While many other sectors of the stock market have recovered much of their losses, oil stocks as a group remain extremely beaten down. And that makes sense, considering that global oil demand is still down by double digits, with global travel all but halted. In the U.S., gasoline demand is down by half.
But there are some signs the economy is starting to open up in some places, and at some point in the near future, oil demand should start growing. So the next step in this chain of thought is, this is good for the oil industry, right? With the potential for an economic recovery as spring turns to summer, are beaten-down oil stocks where investors should be looking now?
One only has to look at how much farther the Energy Select Sector SPDR ETF (NYSEMKT:XLE) and SPDR S&P Oil & Gas Explor & Prodtn ETF (NYSEMKT:XOP) have fallen as compared to the broader stock market as measured by the SPDR S&P 500 ETF Trust (NYSEMKT:SPY). At the end of the week on May 1, the broader market is down about 17% from the 2020 high, while the two major oil and gas ETFs are down 42% and 50% respectively.
So, are oil stocks a buy now? Should you buy oil stocks? In short, while there are a few opportunities that should pay off over time, the worst is still yet to come for the oil industry. There are likely to be a rash of bankruptcies in the weeks and months to come, and in order to avoid the worst of it, many investors may want to avoid the sector for now.
How the oil industry fell apart in 10 weeks
The first clear signals that 2020 was going to be a tough year for the oil industry came in February, when the International Energy Agency reset its full-year expectation for oil demand as COVID-19 ground China to a halt. In late-February Saudi Arabia and Russia went full-on price war, with plans to flood global oil markets and drive out low-cost supplies. Saudi Arabia doubled-down on its plans only a few weeks later.
But while everyone in the oil patch was staring down the competition, nobody realized just how big the COVID-19 pandemic had become, and global oil demand cratered far more than anyone expected, and on April 20, U.S. crude oil prices went negative.
April 20 probably wasn't the bottom
Many observers look at oil prices, and see that U.S. crude prices have rebounded sharply since the day West Texas Intermediate futures went negative. The interpretation for a lot of folks is naturally, that was the bottom. It can't get much worse than traders paying the buyers $38 per barrel to take deliveries, right?
There's a problem with that interpretation: It ignores the reality in the actual oil market. In the 10 days since oil spent most of a trading session with the sellers paying the buyers, the supply/demand imbalance has only worsened.
Global oil production has exceeded demand for essentially all of 2020, and over the past month, it's intensified. Saudi Arabia and several of its OPEC partners, along with Russia, spent the entire month of April pumping even more oil than in the first quarter of 2020, while global oil demand crashed hard. It was only on Friday, May 1, that the record deal to cut output by about 10 million barrels per day kicked in.
Yet even with that deal in place, along with additional output declines in North America as shale production finally starts falling, the expectation is that global oil output will exceed consumption well into the summer. In a lot of cases -- particularly in the U.S. -- the only thing that will cause wells to be shut in (physically turned off) will be nowhere to send the oil.
All that oil pushes the recovery further out
The past several weeks have seen some of the biggest crude oil inventory builds in U.S. history, and it's only going to get worse. There are more than 100 tankers either heading toward or already off U.S. ports delivering crude oil. The expectation is that this new oil will more than offset the decline in U.S. production, keeping american commercial oil storage filled to the brim for another month or more.
This glut is expected to grow even bigger. A large portion of the world's fleet of oil tankers are being leased as floating storage vessels, and that could add another 200 million barrels to the storage mix.
And the implications of all this oil stored above ground and on the water is enormous. Depending on the speed of recovery in oil demand, and when the recovery starts, it could easily be a year before supply and demand are back in balance.
The bankruptcies have already started, and banks aren't going to save anyone
We have already seen major shale producer Whiting Petroleum (NYSE:WLL) and offshore drilling contractor Diamond Offshore (NYSE:DO) file for bankruptcy protection, while Chesapeake Energy (NYSE:CHK) just had its debt downgraded to the lowest "junk" rating that's only one notch above being in default. More companies are expected to go bankrupt in the months ahead.
And unlike in other past energy downturns where banks extended lifelines to indebted oil stocks to prop up their other loans, large lenders like Wells Fargo (NYSE:WFC) and JPMorgan Chase (NYSE:JPM) have reportedly started setting up operations to deal with defaulting borrowers in the oil patch, including seizing and operating assets instead of taking pennies on the dollar to liquidate them in this environment.
Still want to invest in oil stocks? Look for strength, not cheap prices
The U.S. oil industry is in terrible shape, and in most cases there's just too much risk and uncertainty to make it worth investing in. But there are some companies in good financial shape, with diverse operations that make them worth considering. Three in particular investors should look close at include Phillips 66 (NYSE:PSX), Magellan Midstream Partners (NYSE:MMP), and Total SA (NYSE:TOT).
Of the three, only Total operates oil production, and very little of its production is in North America so it's not as exposed to the shale bomb that's affecting so many U.S. producers. Moreover, all three have strong midstream operations that should hold up relatively well during the downturn, and Phillips 66 and Total have large natural gas segments that aren't dealing with anywhere near the pressure that the oil market is suffering from.
Lastly, all three have very strong balance sheets, with either massive amounts of cash, easy access to cheap debt liquidity, or a combination of both. You won't find any stocks down 60% or 80% here; as a group they're down about 40%, a reasonable discount considering the challenges they face. But you also won't find the enormous amounts of risk that many of the oil stocks that are down 60% and more have.
Lastly, don't expect to make a quick buck. We are still in the early stages of a massive economic collapse, and it's likely to be months before we even start working through the excess oil. These three companies are set to be some of the first to see the benefits of increased demand, but it could take a lot longer for the oil recovery to happen than you think. Invest accordingly.