Top Oil Stocks to Buy Post-OPEC Cut

A couple of weeks ago, OPEC agreed to cut production for the first time in almost a decade and the oil market has rallied on the news.

In this week's episode of Industry Focus: Energy, Motley Fool analysts Sean O'Reilly and Taylor Muckerman dive into how the cut will affect oil prices in the short and long terms and how investors might want to think about this opportunity. Also, they also look at how Donald Trump's upcoming presidency might affect the energy industry -- from the president-elect's new pick for the head of the Environmental Protection Agency to his proposed expansion of the coal industry and more.

A full transcript follows the video.

This podcast was recorded on Dec. 8, 2016.

Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, December 8th, 2016, so we're talking about energy, materials, and industrials. I'm your host, Sean O'Reilly, and I'm joined in studio by the one, the only Mr. Taylor Muckerman. How are you today, sir?

Taylor Muckerman: You let me back on the show.

O'Reilly: I missed you. What was this, multiple weeks that we haven't hung out? I missed you. I forgot what you looked like.

Muckerman: I don't know much about airline investing, so it was probably a good idea to sub me out.

O'Reilly: I couldn't believe it, because I set up that show with Adam a week or so ago in advance. I was like, "Hey, Adam, I want to talk about Warren Buffett and airlines if you're willing to join me," and then OPEC cut production that week! He was actually very knowledgeable on the subject.

Muckerman: Where's your crystal ball when I'm around?

O'Reilly: Yeah, right? (laughs) I haven't told you about it yet.

Muckerman: OK, well, secret's out.

O'Reilly: I did get to talk to, last week, Adam Levine-Weinberg about the OPEC cut. We talked about it for five or six minutes. But I did want to talk to you about it. How surprised we were you? Were you elated? Were you like, "I don't believe them at all, they're going to cheat?" What's going on in the mind of Taylor Muckerman right now?

Muckerman: I was kind of surprised. You saw Saudi Arabia took it on the chin. They took the bulk of the cut. I mean, they had the bulk of the production.

O'Reilly: They wanted this bad.

Muckerman: Yeah, they did want it badly, and it shows. They gave into the demands of Libya, Iraq, and Iran. Maybe not to the fullest extent that those countries might have wanted, but they did allow them to keep production where it's at. Rather than a cut, they just installed a ceiling on those three countries. It worked, prices are up -- temporarily, at least.

O'Reilly: Yeah, it took a breather yesterday. Not that we care about daily prices or anything. Boy, the oil sector has been a good sector to own in the past couple of weeks.

Muckerman: Oil, banks, yeah, they're ripping, man.

O'Reilly: Yeah, post Trump's election, too.

Muckerman: He has a few things he's said that obviously energy producers and people investing in energy might want to hear.

O'Reilly: Yeah. This week, we're hearing that OPEC is now going around to all the non-OPEC major oil producers, and they're trying to get them to cut. (laughs) 

Muckerman: Yeah, we'll see how that plays out.

O'Reilly: Did you hear that they're going to accept natural decline rates as part of the cuts that they're looking non-OPEC producers to make?

Muckerman: I did not see that, no.

O'Reilly: Isn't that like playing whiffle ball? (laughs) 

Muckerman: I mean, it's tough to hit or...?

O'Reilly: No, it just sounds ridiculous. Like, of course that's going to happen.

Muckerman: Yeah, it's the beauty of this beast.

O'Reilly: This is the circle of life. (laughs) 

Muckerman: Especially when you're talking about U.S. oil decline rates. I don't think Russia is experiencing the same kind of decline rates because they have more conventional oil. Yeah.

O'Reilly: I just thought that was ridiculous. Are you taking OPEC at their word? Has this changed your investment philosophy up there in Fool Canada? You don't do any producers -- you do mostly midstream stuff.

Muckerman: As far as our recommendations, yeah, you keep your eye on the producers because --

O'Reilly: They pay you, as owning pipelines and stuff.

Muckerman: As the pipeline companies and the services companies. You definitely want to maintain an eye on their activity. That's purely dictated by price nowadays. OPEC is cutting because we are oversupplied, not because we have so much demand that it would be illogical. Companies on the producing side are strictly making money on higher prices now. No one's really going out there and ramping up production. I don't think we'll see a production boom like we saw over the past several years again in the U.S. for at least, in this presidential term, if not a handful of more, if ever, because it is purely price dictated now. Prices are in the $50s. It looks great compared to January but not so --

O'Reilly: Right, bottoming out at $27.

Muckerman: Yeah. Not so great compared to summer 2014.

O'Reilly: Moving on to something we briefly mentioned, which is the election of Donald J. Trump as the president of the United States --

Muckerman: What's his middle name? I don't even know.

O'Reilly: I think it's James? Anyway.

Muckerman: Some Americans we are.

O'Reilly: I know it's J.

Muckerman: I know it's J as well.

O'Reilly: He recently made his pick for the Environmental Protection Agency, the EPA.

Muckerman: Scott Pruitt.

O'Reilly: Talk to me. Who is Scott Pruitt?

Muckerman: I'm just going to say one word, and you might figure out which angle he's leading toward. That's Oklahoma.

O'Reilly: Oh, boy.

Muckmerman: That's where he's from. He is very outspoken about the fossil fuel industry --

O'Reilly: I thought you were going to tell me he used to work for ExxonMobil or something.

Muckerman: I don't know all of his background. But his state is very highly dependent on the production of fossil fuels. So, he's definitely come out and publicly bashed the EPA before he took this position. So, I think he's going to be able to do some knocking of heads from the inside out now.

O'Reilly: Do we know anything else about likely policy changes and how this is going to affect oil companies? You have Continental Resources down there in Oklahoma, I believe, at least the headquarters.

Muckerman: I don't think he's going to specify state-specific regulations. But I do expect them to try to follow through on some things that Donald Trump talked about during his campaign and has talked about after his campaign.

O'Reilly: He did talk about, in the episode where we talked about his energy policies, he talked about federal lands, doing that a lot more.

Muckerman: Deregulating oil a little bit more. He wants to bring back the coal industry. I mean, if he can do that, he can do anything.

O'Reilly: Like, snap your fingers, right? This is about economics, this is not about...

Muckerman: It's about economics purely. Oil as well. You can say all you want about being able to try to bring back jobs to these sectors, but it's dependent on a global demand and supply balance.

O'Reilly: Natural gas is a wonderful substitute.

Muckerman: Yeah, and it's still reasonably priced compared to coal. But you're seeing massive demand centers talk about how they're only going to allow coal production of electricity in their countries for the next 13-30 years. You talk about Canada phasing it out completely by 2030 -- they just announced that recently. They get 7% of their electricity from coal. France, even faster, they want to get rid of coal as early as 2023. Only 3% of their electricity comes from coal, but still, fairly big country, so 3% is a fairly meaningful amount of demand. Germany wants to get rid of it by 2050, half of their demand by 2030. Finland, the largest of these big countries, 12% of their electricity comes from coal, and they are targeting 2030 as well. All of these countries are talking about getting rid of it.

O'Reilly: Yeah. And China, their pollution worries, they are getting rid of all of their coal plants. 

Muckerman: They have a similar target date between 2030 and 2050. The U.S., I don't think we have a specific date in mind. We have seen more than a handful of utilities shed a lot of coal assets in favor of natural gas. When you look at a company like American Electric Power, they get about 60% of their electricity from coal. So if Donald Trump does free up the coal industry a little bit, maybe they would benefit. But again, you need demand and it's disappearing over the next 20 to 30 years, almost completely.

O'Reilly: This is entirely speculative, but I did want to talk to you about it. Donald Trump won, he has this new head of the EPA from Oklahoma -- take that for what you will, wink -- shale oil and the oil industry did pretty well under Donald Trump's predecessor. Are we to expect gangbusters even more deregulations, so shale oil is going to go crazy?

Muckerman: Again, it did great under President Obama for nothing that he did. It was an abundance of technological advances and an abundance of newly acquired oil reserves because of those technological advances, and it caught everyone off guard, OPEC included, which is why they decided to not cut in 2014, a little over two years ago, November 24th. I had just come out of Nationals Park, turned my cellphone on, and saw that oil was down by 50% in a day. That was a nice surprise.

O'Reilly: Happy Thanksgiving! (laughs) 

Muckerman: Right after munching on some Texas barbecue. But, yeah, you might see a little bit more shale activity. But I don't see it. If you do, you want to stick with those biggest and brightest players. If you look at Oklahoma and Texas, that's EOG (EOG -0.42%) and Pioneer Natural Resources (PXD 0.20%).

O'Reilly: Actually, on that note, OPEC just cut production for the first time in eight years, and they did it in earnest. The last time they did this that wasn't recession-based was 2001 or something. This doesn't happen every day, so we have to talk oil stocks. Does this make Pioneer, EOG, Chesapeake even -- they're a little bit more trouble because of that balance sheet... what should shareholders or potential investors in the oil sector be thinking right now?

Muckerman: I think you could look at companies that maybe have a lot of inventory of wells that are drilled but not fracked, because that's the last stage, so they can bring those on quite quickly if oil prices do rise further or kind of plateau --

O'Reilly: I mean, we just named a couple of them. I mean, EOG has...

Muckerman: Yeah, they're one of the biggest independent oil producers in the United States, and they have some of the best acreage. Their management team is extremely respected in the industry. They're fairly integrated. They have the ability to supply some, if not all, of their own sand in the basins that they operate in. They're able to take oil away from their well sites on their own and get it to the pipelines. Again, the acreage is just prime for this company. If you look at Oklahoma in particular, the Permian Basin, which everybody is raving about the opportunity here, in terms of the size and the scale that can be achieved, Pioneer is the largest acreage holder there and a very good operator with the ability to grow production at 15% a year in the environment that we're in. It's pretty impressive.

O'Reilly: Before we head out here, your specialty is midstream guys. How does this affect Kinder Morgan (KMI 0.40%)? Does this all of the sudden make some more attractive? Because obviously everyone is going to be paying their bills.

Muckerman: Yeah, you can renegotiate a little bit more, which the services companies are trying to do, trying to bring those prices back up, because people saw the cost of producing oil go way down. But that's not only because of technological advances, it's also because of concessions from companies like Halliburton and Baker Hughes and Schlumberger. Once they try to recoup that a little bit, you're going to see the cost of producing oil go up a little bit, because it was kind of a handout to keep these companies running during the downturn.

O'Reilly: That's a really good point that I don't think many people are talking about.

Muckerman: Yeah. The cost per barrel of oil is likely to tick up a little because of that, because of these contract renegotiations, because Halliburton and Baker Hughes and Schlumberger, who probably handle the vast majority of oil production and natural gas production in the United States and worldwide over 50%, I would imagine these guys were giving some handouts to keep their customers in business and keep the oil and natural gas flowing. And now it's their turn to say, "All right, we have to mean revert a little bit here price-wise." But, on the midstream side, Kinder Morgan is a company we recommended in our Pro Canada service. It's widely recommended here at The Motley Fool in general. I don't necessarily look at them benefiting from a deregulation side, but if taxes get cut like Donald Trump has said he wants, all the way down to a 15% flat corporate tax, that would be extraordinary. The oil and gas sectors over the past five years have been the most heavily taxed in the United States. You're looking at an effective tax of around 38.7% --

O'Reilly: A little bit higher than 35%.

Muckerman: A little bit higher, yeah. You compare that to biotech at 19%, insurance at 20.2%, and pharmaceuticals at 20.5%. Those three sectors, almost half.

O'Reilly: Just to clarify for the layman, is that basically, they took the entire sectors and said, "What is the total amount the sector paid in taxes? What's the total gross income? And that's the percentage."

Muckerman: Yeah, they take their earnings before taxes and then you apply that, so that's the effective tax rate of those sectors from 2010 to 2015. When you look at insurance, maybe that's why Warren Buffett really didn't care whether or corporate taxes were cut or not because Berkshire's --

O'Reilly: Aha! The truth comes out!

Muckerman: -- has all those insurance companies under its umbrella. But, with Kinder Morgan in particular, they were the highest taxed last year on an effective tax basis.

O'Reilly: So, that's all the local taxes and the state and all that?

Muckerman: Yeah. So, they're like 73%, international taxes, domestic taxes. If you trim that down to an even more conservative amount, if you take that down to 25%, say, they would have saved an extra $371 million last year, which amounts to about 10% of their long-term debt, which has been a stated goal of theirs to pay down. So, right there, you knock 10% off your long-term debt.

O'Reilly: And that ups your interest coverage ratio, which allows them to increase their dividend.

Muckerman: Yeah, might get their credit rating back up to where it used to be. And yeah, the long-term goal here is to get that dividend back up to where it was before the cut.

O'Reilly: That would help.

Muckerman: Freeing up 10% of your long-term debt to pay down would certainly accelerate that process.

O'Reilly: Awesome. Thank you for your thoughts, Mr. Muckerman. Have a good one.

Muckerman: You got it. You, too.

O'Reilly: Before we head out, I want to take a second to give a special shoutout to our producer, Mr. Austin Morgan. Austin, we love you. Before we conclude our podcast, do you own an Amazon Echo? You can now get a brand-new skill from The Motley Fool. You can get stock quotes, create a watch list, ask Alexa how your portfolio is doing -- and it's all free. For more details, including a demo of how it works, go to www.fool.com/alexa. Lastly, thank you, Mr. Muckerman, again, for joining me on the show.

Muckerman: One more thing -- we have a Motley Fool flash briefing you can add. When you say, "Alexa, give me the news," that would be a flash briefing. It's a 90-second clip on one big header news topic of the day.

O'Reilly: Do you do that 20 times a day? (laughs) 

Muckerman: No, it's only once a day. We generally have an analyst from MarketFoolery stick around after the show and tape that.

O'Reilly: Awesome. Cool. As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear on this program. For Taylor Muckerman, I am Sean O'Reilly. Thanks for listening and Fool on!