Are Oil Stocks Undervalued? - Financespiders

Are Oil Stocks Undervalued? - Financespiders

Interest in the energy sector has been dormant for quite some time, but all it takes is one crisis, and oil snaps back into everyone's collective psyche.

War in Ukraine and economic sanctions imposed on Russia have left the world wondering where oil and gas supplies will come from, and what that can mean for commodity prices.

These events may have brought oil to the forefront of the conversation, but the fundamental long-term drivers have been trending toward higher oil prices and a favorable market for oil stocks over the past several years.

Here's why, even absent the war in Ukraine, there is reason to think oil stocks are undervalued.

Addressing the biggest "known unknown"

Before really diving into the merit of oil companies and their relative valuations, let's set the table here. The war in Ukraine is having a profound impact on the market right now, and the consequences of that conflict are being felt in commodity markets. 

The trouble with using such a drastic and volatile market catalyst as the core of an investment thesis is it puts a huge onus on having that event continue in its existing state for a long time.

I think it's fair to say that individual investors don't have enough information at our disposal to make an accurate assessment of the situation, how long it will remain this way and its definitive impact on the market for the foreseeable future. 

So while the war in Ukraine is playing an outsize role in commodity prices, that may not be the case one, two, or five years from now. That is the kind of investment time horizon long-term investors want to target. 

So for this exercise, let's focus on the most important long-term drivers: Where will demand be in a few years? And will supply be sufficient enough to meet that demand? 

Demand and its drivers

When it comes to oil demand outlooks, you can find a forecast to support your preconceived notions on the market. In the past week alone, I've seen oil demand forecasts say that peak demand will come as early as the latter half of this decade, while others say it will come between 2040 and 2050.

That's an incredibly wide range of outcomes, but they all more or less say the same thing: Electrification and alternative fuels, especially in the road transportation sector, will play a key role in reducing overall demand.

Demand in emerging markets is likely to climb for several more years, while more mature market demand will start to taper off.

All forecasts come down to how quickly those things happen. A decent gauge of how quickly this is likely to happen is the size of the global fleet of internal combustion engines (ICE). According to U.S. Energy Information Administration, the global fleet of ICE vehicles is expected to peak in 2038.

Almost all of that fleet increase is expected to come from emerging and developing markets, while mature markets have probably already hit their peak ICE size.

There are, of course, a lot of other things that require or rely on oil outside vehicles -- aviation, petrochemicals, asphalt, construction materials, and more -- and innovations in renewable fuels could displace conventional oil before vehicle consumption peaks.

That said, the global ICE fleet is a pretty decent gauge for now to determine oil's long-term demand. So it's fair to say that oil demand is likely to increase for at least another decade.

Supply's potential shortcomings

There is one core tenet of oil supply and production: You have to replace what you extract. Oil reservoirs get depleted, and companies need to spend to discover, assess, and develop new sources to replace diminishing ones.

According to the International Energy Agency, production at existing fields declines between 8% and 9% over a four-year period. 

For the past several years, though, fewer and fewer dollars are getting spent on exploration and development. Again from the IEA, global upstream investments -- that's exploration and production only -- from 2015 to 2019 was $1.2 trillion, or 31%, less than from 2010 to 2014. What's more, total spending in 2020 and 2021 were the lowest spend rates in decades.

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For those years, producers were talking multibillion-dollar losses and trying to cut costs to keep the lights on. So the amount of money invested in developing new sources to offset declines and meet growing demand over the past seven years has been incredibly low.

That, in turn, means there are fewer new sources set to come online in the coming years.  This can change, and high prices are likely to lead companies to spend more on developing reserves and increasing production. Increasing production isn't as opening a tap, though.

For example, ExxonMobil's (NYSE: XOM) development of a find in Guyana took five years to go from discovery to commercial production, and that was one of the fastest offshore developments in the history of the industry.  

The long lead time it typically takes to ramp up production suggests that we will be in a period of higher oil prices for several years. That may not mean prices as high as what we've seen recently, but certainly high enough for producers to justify increasing their capital spending budgets and generate returns for investors.

Undervalued oil stocks?

Even absent global current events, there were a lot of long-term market forces that suggested oil prices were going to be higher for some time. Several years of diminished spending are starting to take their toll on the industry's ability to offset declines and meet increasing demand.

That combination of a weaker supply pipeline and years of cost-cutting has left many producers able to generate significant free cash flow at decently high oil prices. For example, producer Devon Energy (NYSE: DVN) estimates that at $95 per barrel, it can generate a 15% free cash flow yield.

Generating 15% of its entire market capitalization in free cash flow annually is absurd and suggests that, if that price level can stay there for some time, Devon is probably an undervalued oil stock. That's one example, and there are probably several others that offer similar types of returns out there. 

Here's the rub, though. As these past few years have shown, the market can turn on a dime. So any investment in this industry should come with some very conservative assumptions about the future.

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There is likely to be some significant returns to be had in oil stocks right now, based on the long-term fundamentals of the industry, but current events could lead to wild swings in the short term. Be ready, and be prudent. Source: The Motley Fool...

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