Oil Stocks: Don't Get Fooled into Following the "Smart" Advice

Whenever oil prices drop as dramatically as they have recently, just about anyone that wants their face in front of a camera will come up with some new oil price target or will want to show investors some new insight that will help you navigate the troubled waters. Well, guess what, half the time this new insight being brought to light is absolutely useless, and investors would be wise to steer way clear of this advice.

In the most recent eposode of Industry Focus, Motley Fool Analysts Taylor Muckerman and Tyler Crowe take a look at some of the recent "smart analysis" being put out there and show why following the advice in these articles may not be the best thing for you to do.  Tune in to today's energy edition of Industry Focus to discover what the savvy investor should do instead.

A full transcript follows the video. 

Taylor Muckerman: Step right up, Fools. If you can guess the right price of oil, you will win a teddy bear! This is Industry Focus.

[INTRO]

Hey Fools, Taylor and Tyler here, talking about oil and gas on Thursday.

Tyler Crowe: I would really like to win one of those teddy bears. I don't know, do you have them stored in the back there? I'm going to say $150, why not? Because every other price prediction nowadays seems to go all over the place, so why don't we just do something completely ridiculous out of everybody else?

Muckerman: We're reverting back to 2008?

Crowe: Yes. Everybody's going to be scared again. Everybody's wondering "peak oil?" stuff like that. I'll throw just a stupid number out there like that, because everybody else is now too.

Muckerman: My portfolio would certainly like $150. That's more than double some of the projections you've seen out there.

Crowe: Way more than that, and here's the funny thing. So many of these almost seem like knee-jerk reactions. About a month ago so many banks were putting out their 2015 outlooks for crude, and basically within two weeks they've slashed them almost in half.

The biggest one, Goldman Sachs (NYSE: GS). They just recently changed their six-month outlook which was last month $75; they've slashed it all the way down to $39.

Muckerman: Good for them!

Crowe: Société Générale, they've gone from $65 to $50. Citigroup (NYSE: C) is really ambitious. They're saying $63 for the entire year.

It just seems like all the stuff that these guys are saying when they make these price targets ... it sounds smart. It's like, "U.S. drilling is going to be slower than expected. OPEC isn't going to cut."

There's this ton of assumptions that you have to make when you make these sort of price targets, but they don't know if these actual assumptions that they make are going to be right. OPEC could go back, they could make a cut. Or the capital spending in the U.S. could be extremely smaller than what they're predicting, so these price targets could be null and void.

Muckerman: Yes. Just one cell in an Excel spreadsheet changes ...

Crowe: Exactly, and it just gets thrown out the window. That's the crazy thing about it. They all sound smart because they make a ton of smart-sounding assumptions. But those assumptions could be wildly wrong.

You hear this all the time, whenever something radical changes with commodity prices. We've even seen metals prices drop significantly in the past couple years -- or couple days, actually -- and I heard one of my favorite phrases.

I was watching Bloomberg and somebody said, "This is the new normal." It's that idea that oil's going to stay below $60 in perpetuity, everything's going to be fantastic ...

Muckerman: Because it has in the past, right?

Crowe: Because it has, and it just means forever. It's going to stay this way. But anybody that's an investor knows this: the new normal is that prices change.

Muckerman: That's right.

Crowe: They go up, they go down. The normal is change. It's always going to change, and people should invest anticipating that these sort of changes are going to happen.

Muckerman: If you don't believe us, just look at multiple periods in history with oil, or any commodity that's still around. You look at oil in 1981 and '82, fell off a cliff over a few months.

Crowe: A few years, even.

Muckerman: Rose back to $150 a barrel in 2008, fell off a cliff at the end of 2008 into 2009, rose right back to triple digits. Only a few months it took for $110-115 to drop to where we are now, in the $40s.

Its price drops are so quick and so dramatic, but then you have these nearly decade-long strings of rising prices that really benefit investors over the long haul, and that's why you have to find companies that can weather these downturns.

Crowe: Yes, because it scares the bejesus out of you when you see these big price drops like that. "I have got to get out of every single one of these things. There's no way any of these companies can handle this." But if it only lasts 20-30 days, everybody's right back up. It's no big deal.

Muckerman: We were looking at this article talking about, people are now trying to get nit-picky, trying to pinpoint tiny little fractions of how you can identify good companies. We saw an article that identified basins as being cheaper to drill in. They kind of tossed out the idea of reserves in these basins or the amount of companies trying to go in and buy up these leases.

They were just strictly looking at profit and prices in these basins. There are several companies, that fell across the entire spectrum. We want to talk about why it isn't just the basin that these companies are operating in, but it still all boils down to the company that you're investing in.

Crowe: Yes. We're not going to mention any names -- Wall Street Journal -- but basically what it was saying was proppant price efficiency; like how much dollar per barrel are you spending on proppant to actually drill a well?

Muckerman: Now, proppant is the sand and the (unclear) to keep the fissures open.

Crowe: The sand, and anything that they're using to do that. One of the funny things that I found fascinating about this is the places they thought were the cheapest; places in the Rocky Mountains, like the Piceance Basin and the Niobrara, are some of the places where today it's a little bit more expensive to do other things.

Muckerman: Right.

Crowe: Your takeaway capacity is more expensive.

Muckerman: There's no rail there.

Crowe: Yes, you don't have any rail capacity or anything like that. It's one of those things where it was basically saying, "These companies won't be as affected because they're in these basins, where it's less expensive to do this one point of the entire drilling process" -- which kind of seems like one of those tricks.

You're trying to find the little tricks to make your actual analysis work a little bit better, but it seems to me almost a little reckless to throw out the idea of the holistic approach that you need when you're looking at a company.

I went down through the entire list of all the companies there were.

Muckerman: There were some interesting names on the list.

Crowe: Very interesting names, and some things that you wouldn't expect, like a company like WPX Energy (WPX) was at the top of the list because it was in that Piceance Basin where cost efficiency is the best.

But at the same time, this is a company that's already in the lower third of its peer groups in terms of EBITDA to interest expense. That means it's spending a ton of money on interest already, before we've seen this ...

Muckerman: Very (unclear) near term.

Crowe: Yes, and before we've even seen this big drop in the price in oil, which could make the situation worse.

And over the past two-three years, it's been a capital killer. It's spent more trying to drill than it's actually brought in on operational cash flow, so it's really hard to see how just because they've got proppant efficiency means they're going to be able to weather the storm, when they've got a completely bloated balance sheet.

Muckerman: Right. I'm looking at a couple companies on here as well. Some of them are no-brainers, like an EOG (EOG 0.67%), in my mind. Sure, if you want to buy an independent exploration and production company, this might be one of the best if not the beset, up there with a ConocoPhillips (NYSE: COP).

Wolfe Research called EOG the "new Saudi Arabia of global oil barons," highlighted that earlier this week and basically is calling them a swing producer because they do produce so much oil in the United States.

A lot of their oil that they're drilling; because they're diversified they're not paying attention to these basin-by-basin proppant costs. They can actually produce in the bigger basins that they're operating in at $40 a barrel and still make a 10% return after tax.

You're talking about the Eagle Ford, which is their biggest basin, the Bakken, and some Delaware basins that they're operating in. They're operating in pretty much every oil-producing basin in the U.S., but their biggest properties are in those high-performing basins, and slowly getting into the Permian as well.

Crowe: One of the things that I do find interesting about EOG, and there's a couple other players in this space, some of the larger ones -- EOG, Devon Energy (NYSE: DVN) -- what they're starting to do is, we'll call it the "semi-integrated" oil and gas producer.

You know, when we think of integrated companies they've got the refining, they've got the retail. What I mean by this is that EOG and Devon have gone out and taken a lot of those subcontractor roles; your water recycling and water treatment ...

Muckerman: Devon's at the forefront of that.

Crowe: Devon, EOG has been really big on that. They supply their own sand for proppant, so they're not having to pay out to another company.

Muckerman: Right.

Crowe: Very simple, basic things like this, where they're able to cut costs that would eventually go to a profit of a supplier or something like that...

Muckerman: Ceramics on the proppant side.

Crowe: Exactly. By doing that they're able to keep their costs down, so even though it may say, "That basin is the most expensive on proppant efficiency," but they're doing it themselves so they're saving a lot more in respect to a lot of their peers in that place anyway.

Again, when you see these sort of articles that try to find the trick to your portfolio ...

Muckerman: A lot of generalization, rather than a specific ...

Crowe: Yes, you really need to dig into these companies to understand them a lot better than what these very simple explanations give.

Muckerman: Two that stuck out to me that might be, if investors want to take a little risk, Apache (APA -1.26%) and Chesapeake (CHKA.Q) both selling non-core assets. Chesapeake trying to turn that huge corner, almost a hairpin turn, that they had to navigate around after Aubrey McClendon left.

They've got more liquidity. They've just authorized a $1 billion share buyback. I was actually waiting for companies in the energy sector to start saying, "We're going to start to buy back shares."

Chesapeake was one of the first that I heard of, and $1 billion equates to 7-8% of their outstanding shares, so that's pretty meaningful. These are likely attractive prices right now, especially because these oil companies, they know. They've seen this before, and I appreciate them going to put their money to work where I believe price appreciation is set to take place.

Crowe: Certainly having that little bit of extra cash on the balance sheet from sales -- like a Chesapeake or a Devon Energy right now -- certainly looks pretty valuable.

Muckerman: Yes. You look at it, the share buybacks could prove pretty prescient if they get involved over the next 5-10 years, which is what you kind of have to look at this as, as an investor.

You look at these riskier plays. They might provide a short-term pop, but you put out an article not too long ago about Exxonmobil since 1981-82. It was over a 6,000%, almost 7,000% total return.

Crowe: Total return. When you add the dividends and stuff like that, it's basically the idea of, if you're looking at it from a long-term perspective ... everybody has their own investment time horizon. A very important thing that everybody should know is if you're looking to invest 2-3 years from now, 5-10, maybe even 20-30, you need to know those time ranges because it will dictate immensely what you're going to do.

If you're looking only 2-3 years, buying an ExxonMobil where you're basically generating all of your value from dividends, dividend reinvestment, and share buybacks, that doesn't really start to kick in until that 10, 20, 30-year time horizon. If you have that time horizon, it's an amazing stock.

Muckerman: My thinking is this is a good time to ...

Crowe: Exactly. But looking at a two-three year time horizon, it may not look as great.

Muckerman: Fair point.

Crowe: Anybody looking at the energy space -- and anywhere else -- know your investment time horizon.

Muckerman: Know thyself.

Crowe: Yes, know thyself more than anything else. It'll be an extremely important thing going forward with your portfolio.

Muckerman: Couldn't agree more.

Well, that's it for today's show. I think if you want to send in your price estimates to @TMFEnergy on Twitter or [email protected] if you're an emailer. By all means, maybe in six months we'll send the winner a teddy bear.

Crowe: A teddy bear, or at least a Twitter shout-out.

Muckerman: You'll get a shout-out, that's right. Maybe boost your follower count by a little bit.

That's all for Tyler. I'm Taylor. Fool on!