There are different tiers in the oil industry that investors need to pay close attention to. That's more true today than it has been in many years. If you are looking at oil stocks right now as the price of this energy commodity has soared, make sure you are getting into the right area of the market for your long-term needs. To help you figure out whether it's the right time to buy oil stocks, it'll help to examine Centennial Resource Development (PR -0.58%), ConocoPhillips (COP 1.23%), and Chevron (CVX 1.54%).
The basic problem
Oil, as noted, is a commodity. That means that, for the most part, a barrel produced by one company is largely interchangeable with one produced by another. Thus, the price is determined by supply and demand, with the balance here fluctuating over time. The last couple of years is a telling example.
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In 2020 the coronavirus pandemic led to widespread economic shutdowns. This quickly reduced demand for oil, causing prices to plunge. As is common when prices fall, capital investment in the energy patch also declined. In 2021 demand has come back, along with increased economic activity. But because of the pullback throughout the energy sector, supply is lagging behind that demand, and energy prices have hit highs not seen since 2018. The bigger news, however, is how quickly energy prices have spiked, with Brent crude prices rising around 75% over the past year.
"Is it time to buy?" vs. "What do you want to own?"
That's extremely exciting, and has led to a strong rally among energy stocks. But here's where things get a little interesting. Tiny exploration and production name Centennial Resource Development, with a market cap of just $1.9 billion, has seen its shares rise a dramatic 880% or so over the past 12 months. That's a massive rally by any stretch of the imagination. Nearly-$100 billion market cap driller ConocoPhillips' shares are up about 120%, while diversified industry giant Chevron, with a market cap of more than $200 billion, has seen its stock gain "just" 50%.
The size distinctions here matter. Centennial is small and entirely focused on drilling, which means that oil and natural gas price moves can have a disproportionate effect on its top and bottom lines. Its tiny scale also means that it tends to rely heavily on leverage, often tied to its reserves (which change in value along with the price of energy), to fund its business. That means that commodity rallies can be hugely beneficial, while price declines can be particularly painful. Centennial is the kind of company you buy when you want to leverage yourself to energy commodity price moves. After such a huge price gain in the past year, for the stock and oil, investors looking at Centennial today need to be very confident that oil and gas prices will continue to advance if they step aboard this stock. This is a highly leveraged bet that most investors probably shouldn't make.
ConocoPhillips is sort of in the middle here, with enough scale that it can generally weather the ups and downs of commodity prices while still having adequate access to capital markets. Thus, it can generally navigate troubled oil markets with ease. That ability, which generally comes with less sensitivity to oil price moves, is what focusing on a mid-tier name in the energy sector affords investors. However, as with Centennial, after such a big run up in ConocoPhillips' price and the price of oil, investors need to have a positive outlook for so-called black gold if they buy this stock. Sure, an oil downturn wouldn't hurt as much here, but it would still hurt.
Chevron falls into the integrated energy major category, which is basically made up of the biggest and most diversified names in the energy patch. Chevron's business spans across the drilling (upstream), energy transportation (midstream), and chemicals and refining sectors (downstream). The ultimate goal is to smooth business performance over time, since each of the sectors has a different earnings profile. While Chevron's top and bottom lines are still highly dependent on oil prices, it tends to be a more predictable and consistent stock -- for example, the company has increased its dividend annually for over three decades. Chevron didn't drop as much when oil prices tanked and hasn't risen as much as they've recovered, with dividend investors continuing to collect a generous dividend all along the way. The current yield, meanwhile, is historically high at nearly 4.9%. This is the type of stock you buy when you want to invest for the long term. Even in today's environment, it would be a worthwhile addition for income investors looking for energy exposure.
What to do with oil?
In the end, the question of whether or not it's time to buy oil stocks really boils down to a timing call. Energy commodities have had a big rally, and based on the supply/demand imbalance they could continue to rise. However, eventually supply will catch up with demand and prices will decline again. That's just how the industry works. After such massive runs up, pure play drillers like tiny Centennial and mid-tier name ConocoPhillips probably don't have a lot of room to run unless oil keeps moving higher. That's the bet you are making with these two drilling-focused names. Chevron, meanwhile, still looks historically attractive based on its dividend yield, and should provide a smoother ride no matter which way oil prices go because of its more diversified business model.
In other words, long-term investors looking to own an oil name should stick with Chevron today. Speculators will probably prefer Centennial or, for those with lower risk tolerances, ConocoPhillips. However, neither of these two drillers are "set it and forget it" stocks, so you'll need to watch carefully just in case oil prices move against you.
