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Is Now the Time to Buy Energy Stocks?

Fears of the new coronavirus (Covid-19) have now spread to the energy sector as the dramatic reduction in travel has resulted in lower global fuel demand.

On Friday, Saudi Arabia and Russia ended their three-year-old agreement on price cooperation, kicking off a price war as Saudi Arabia announced steep discounts and a boost in production. Following the news, the prices of Brent crude (the international oil price benchmark) and U.S. West Texas Intermediate (the U.S. oil price benchmark) dropped 24% on Monday before rebounding approximately 10% on Tuesday. This marks the steepest oil price drop since Iraq invaded Kuwait in 1991.


A price war affects more than just the ones who kick it off, though. The U.S., which surpassed Saudi Arabia and Russia as the world's biggest producer of crude oil in 2018, will face significant downward price pressure as well if it wants to keep exporting oil.

This has resulted in approximately 55% of the world's largest publicly traded oil companies trading within 10% of their 52-week low prices, according to GuruFocus data. Shares of ConocoPhillips (NYSE:COP) are down 24.84% from Friday, March 6, while shares of ExxonMobil (NYSE:XOM) are down 12.22%. Occidental Petroleum (NYSE:OXY) lost a whopping 46.61% as investors were already worried about the company's high amount of debt.

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Given all the downward price pressure, value investors may be wondering if now is the right time to pick up cheap energy stocks. However, before deciding to buy energy stocks, investors may want to consider how long the downward pressure is going to continue - and which oil companies have the financial strength to capture market share during a price war.

Supply and demand

Since 1991, there have been two major declines in oil prices, which can be observed through ExxonMobil's yearly revenue chart below. One was in 2009, when prices fell to $35 per barrel (down from $55 in 2008) as a result of the Great Recession, which left large amounts of oil in storage facilities in the wake of reduced consumer spending. The other was from 2014 to 2016, when prices spiraled from $125 per barrel to $30 per barrel as oil companies around the world competed to supply emerging economies such as China and India with oil and ended up oversupplying.

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"With a combination of a massive supply overhang and a significant demand shock at the same time, the situation we are witnessing today seems to have no equal in oil market history," tweeted International Energy Agency Director Faith Biriol on Monday.

The oil industry recovered from the last three price collapses because global growth in demand was strong, but with demand growth expected to continue its slowdown, investors that follow the energy sector may see a new situation emerging.

According to IEA reports, global oil demand is expected to increase by 1.2 million barrels a day in 2020. "Unless other things change, we will see a surplus probably, unless there is very strong demand growth recovery," Keisuke Sadamori said in a CNBC interview.

While OPEC and Russia cut production by 1.2 million barrels per day in 2019 in order to support prices, the U.S. did not follow suit, and neither did most other major non-OPEC oil-producing nations, including Brazil and Norway.

Now, not only is the oil industry facing demand growth slowdown and a supply glut, it may also see reduced demand in 2020 due to slower overall economic growth and reluctance to travel in light of the new coronavirus. On March 5, the International Air Transport Association upped its estimates of the virus' total global toll on the air transport industry from $29.3 billion to between $63 billion and $113 billion, illustrating just one of the ways in which demand for oil will be negatively impacted as fewer planes take to the air.

As long as oil prices continue to decline due to various factors, the stocks of the companies that produce it are not likely to see growth in their earnings or share prices. Thus, stock support will need to come in the form of demand growth, supply cuts or increasing market share.

Fighting for market share

Without changes to supply or demand, oil companies will need to scramble to gain more customers and sell more oil than their competitors. This is a fight for market share, and the winners will be the companies that can survive devastatingly low profit margins while expanding their customer bases.

In this scenario, the most important characteristics for success are reputation and financial strength. Customers will naturally flock to producers that provide the best-known prices, ensure their drilling practices have the least impact on the environment, produce from a certain region or have some other characteristic that buyers find desirable. Meanwhile, even a good reputation cannot keep a bankrupt company afloat, so financial strength is important in order to survive having to sell at lower prices.

Oil companies that have both a good reputation and high financial strength are thus in a better position to capture market share while prices are low, which could leverage their profits once prices recover.

To buy or not to buy

Given the recent price declines, some investors may be thinking that now is the time to buy energy stocks at rock-bottom prices. Depending on the company, that may be the case. The best opportunities are likely to come from those companies that can capture market share and continue paying dividends as their profits drop.

Several large global oil producers now have dividends yields near or above 10% when you compare their current price to the trailing annual dividend (i.e., how much one share of common stock has earned in dividends over the past year). As of March 10, ExxonMobil has a dividend yield of 8.02%, Royal Dutch Shell (NYSE:RDS.B) has a dividend yield of 10.64% and Valero Energy Corp. (NYSE:VLO) has a dividend yield of 6.08%, all of which mark historical highs.

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With a GuruFocus financial strength score of 6 out of 10, ExxonMobil has paid uninterrupted dividends since 2018. Royal Dutch Shell has paid uninterrupted dividends since 2013 and has a GuruFocus financial strength score of 5 out of 10. With no debt and a financial strength score of 6 out of 10, Valero has paid uninterrupted dividends since 2014.

As there is little to suggest that oil prices will see a significant increase anytime soon, investors wanting to get a slice of the energy industry may want to prioritize financially strong, big names with good dividend track records, and prepare to be in it for the long haul.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.

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This article first appeared on GuruFocus.