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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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Why Big Oil Is Still A Good Bet For Investors

Investors getting cold feet about the spiking price of Big Oil stocks over the last year may risk missing out on further gains, according to one top ranked analyst. Doug Terreson of Evercore, one of the top ranked oil analysts according to Institutional Investor magazine, is recommending that investors stick with integrated oil majors like Royal Dutch Shell, Chevron, and Exxon despite the run up in their prices.

Terreson’s thesis is that many of the catalysts for positive price performance remain in place. In particular, integrated oil companies have effectively reduced operating capital costs permanently, which lowers their breakeven expense to produce oil. The retort to this point of course is that Big Oil stocks may have cut costs but frackers have been much more successful than integrated majors in cutting their costs as a percentage of pre-crash production cost.

Still, there are other reasons to be optimistic about Big Oil stocks, especially since Terreson sees many companies already having more than their fair share of negative news priced into their share prices. Integrated majors are generally trading near 25-year lows based on various valuation metrics and many are paying safe dividend yields near 5 percent.

It’s possible that Exxon and other majors could cut their dividends, but that’s very unlikely short of a complete collapse across the industry. The oil majors know that dividends are one of the most important signals to their current shareholders about the company’s financial health, and no major will cut its dividend unless it has absolutely no other option.

Moreover, while integrated majors are facing a new threat from the downstream glut that is developing in refined products, that glut should not be enough to offset the benefits from the diversified cash flows integrated majors enjoy. Refining operations may be shifting from a buoy to a weight for the majors treading water in the current oil environment, but that should be a temporary phenomenon. Terrerson sees oil majors as being in a “sweet spot” in the current environment, and there is something to that analysis. Related: Did Oil Kill The Dinosaurs?

In particular, oil majors are generating significant amounts of cash in a way that none of the smaller fracking firms are. With the oil environment starting to stabilize, that cash flow generation should enable firms like Exxon to scoop up attractive acreage, assets, and even whole companies that complement their current portfolios, all at rock bottom prices. If oil prices start to spike in the next few years as some analysts are predicting, then the oil majors will benefit tremendously. Fracking firms may or may not have the financial backing to be able to ramp production back up as prices rise, but oil majors certainly can.

Given all these factors, investors might want to consider the oil majors if they are looking for attractive yields, good risk-adjusted expected returns, and reasonable downside protection. Companies like Royal Dutch Shell may not be as “sexy” or high-growth as some of the fracking firms are, but positioning one’s portfolio defensively in light of the current market volatility is a reasonable approach.

By Michael McDonald of Oilprice.com

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