When people look back at 2020, it will almost certainly be viewed through the lens of the coronavirus pandemic. A lot will get lost in the haze, but the severe hit the oil industry took because of the novel illness will probably be a key highlight. For investors looking to find bargains, meanwhile, the current pain could set up longer-term gains. Will those come in 2021?
The terrible, no-good year
There's no way to sugarcoat 2020 for energy companies. It was really awful -- but that didn't start in 2020. There's a bit more history here. The backdrop really goes back to the start of the onshore U.S. fracking boom. As the United States became an increasingly important global producer of oil and natural gas, the world's supply/demand balance tipped toward oversupply. That was being managed by OPEC and its partners, which had been cutting their production.
The problem is that every time OPEC trimmed its output, U.S. producers simply increased theirs. In early 2020 that led to a rift between OPEC and Russia, which was growing tired of this dynamic. The two sides opened the oil spigots, and the market was flooded with production. A slight oversupply quickly became a material oversupply, and energy prices fell. That's exactly what you would expect.
The problem is that at around the same time this was happening the global pandemic was starting to pick up speed. Countries around the world effectively shut their economies in an attempt to slow the spread of the illness. That resulted in a massive decline in demand at the exact moment that supply was dramatically increasing. Energy prices plunged, with key U.S. benchmark West Texas Intermediate crude briefly falling below zero at one point. Needless to say, profits in the energy patch plunged, and so did the stocks of the companies in the space, including global energy giants like ExxonMobil (XOM 0.24%), Chevron (CVX 0.84%), BP (BP -0.85%), Royal Dutch Shell (RDS.B), and Total (TTE -1.00%).
Where to from here?
OPEC and Russia quickly patched things up and started to constrain output again. However, the damage was done, with all of the excess oil getting put into storage. That oil will need to be worked off before energy prices are likely to mount a sustained rally.
Drawing down supply will likely require the world getting a better handle on the pandemic. There are signs of progress on that front, with coronavirus vaccines now being distributed around the world. But it will be months, if not quarters, before the vaccines are distributed widely enough to have an impact on the direction of the pandemic. In the meantime, OPEC and the broader energy industry will continue to struggle to keep the supply and demand situation from spiraling out of control again.
Some companies have taken the current downturn as a sign of what the future might hold for oil and natural gas, which are carbon-based fuels and are central in the global warming debate. BP and Shell both cut their dividends and announced plans to dramatically shift their businesses toward cleaner alternatives, including electricity and solar and wind power. Total made a similar commitment, but is making plans for a longer transition, and hopes to sustain its dividend despite the headwinds. Exxon and Chevron, meanwhile, have both basically decided to stick with oil.
With the industry so out of favor, investors might be enticed to jump into the energy sector to pick up some bargains. The key is that there are very real risks that need to be addressed, and focusing on the largest and strongest names, like the oil majors, is probably a better option than taking a risk on a small wildcatter. That's because the pain isn't over yet, and it won't be until the world moves past the coronavirus. That transition will only start to take place in 2021, so don't expect a quick fix. Small and financially-strained energy names are likely to continue struggling.
Of the oil majors, Chevron is probably the best positioned financially. Its debt to equity ratio is a very modest 0.26 times. The next lowest debt to equity ratio belongs to Exxon, but this company is facing notable spending requirements if it wants to maintain its production over the long term. There's more risk there than the roughly 0.4 times debt to equity ratio suggests. Indeed, investors are increasingly worried that the company won't be able to sustain its dividend at current levels.
After that, you get to the European majors, which tend to have higher leverage and higher cash balances. BP is the most leveraged, with a debt to equity ratio of nearly 1.1 times. Add in the business shift it is undertaking, which will be costly, and most should probably avoid it. Shell is in a better spot, with a debt to equity ratio of around 0.7 times. However, given the dividend cut and the big corporate overhaul, it might not be the best bet either.
Total is something of a punt, with a debt to equity ratio of 0.75 times and a slower transition plan that includes sustaining its dividend. However, when you look at the French company's balance sheet, you see that its roughly-$62 billion in long-term debt is partially offset by roughly $31 billion in cash. The company estimates that its net debt to capital ratio is around 0.26 times, putting it on par with Chevron. That's a much more compelling picture.
It will take time
Investors try to anticipate the future, so it wouldn't be shocking to see oil and energy stocks move higher before there's a material change on the coronavirus front. That said, it is highly likely that the world will only start to move beyond the pandemic in late 2021, and it might even take until 2022 for material progress to be seen. A cautious stance with regard to the energy patch is probably a good call.
In that regard, the standout name for those looking to focus on oil is Chevron. Investors that want to hedge the clean energy issue should probably take a closer look at Total. And while the upside potential is probably greatest for smaller and more leveraged energy names, the risk/reward trade-off isn't likely to be a good one for most investors given the ongoing supply/demand headwinds. Big and strong is the way to go in 2021 in the energy sector.