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Bad News Is Good News for (Some) Oil Stocks Right Now

By Reuben Gregg Brewer – Jun 11, 2020 at 7:19AM

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Oil stocks have been on a run lately, but there's one negative that's still a big issue. But this bad news is good news in the long run.

OPEC has agreed to extend production cuts, which energy investors expect to help correct the painfully out-of-balance global supply/demand equation. That's got oil prices up off their recent lows and energy stocks moving higher again. But there's something else going on in the industry that investors need to consider that could limit the growth of energy companies both large and small. Here's what you need to watch, and how you should think about it.

Forget the near-term ups and downs

Oil and natural gas are commodities prone to dramatic and frequent price moves. All it takes is a bit of news and prices can soar or collapse, often taking the share prices of energy industry giants like ExxonMobil (XOM 5.28%) and Chevron (CVX 5.61%) higher or lower. The stocks of smaller players like Chesapeake Energy (CHKA.Q) and Matador Energy (MTDR 10.02%) are usually impacted even more.

A man standing in front of an oil rig with tablet in his hand

Image source: Getty Images

There's a mismatch here that's important to recognize, though. Oil majors like Chevron frequently explain to investors that they don't pay all that much attention to near-term energy price moves, preferring to focus on the long-term supply and demand equation in the energy sector. That isn't to suggest that near-term price changes don't have an impact -- the current low oil prices have led Chevron to reduce its capital spending plans as it attempts to balance cash going out the door with cash coming in. However, Chevron still sees a bright long-term future for oil, as does Exxon. So while these companies are pulling back, they are keeping their eyes on the long term and still spending. 

Smaller players are pulling back, too, but the impact on their businesses can be more dramatic, particularly when it comes to onshore U.S. drilling. That's because non-conventional wells tend to produce a lot of oil up front, but the flow slows quite quickly to a trickle. In order to keep production growing, unconventional drillers need to keep drilling. Exxon and Chevron have diversified businesses, mixing short-cycle assets (like unconventional U.S. wells) and longer-cycle assets (like offshore wells), along with material downstream businesses that add even more variety to the cash flow stream. 

Put simply, the bigger players can not only afford to spend more even during difficult times, but they also have business profiles that allow greater flexibility. But that brings up the bad news that's taking shape in the energy market, despite rising oil prices.

Historically low

This down cycle in the oil sector has been particularly brutal due to a combination of factors, including the long-term increase in U.S. onshore production, an ill-timed price war between OPEC and partner Russia, and the demand drop off related to the global effort to slow the spread of COVID-19. It got so bad that oil prices briefly fell below zero, which, in theory, means that oil drillers were paying customers to take oil off of their hands. And there's still a huge glut of oil sitting in storage that needs to be worked off before a sustained price increase can really take hold.

XOM Chart

XOM data by YCharts

That's where the "bad news is good news" factor comes in. Generally speaking, pulling back on capital spending means slower production growth for oil companies. For an onshore U.S. driller that can quickly lead to production declines. So it's terrible for onshore U.S. drillers that the number of rigs operating in the United States today is near historic lows. This isn't a small issue -- the current active rig count is now about 80% below the peak levels seen in 2012.

Drillers are pulling back very hard, and that will have material implications for their individual businesses. But with cash flow weak because of low oil prices, there really hasn't been much of a choice. Indeed, some companies in the U.S. onshore space are already going bankrupt, and more are likely to follow

However, from a big-picture point of view, fast-growing U.S. production was one of the factors that led to an oversupply of oil in the first place. So a material pullback in onshore drilling will actually help speed up the process of getting supply and demand back in balance. Add in OPEC's production cuts and the outlook starts to look even brighter on the supply side of things. On the demand side, there's still a lot of excess oil sitting in storage to work off -- but with economies around the world starting to reopen, the need for oil is again getting back to more normal levels. So a steep drop in drilling is bad news on the one hand, but on the other it's exactly what the oil market needs.

Turning things around

As you watch the news in the energy sector, be careful to think about the long-term supply/demand equation like the energy giants do. That's what matters, and what will really determine what is good news and what is bad news. On that score, a drop in drilling in the U.S., a key source of oversupply in the global market, is very good news, even if it means that there's likely to be a shake up in the sector. In fact, a few more bankruptcies might actually be a benefit, too, if they foster more rational long-term drilling plans. On the negative side, what you'll want to watch out for is a material uptick in energy prices leading to a material uptick in U.S. drilling, as that could start a brand new down cycle again. All in, as an investor today, you should probably focus your attention on companies that have proven they can manage through volatile periods like this, like the integrated giants. 

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Exxon Mobil Corporation Stock Quote
Exxon Mobil Corporation
$91.92 (5.28%) $4.61
Chevron Corporation Stock Quote
Chevron Corporation
$151.73 (5.61%) $8.06
Chesapeake Energy Corporation Stock Quote
Chesapeake Energy Corporation
Matador Resources Company Stock Quote
Matador Resources Company
$53.82 (10.02%) $4.90

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