Energy Stocks Are Still Overpriced

Green curve above shows the WTI oil futures curve at the market peak on February 19th, orange curve shows what it looks like today.

Ignoring the debacle in the front month (May and June) contracts, the July oil is trading for $20/bbl which is down 66% from the 2019 year-end price of $59/bbl. The out-year contracts are now converging on $40 which is down by 33% from the 2019 year-end price.

Meanwhile, Exxon is down 40% year-to-date and the XOP fund is down by about half. The equities have fallen by slightly more than the commodity price, but there are two problems with that:

1. Equities should fall by more than the commodity price because of operating and financial leverage
2. Energy stocks were overpriced to begin with

The leverage should be obvious. If your oil costs $15 per barrel to produce, a price decline from $60 to $40 (-33%) lowers your profit per barrel from $45 to $25, a 45% decline. Having debt also leverages the enterprise value decline impact on the equity. 

I have been watching Exxon for years trying to justify owning it. My clients would be a lot happier owning a "blue chip" selling dinosaur juice than sitting in T-bills. Here are my notes from June 2016:

They had net income of $1.8 billion in the first quarter. The upstream lost a little bit of money, but downstream and chemical made money. If you value those two segments at 15x Q1 annualized net income, they're worth $135 billion. (That would be in the top few dozen of the S&P 500.) The enterprise value of XOM is $400 billion, so you're paying $265 billion for the oil and gas reserves. The PV-10 was $208 billion at the end of 2014, down to $71 billion at the end of 2015.

Can also think in terms of a very attractive price to pay for XOM. Let's say $135B for the two segments and then $100B for the oil. That's $235B EV, which is $165B less than current EV. Means 45% lower stock price - $40. 

The stock was trading at $90 then and now it's at... $40. Oil was at $50 then, now the weighted average from a DCF valuation would be in the high $30s. Again, that 20% commodity price decline should be magnified by the operating and financial leverage into an even bigger share price decline.

This pattern exists at every energy company I have looked at recently. At least Exxon makes money - so many companies in the industry do not, and did not even at higher prices. Last fall I asked, "What happens to oil prices when producers have to be profitable?" One reason I have had to hide out in cash this cycle is that when people are too optimistic (delusional), no one can make money investing. Either the business operators are overfunded and compete all the profits away (energy, startup sector, "disruptors," Netflix, Amazon) or investors are too optimistic and pay prices for share interests that almost guarantee losses. The willingness to pay high multiples for hypothetical future earnings is an extreme example of double counting. (The Nifty 50 were expensive but they all made money.)

The most popular stock on retail brokerage (bucket shop?) Robinhood during the historic oil futures decline to negative prices this week was the United States Oil Fund ETF. What they don't seem to realize is that USO is not a tank farm full of cheap oil that is going to bounce back in value. It is just an entity that buys front month oil futures contracts and rolls them over. It is getting chewed up by the contango (having to sell the future low and buy a higher priced one to roll over) and will probably go to zero this summer.

This bear market should give a final washout of the energy sector. There will be lots of bankruptcies with equity wipeouts and very low creditor recoveries. As long as the profitability-indifferent investors are scared away, the survivors would be able to consolidate the remaining properties, develop them rationally, and make money.