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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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Energy Stocks: Undervalued Or Value-Trap?

Oil stock investors have rarely faced such a conundrum. Exxon Mobil: 3.5 percent and 12.5X; Royal Dutch Shell: 6.6 percent and 12.5X; Chevron: 4.6 percent and 10.2X; BP: 6.6 percent and 41X.

Oil majors like these and many others are paying huge dividends and are generally trading at attractive price to earnings multiples. When a stock like Exxon or Chevron is paying 3-5 percent in dividend yield and carrying a trailing twelve month price-to-earnings multiple between 10 and 12, serious investors need to wake up and pay attention. The question these investors face though is ‘are these attractive investments that are being irrationally ignored by a fearful market, or are hard times coming and the firm has not yet responded by cutting dividends?’

Most of the stock market is, at best, fairly valued and at worst somewhat overvalued. That’s not the case in energy stocks. Regardless of one’s view on future oil prices, it is clear that the stocks are not expensive. They may be fairly valued or undervalued, but they are not expensive by virtually any conventional metrics. Indeed, long-time value maven and Nobel Prize winning economist Robert Schiller earlier this year mentioned just one sector that he thought was undervalued; oil stocks. Related: The Battle For China’s Oil Market

However, investors buy stocks not just because of their current valuation, but because that valuation is expected to rise in the future. The ultimate fairly valued asset is cash. It’s always worth exactly the same amount in nominal terms. Yet no one thinks of cash as an investment.

Oil stocks are increasingly looking like they may provide strong returns over the long-term though. In particular, while small shale E&P firms may be at risk in the current oil situation, oil majors like Royal Dutch Shell and Total clearly are not going anywhere. Analysts seem to agree that, for investors with a long-term time horizon, oil stocks represent a good opportunity.

Morgan Stanley noted that investors who bought into oil stocks in the 1980’s after the last supply induced crash enjoyed a 16 percent annual return over the next decade compared with a 12 percent return for the broader stock markets. For reference, average stock market returns since the end of World War 2 have been about 11 percent per year. Expert oil traders like Martin Tillier see an opportunity in oil as a safe haven compared with the risks faced in the rest of the markets. Related: Shale Industry May Need A Complete Rethink To Survive

While the future path of oil prices and the short-term valuation of oil majors is certainly unclear, one thing is not; dividend sustainability. Exxon Mobil is likely to earn around $10.50 per share in operating cash flow over the next 12 months. The stock should pay a dividend of $2.80 during that time. In the depths of the first quarter low oil prices, Total earned $1.13 per share. The stock is paying a dividend of $0.68.

ConocoPhillips actually raised its dividend by a penny per share earlier in July. Overall it is clear that oil majors are not worried about sustaining their dividends, and at this stage short of another large leg down in oil prices they should not be. Indeed, many major oil companies offer substantial income opportunities for investors. Related: This Is Why Californians Pay More For Their Gasoline?

Oil major stocks have held up better than smaller E&P stocks over the last twelve months, but they also have not enjoyed the same rebound as the smaller firms. That might be a mistake on investors’ part though. Oil majors have the asset base and cash cushion to snap up the most attractive E&P firms in the market. So far, M&A activity has been slow but as Iran appears poised to push more production back onto the markets over the next year, the prospects for a rapid rebound in prices are looking grim.

In light of that, struggling E&P firms may finally accept reality and offer to sell out to a major at a reasonable price. There are certainly a number of attractive oil takeover targets out there today. This, in turn, would give the majors upside on operational and technological improvements. Overall, it certainly looks like a good time to be an oil investor.

By Michael McDonald for Oilprice.com

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