As you've probably heard by now, oil is getting hammered. Fears of a global supply glut, brought on by rising production in the United States and OPEC's recent decision against cutting production, have resulted in a huge sell-off. The price of West Texas Intermediate crude oil is now all the way down to around $55 per barrel, which is amazing considering that it traded near $100 per barrel earlier this year.
This situation had a clear effect on the publicly traded oil majors. Shares of Exxonmobil (XOM 1.98%) and Chevron (CVX 1.64%) are down 14% and 18% year to date, respectively, compared against the 7% gain in the broader market so far in 2014. But their performance could be even worse, considering how far crude oil has declined. ExxonMobil and Chevron are navigating this environment much better than other companies across the oil and gas industry. Here's why.
Downstream serves as a saving grace
Declining oil prices are disastrous for exploration and drilling activity. Production becomes far less profitable, and new projects are often put on hold in light of the diminishing returns. This has a distinct impact on earnings in the upstream side of the business, which includes production. For example, last quarter, Exxonmobil's year-over-year upstream earnings fell 4% to $6.4 billion, due to falling oil prices. Likewise, Chevron's upstream profit fell by 8% in the quarter. With oil's continued sell-off, fourth-quarter upstream profit are also likely to be ugly.
However, the integrated majors hold a key advantage over their pure exploration and production peers. Exxonmobil and Chevron have downstream businesses as well, which includes refining. Downstream earnings usually improve when oil prices decline, because pricing spreads typically increase, which leads to higher margins and profits. This has played out so far this year, serving as an insurance policy of sorts for the super-majors. Exxonmobil's downstream profit soared 73% in the last quarter. The company realized an $820 million tailwind from expanding refining margins. Meanwhile, earnings in Chevron's downstream business increased to $1.3 billion last quarter, up from just $380 million in the same quarter of 2013.
Measures to fortify upstream profits should help, too
Investors need to brace themselves for unpleasant fourth-quarter earnings reports out of Big Oil. Downstream is helping keep profits afloat, but only so much can be done considering that the price of oil is down by nearly half this year. In addition, upstream earnings still represent the bulk of the integrated business model -- Exxonmobil derived 79% of its profit last quarter from upstream operations. But even in the upstream side, steps can be taken to avoid a collapse.
First and foremost, look for Exxonmobil and Chevron to meaningfully reduce capital expenditures next year. Both companies have yet to announce their capital and exploratory spending programs for 2015, but investors should fully expect a continuation of a recent trend of capital restriction. Chevron's 2014 capital budget of $39.8 billion was down $2 billion from the prior year's spending. Further spending cuts will help shore up cash flow.
Stocks look cheap, offer compelling value
When combined with the benefits of an integrated business model, the cost cuts will help ExxonMobil and Chevron generate enough free cash flow to continue paying their strong dividends and invest in future growth. Both stocks also look cheap right now, thanks to their poor performance this year. Exxonmobil and Chevron trade for just 10 and 9 times trailing earnings, respectively, which is a significant discount to the market multiple. In addition, Exxonmobil's 3.1% dividend yield and Chevron's 4.1% dividend yield offer a nice opportunity for income investors. These yields represent multiyear highs for both companies.
While it's certainly scary out there, Exxonmobil and Chevron are two high-quality businesses selling at a discount. Right now might just be a great buying opportunity.