Investing in Top Oil Stocks

Updated: Oct. 5, 2020, 4:33 p.m.

An oil company is an entity engaged in at least one of the following three activities:

  • Upstream exploration and production (E&P) of oil and natural gas, as well as oilfield services.
  • Midstream transportation, processing, and storage of oil and related liquids, including refined petroleum products and natural gas liquids (NGLs) like ethane and propane.
  • Downstream refining and distribution of petroleum products.
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The oil industry is rapidly changing in the current economic climate. Find the latest information in the newsfeed at the end of this article.

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Oil companies are crucial to the global economy because they provide the fuel needed for transportation and power, as well as the building blocks of petrochemicals.

However, the oil industry is highly competitive and volatile. That volatility was on full display in 2020, as crude prices went on a wild ride because of COVID-19. Because of these and other factors, investors need to tread carefully around the oil patch, especially when it comes to the companies that explore for and produce oil and gas. Here's a closer look at the factors to consider before buying oil stocks, as well as the top companies in the sector.

Oil rig silhouette against a reddish golden sunset.

Image Source: Getty Images

How to analyze oil stocks

The oil industry is inherently risky for investors. While each segment has a specific set of risk factors, the overall business is both cyclical and volatile.

Oil demand grows along with the economy, which when robust can support higher oil prices and producer profitability. However, geopolitics and capital allocation also play crucial roles in the industry. Several large oil-producing nations are part of OPEC, an organization that works to coordinate national oil policies. OPEC's actions can significantly affect the price of oil.

That was the case in early 2020, as the organization’s market support agreement with Russia collapsed right as COVID-19 knocked the wind out of demand. Meanwhile, oil companies that operate independently of OPEC can also have an impact on the oil market if they allocate too much or not enough capital to new oil projects.

Given the volatility in oil prices, an oil company must have three crucial characteristics to survive the industry's inevitable downturns.

  • A strong financial profile with an investment-grade bond rating, significant amounts of cash on hand or ample access to credit, and manageable debt maturities.
  • Low cost of operations or less volatile cash flow streams. E&P companies need to be able to sustain operations at oil prices below $40 a barrel. Midstream companies should get more than 85% of their cash flow from steady sources like fee-based contracts. Downstream companies should have operating costs below the industry average.
  • Diversification. Oil companies should operate in more than one region or engage in several different activities.

What are the top oil companies?

With those factors in mind, here are three top oil stocks worthy of investors' consideration:

ConocoPhillips

Kinder Morgan

  • NYSE:KMI
  • A large-scale, diversified midstream company

Phillips 66

  • NYSE:PSX
  • A leading refining company with midstream, chemicals, and distribution operations

ConocoPhillips

ConocoPhillips (NYSE:COP) is one of the largest E&P-focused companies in the world, with operations in more than a dozen countries. It also produces oil using a variety of sources and methods, including horizontal drilling and hydraulic fracturing of shale in the U.S., oil sands mining in Canada, and deepwater drilling, as well as other conventional production techniques elsewhere around the world.

ConocoPhillips' diversified portfolio has low supply costs, with a significant portion of its oil reserves economical below $40 a barrel. Because of that, the company can produce a substantial amount of cash flow at lower oil prices.

Finally, the company complements its diversified, low-cost portfolio with a top-tier balance sheet. ConocoPhillips routinely boasts one of the highest credit ratings among E&P companies, backed with a low leverage ratio for the sector and lots of cash. Because of this, it's highly resilient to lower oil prices, making it one of the best-positioned oil companies to handle the sector's volatility.

Kinder Morgan

Kinder Morgan (NYSE:KMI) is one of the largest energy infrastructure companies in North America. It operates the continent's biggest natural gas pipeline network, and it’s a leader in transporting refined petroleum products and storing oil and refined products. Finally, it's a major carbon dioxide transportation company, using CO2 to produce oil in Texas by injecting it into aging oil fields to coax more crude oil out of the ground.

Kinder Morgan has minimal direct exposure to oil prices because it generates most of its income from fee-based contracts. Overall, those agreements typically support more than 90% of the company's annual earnings, with about two-thirds having no volume risk (meaning customers pay the company even if they don't use their contracted capacity). While about 10% of the company's cash flow usually has some direct exposure to commodity prices, Kinder Morgan typically secures hedging contracts to lock in pricing on about half of those earnings. Because of those features, Kinder Morgan’s earnings proved to be fairly resilient during the market downturn of 2020.

Finally, Kinder Morgan has a strong investment-grade balance sheet. That provides it with the financial flexibility to continue making growth-related investments as well as return cash to shareholders via its buyback and dividend, even during rough patches. That was the case in 2020 as Kinder Morgan increased its dividend even though many rivals reduced their payout.

Phillips 66

Phillips 66 (NYSE:PSX) is one of the leading refining companies, with operations in the U.S. and Europe. It also has investments in midstream -- including sizable stakes in two master limited partnerships, Phillips 66 Partners (NYSE:PSXP) and DCP Midstream (NYSE:DCP) -- and in chemicals via its CPChem joint venture with Chevron (NYSE:CVX). Finally, its marketing and specialties business distributes refined products and manufacturer specialty products like lubricants.

Thanks to its large-scale operations, Phillips 66 is among the lowest-cost producers in its industry. The company, for example, leverages its midstream network to provide its refineries and petrochemical facilities with low-cost oil and NGLs. It also focuses on producing higher-value products like low-sulfur diesel, which boosts its profitability. Finally, it invests in projects that improve its margins, especially on the refining side.

Phillips 66 also boasts a strong financial profile, which includes an investment-grade balance sheet, well-laddered debt maturities, and lots of liquidity. Those factors provide it with the financial flexibility to invest in expansion projects, pay an attractive dividend, and repurchase shares.

Related topics

Risk management is the key to investing in the oil patch

The oil market can be quite fragile, with a slight imbalance between supply and demand often causing it to go haywire. That was abundantly evident in early 2020 as the COVID-19 pandemic sent the sector into a tailspin. As a result, investors need to be careful when choosing oil stocks. Focus on oil companies that can survive rough patches; they’ll be better positioned to thrive when markets turn healthy again.

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