicely. There is one fly in the ointment: Energy stocks, which as a group are down more than 10 percent this year. This, while the S&P 500 is up almost 7 percent.
It wasn’t supposed to be this way. This was supposed to be the “Year of the Turnaround” for big oil, but it’s not turning out like that.
The spoiler are the commodities: oil down 9 percent year-to-date, and natural gas down 12 percent. The global energy market is undergoing a massive transition, from a Middle East focus to a North American focus. It’s a huge help to consumers, and a headache for big oil.
The result: the investor love affair with Energy, so evident toward the end of last year, is over. Oil stocks don’t just lose on a fundamental level, they lose as a relative value play. Think about it: you have the rest of the market at or near historic highs, with energy stocks the worst performing group year to date.
Take ExxonMobil, which reported earnings this morning. The good news: they beat earnings expectations, and overall earnings more than doubled, from $1.8 billion a year ago to $4.0 billion in the first quarter of this year.
They doubled largely because oil prices improved, from roughly $31 a barrel average in the first quarter of 2016 to roughly $51 a barrel in the first quarter of 2017.
Here’s the bad news:
1. The price of oil is trending down.
2. Capital and exploration expenditures are down 19 percent from a year ago.
3. Production is down: on an oil-equivalent basis, production decreased 4 percent from the first quarter of 2016.
Bottom line: they are getting less for oil than the first quarter, and they are producing less of it.
This is one of several reasons oil stocks are trading near their lows for the year.
Is it any surprise oil stocks have been for sale for months? Any surprise that every major oil index (XLE, OIH, XOP) are sitting at or near lows for the year? Any surprise investors are now asking, why should I be in oil stocks when the broader market is screaming?
Any surprise that only 3 of 25 analysts tracked by CRFA have a Buy recommendation on ExxonMobil?
How did this happen? Toward the end of last year, the analyst community bought into two ideas: 1) the reflation trade, the idea that global commodity prices would rise as the global economy improved, a bet that looked pretty good when the Trump victory turbocharged the whole idea, and 2) that oil would gradually recover due to OPEC collaboration to cut production and the relentless cutting of capital spending by big oil.
This magic combination was supposed to drive oil to $60 and beyond. With this in hand, analysts handily modeled a turnaround in oil company profits, particularly big oil. Chevron, for example, was going to go from $1.07 in profits in 2016 to $4.72 in 2017, according to Factset.
And Chevron was one of the lucky ones that still made money: most of the smaller companies were still losing money. Lots of it.
In theory, these were not crazy ideas. The global economy was getting better, and commodity prices were rising. And OPEC did cut production, and big oil did indeed cut capital expenditures. A lot: ExxonMobil went from $34 billion in capital spending in 2012 to a projected $18 billion this year.
What screwed the whole thing up, of course, was shale production. Even if OPEC continues to cut, how can oil move up when you have the enormous open faucet that is North American shale?
Here’s the irony: big oil is seeing reduced production, but the shale producers are seeing increased production. Big oil is still marginally profitable, but the shale producers, for the most part, are not. Look at Whiting Petroleum: they had good operating results. But they lost money!
So why don’t the shale producers just stop producing? You’ll notice the rig counts keep going up. Are they just stupid?
No, they are desperate. Here’s my old friend Fadel Gheit, oil analyst at Oppenheimer: “Their attitude is, ‘We can’t control the price, so we might as well keep producing because we desperately need the cash flow.'”
The result? Slow but steady haircuts for big oil. Chevron’s expected profits of $4.61 in 2017 have now been whittled down to $4.42, and are still dropping. ExxonMobil, which was expected to make $4.21 in 2017, was at $3.88 last night and still dropping.
Expect them to drop even more.
Is there any hope at all? Sure, the bulls never go away. The big hope is that eventually oil prices will rise again, partly because capital spending keeps lagging. The decline rate requires you to invest large amounts of money to get new oil. No money investing, less production.
What about some good old fashioned M&A play? You notice we are not seeing any of that either? Here’s Fadel again: “The bids and asks [between buyers and sellers] have never been wider, because a few years ago we had $110 oil, and last year we had $27 oil. Which is the real price? They can’t agree.”