Should You Follow Goldman Sachs Advice on Oil Stocks?

Exxon (XOM -0.23%), Chevron (CVX 0.01%), Shell (RDS.A) (RDS.B): these are the names one would think of when discussing energy stocks. So, why is a company like Goldman Sachs (GS -0.71%) -- an investment bank -- rating these stocks?

Some could say their ratings were simply a ploy to disincentivize investors. With the weight of their name towering in their favor, it seems Exxon is the only one holding its ground. But how long can it keep its drills down before the company is taken in the others' wake?

In this episode of Industry Focus, Motley Fool analysts Tyler Crowe, Taylor Muckerman, and Sean O'Reilly discuss a slew of energy sector downgrades by Wall Steet investment banks and why long-term investors should just ignore them.

A full transcript follows the video.

Sean O'Reilly: Why investment banks would make ratings for energy stocks is beyond us ... on this energy edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly joining you here form Fool headquarters in Alexandria, Virginia. I am joined today by the ones and only Tyler Crowe, and Taylor Muckerman. How are you, guys?

Tyler Crowe: Doing all right, man.

O'Reilly: So, Goldman Sachs making some moves. Putting out some energy stock ratings on -- trying to follow up on their awesome record with this sort of thing. What's going on?

Crowe: Just so everybody's clear on this one, Goldman Sachs -- this is the same team at Goldman Sachs that said six months ago that oil today would be right around $45 a barrel or less because that was what's 'necessary to'...

O'Reilly: Disincentivize investment.

Crowe: Exactly. For oil producers in the United Sates to shut down production. This was also the same team that a year ago said that oil would be at $90 or better...

O'Reilly: Forever.

Crowe: For a long time, because that was the price that it took to be sustainable. So, anything that you hear, you kind of have to take with a grain of salt because that's their record.

O'Reilly: So, they started with the oil majors, of course, and you've got Exxon, Chevron, BP (BP -0.32%), and Statoil (EQNR -0.54%), and they still have Exxon at a sell.

Crowe: No. Exxon is a buy.

O'Reilly: Oh, that's the only buy. Okay.

Crowe: That's the only buy.

O'Reilly: Everybody else is a sell.

Crowe: Yeah. It's a really bold move to say somebody who's as large as Chevron or BP to be an outright sell.

O'Reilly: It's hard to imagine Exxon thriving while these other guys just die. It's just not -- there are macro-economic factors here.

Crowe: Yeah. In no way are these -- if the everyday investor were to look at this, I don't think anybody should be running out and selling their shares of BP or Chevron, or anybody like that. Just simply because Goldman Sachs is saying so. An individual investor: probably not doing it for the short term, quarterly profit of somebody like a BP. Probably doing it because they're looking for a long term dividend. Something nice and stable for an income.

O'Reilly: That's the reason Goldman likes Exxon so much; is their ability to raise their dividend for the next one to two years.

Muckerman: Yeah. The next one -- two years is right.

Crowe: Yeah, because if you're only buying until 2016 then you're really...

O'Reilly: But guys, I invest for the long term.

Muckerman: So, maybe they're all worth a look. What they're trying to say, I think, is that Exxon has planned their projects out fairly well. In hindsight, now that you see the price of oil collapse, where a lot of their major projects are online, or very near to be coming online. Whereas Chevron keeps missing on its Wheatstone project, which is costing them billions of dollars more than they had expected.

They had other big LNG projects that they're talking about. Now, Shell's got this huge deal for BG Group, which is going to cost them $70 billion.

Crowe: Yeah. With the assumption of debt it's going to be there.

Muckerman: So, $50 million in cash, or whatever. So, $50 billion, sorry.

O'Reilly: I was like "What?!"

Muckerman: Yeah. That's a big deal that now they've got the -- they're on the hook for. So, dividend worries for 2016 and 2017, but not to erase the dividend. They're still going to have a decent yield, but no investor likes to see their dividend cut.

Crowe: Yeah. I think another things that ExxonMobil may be seeing -- maybe on a short term basis this might credit something, or maybe long term it might all come out in the wash -- but somebody like BP, in terms of oil and gas -- integrated oil and gas companies, the big oil companies -- they're one of the ones where there's production mix. The amount of oil versus the amount of natural gas that they produce.

They're one of the ones that's more heavily weighted toward production of oil. Normally that would mean you would have better margins because normally selling oil would generate higher margins than selling natural gas. However, if you look at the margins -- at BP gross margins, EBITDA margins for their exploration and production side -- they're actually kind of low. That was even back last year...

O'Reilly: Did they have an expense problem? Is that...?

Crowe: They have some -- up until -- well, obviously they had the Deep Water Horizon. So, that's been...

O'Reilly: Awkward.

Crowe: Paying for things a little bit there.

Muckerman: We're still talking about that. I think Transocean (RIG -2.78%) and Halliburton (HAL 0.21%) finally settled with BP today -- or yesterday.

Crowe: There was a final settlement on that one. So, you've got cost associated with that. They haven't -- prior to that spill, and prior to this massive cost cutting thing that they've been going through, as a result they didn't have great margins in the first place. Maybe they weren't exactly the most prudent capital spenders.

So, when you have that and you're looking at that $90, $100 barrel level and the margins aren't looking that great, then when you bring it down to the current level, you're seeing that major difference. Even on conference calls BP was saying "Now we're going to start rating all of our projects to be profitable at $60 oil."

Well, I guess the question is "Why weren't you doing that before?"

Crowe: I hate to be harsh, but...

O'Reilly: Calling it like he sees it.

Crowe: Yeah.

O'Reilly: Does BP still stand for "Beyond Petroleum"?

Crowe: I think that's just the marketing.

Muckerman: That was just the marketing.

O'Reilly: That elephant that GE had dancing in the rain 10 years ago.

Crowe: So, if you look at somebody like Exxon...

Muckerman: I'm going to have to YouTube that. I don't remember that.

Crowe: Yeah, I don't remember...

O'Reilly: It was a...

Crowe: A dancing elephant?

O'Reilly: Yeah.

Muckerman: That's a long time ago. It's been a long time.

O'Reilly: They don't even live in the rain. It's on YouTube.

Muckerman: I believe it.

O'Reilly: Tell that to GE.

Crowe: So, with ExxonMobil being a buy; yeah. They've been the only one in terms of exploration and production, been able to generate decent enough returns on that production to actually justify over the next couple -- at least in Goldman's view, that next year and a half, two years of actually raising, and sustaining, and building up dividend.

To say that any of these companies are going to significantly be compromised because of dividend payments over the next year or so, that seems a little bit of a knee jerk reaction.

O'Reilly: It seems like Exxon -- if it's a buy -- than the other ones are, at the very least, a hold or something. It's very -- yeah.

Muckerman: Agreed.

O'Reilly: So, they went on. They didn't stop at the majors, and they went on to the offshore drillers. Of course, these guys are kind of in a catch 22 because oil prices dropped six months ago, and here we are. We don't know where they're going to go in the future, but deep-water drilling is -- you plan this stuff five years out. This is very long term stuff. When we don't do this, we will be short of oil as a planet in 2020 or something. That's hypothetical.

So, they're really beaten up on these days. Downgraded Diamond Offshore (DO), Atwood (ATW), and Transocean; what did they say? What was the deal here?

Muckerman: There's oversupply of rigs. They're going to have to shelf some of these rigs. "Aisle them", as they call that, or 'dry dock' them. You look at new fleets -- they're going to be en vogue moving forward. If you've got an old fleet, if you're not capable of drilling in ultra-deep water then you're going to be hurting.

I think that's where Transocean and Diamond Offshore at least lie.

O'Reilly: Transocean's fleet is, what, 20, 25 years old?

Muckerman: It's huge, and it's old.

O'Reilly: Yeah.

Crowe: Yeah. They're trying very hard to...

O'Reilly: It's an elephant.

Crowe: Yeah. It's not dancing in the forest, but it's...

O'Reilly: It's floating on the ocean.

Crowe: To their credit, Transocean is taking some very large steps to modernize their fleet with construction and they are taking a lot of their older rigs off -- out of commission through retiring and whatnot. But it is going to be a major issue for the next several years in how they're going to be able to move forward as a market in general.

I believe -- Diamond Offshore Rig has several rigs that are still under contract that are more than 25 years old. As much as they would love to keep these things in operation, with all these brand new rigs that are coming online, producers like the Chevrons, the BPs, ExxonMobils; they're going to look and say "Why are we spending money for a 25 year old piece of equipment?"

O'Reilly: With oil at $60.

Crowe: With oil at $60. When we can do it with a brand new piece of equipment that can do it at a better, safer, more efficiently, it can go different places. Once those contracts start to roll of we're going to see even more of these rigs from Diamond, from Transocean starting to get retired.

O'Reilly: So, you have the opinion of what I hinted at. Long term we're going to -- a lot of conventional oil plays on this planet are not -- they're starting to decline and we're going to have to start drilling more and more offshore. Shell just had that deal to start looking in the Arctic. I was really surprised to see that because you still have to have somewhat of a bullish outlook [...]

Muckerman: Especially because they keep failing at it, yeah. They're not exactly the best at it.

O'Reilly: Well, that's another matter. If you were of the opinion that, long term, we're still going to be using these rigs to drill offshore; which one is the best one to take advantage of that?

Muckerman: On three. One ... two ... three:

All: Atwood!

Crowe: Looking at the Goldman stuff, again, just like the big oil companies....

O'Reilly: So, they're not 'wrong' per se.

Crowe: They're not wrong, they're just -- instead of looking -- I like this ...

O'Reilly: They're not wrong from a competitive perspective, but they are probably wrong on the macro.

Crowe: From a -- I like to use this nice metaphor. I believe that Goldman is looking at the waves, rather than the horizon. You've got...

Muckerman: Very fitting for the offshore industry.

O'Reilly: Deep philosophy.

Crowe: Yeah.

Muckerman: True. Deep.

Crowe: You have a commodity cycle in anything that's oil and gas, and with rigs it's a little different because it's the cycle of rigs coming on and offline. So, as companies go through these cycles, yeah; they're going to be a sell on a short term basis because they might not do as great in terms of profitability.

But if you're looking on the long term horizon -- like you said -- drilling activity in the offshore is going to continue to increase, these rigs are going to be in use over the long term, and to do that -- like we were saying -- Atwood is just one of the better companies to do it. Taylor and I, talking about this earlier, we both really liked their balance sheet, we like the fleet that they have.

O'Reilly: So, it's the best of both worlds. They have a good fleet, their balance sheet...

Crowe: They have a modern fleet, they have a decent balance sheet, they're not a huge company. Their fleet is considerably smaller than any of the other companies that we've -- when we talk about Diamond, or Transocean or Seadrill, or anyone like that. But all those things said, just because they're smaller doesn't mean that they're not well positioned.

O'Reilly: Right.

Muckerman: Agreed. And they have a CEO who used to work for Transocean. So, he knows how to run it if it does decide to get better.

O'Reilly: And he has better assets over where he is now.

Muckerman: Much better assets, and they've slowly started to sign contracts with the ultra-big producers, not just the small time independents that they started out with a couple years ago. They're getting big time contracts from other companies with strong balance sheets that aren't going to as quick to pull the plug on projects.

Crowe: Yeah, and if you are one of those investors who wants to look at that horizon instead of the waves; it seems like a very opportune time to pick up shares of Atwood as well. Right now they're trading at .77x their book value. So, $0.77 on the dollar for the assets they have on hand are worth. If you look at it you could say "Well, maybe it's because some things are coming down the pipe."

But if you look, like we said, about their fleet; they might retire one or two, but they're not going to have those huge asset write downs like we're seeing with other companies in the space as they retire those things. So, that book value is pretty accurate in comparison to what we should expect over the long term.

O'Reilly: Very good. Well, before we go, guys I wanted to get your guys' thoughts. I saw this on the news scroller earlier. Fun fact: Oil has the lowest share of U.S. transport since the steam age.

Muckerman: What?!

O'Reilly: That's scary, guys!

Crowe: Oh my God!

Muckerman: I don't even remember the steam age.

Crowe: What is it down to?

O'Reilly: 92.

Crowe: 92%?

O'Reilly: Down from 93%.

Muckerman: Yeah. Electric vehicles, people are moving more to urban areas.

O'Reilly: So, this needle moved a little bit because a couple of people we know probably bought a Prius and that was it.

Muckerman: Prius, Tesla, there's not a huge adoption yet, but people are moving to cities. More foot traffic, more bikes, more metros, and even the buses here in D.C. are advertising how clean they are. Some people, you can visibly see the reduction, but I think people see it with their eyes more so than the actual data might hint. You might think that oil's on its way out, but as we just said it's still 92% of transportation fuel.

So, LNG, electricity have a long way to go.

Crowe: Yeah. If there's any takeaway from that it's -- for the investors -- it's patience. There are -- I remember we talked about this about three or four years ago. With natural gas being as cheap as it was --and still is, in comparison even at today's prices of oil -- natural gas could become a legitimate substitute for fueling vehicles in the United States.

We have seen some progress there. Companies like Westport Innovations (WPRT -3.08%), Clean Energy Fuels (CLNE -3.25%) ...

O'Reilly: It still requires trillions...

Crowe: Yeah. This is a really, really big shift that we're talking about. To usurp oil is going to be a huge, huge, monumental effort. I think two or three years ago when this idea, this seed got planted in a lot of people's minds they got very excited about the idea. You saw huge run-ups in stock prices at places like Westport Innovations, and Clean Energy Fuels, and whatnot.

But since then, that progress hasn't happened as fast as stock prices did.

O'Reilly: And those companies -- to be fair -- are still growing at 20% or 30%. They're still making money.

Crowe: Sales are growing. It's a steady slog uphill and it should be a slog because we're trying to move a very large boulder that is oil by transportation. But at the same time investors have lost patience with a lot of these stocks because they didn't meet their expectations within a year, or two.

Which, I guess is kind of surprising that -- if you were investing in that, you would think it would turn around that quickly. But if you see stuff like this, it shows that there is progress away from oil and that optionality will make things better for everybody in the future. Optionality becomes more competitive prices and things like that.

So, if you're an investor in something that is looking to disrupt the transportation fuel industry, I would just say "Have patience. It's coming, it's just not coming as fast as you may have expected."

Muckerman: Not a freight train yet.

O'Reilly: Not yet. Wait a while. Well, that is it for us, Fools. Before we go, I wanted to make our listeners aware of a special offer for all Industry Focus listeners. If you found this discussion informative and you're looking for more Foolish stock ideas, Stock Advisor may be the service for you. It is our flagship newsletter started more than 10 years ago by Motley Fool co-founders Tom and David Gardner. We're offering the lowest price out there for Industry Focus listeners. It is $98 for a two year subscription to Stock Advisor.

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