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Low Interest Rates Mean Cheap Oil Is Here to Stay

Oil prices peaked at over $100 a barrel in mid-2014 before falling sharply. They have, basically, been moribund since. Normally, low energy prices help to weed out the industry's weak players, but that's taking a painfully long time to happen this time around. A big piece of the problem is the historically low interest rate environment. Here's what you need to know, plus the reason why sticking with the industry giants remains your best course of action.

The normal boom and bust cycle

Oil is a commodity prone to frequent ups and downs. In fact, there has been a series of bull and bear markets in oil over the last few years, despite the fact that the commodity has been largely stuck in the $50 to $60 range most of the time. Although oil prices are historically quite variable, there's something throwing a monkey wrench into the normal cycle today -- low interest rates.

Image source: Getty Images.

In a typical cycle, growing demand eventually outstrips the supply of oil and leads to increased energy prices. High oil prices, in turn, lead to increased spending on new production. As that new production comes online the supply/demand imbalance is corrected. Normally production overshoots demand, however, and oil prices start to fall, often quite dramatically. When that happens, the weakest players in the industry -- which generally overextend themselves during the upturn -- end up getting flushed out of the system. This can take many forms, but usually it means bankruptcy or getting bought out. This cycle isn't unique to the energy sector; it's how most commodities work.

The problem today is that the downside of the current cycle isn't playing out quite like it has before. It has been long and drawn out, increasing the pain that all oil drillers are feeling.

Why it's (kind of) different this time

Although the news is filled with stories about oil industry bankruptcies, the supply/demand imbalance simply isn't going away. For starters, demand growth has been relatively soft because of conservation and a weak global economy. But equally important today is that interest rates are historically low and demand for income-producing securities is incredibly high. The upshot is that even financially weak companies, including those that have taken a turn through bankruptcy court, can still get financing.

So the shakeout that normally happens at the bottom of the cycle isn't taking shape quite as quickly as it has in the past. Weak companies are limping along hoping for better days. Adding to the issue is the fact that so-called "unconventional" onshore U.S. oil drilling has made the United States a global leader in oil production. Known as fracking, this method of drilling tends to result in quick increases in production (think weeks and months) compared to things like offshore oil drilling, which can take years to produce results. Put cheap, easy money and fracking together and every time oil prices start to rise again, U.S. production picks up and puts a damper on the price increase.

The easy cash is giving the weakest players breathing room that they typically wouldn't have, so they can hang on a little longer. At the same time, however, industry giants like ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX) are starting to move more aggressively into the unconventional oil space. This would normally be a case of well-financed players displacing weaker companies, but not this time around. The weaker drillers are still in the game because, despite low oil prices, they continue to get cash from investors to fund their businesses.

It is an ugly scenario that has been hard to solve, even though OPEC has been working to curb production in an attempt to balance supply with demand. Onshore U.S. production, however, is simply picking up the slack that this oil group is attempting to create because a large enough shakeout hasn't taken shape.

Waiting out the storm

All in, the oil sector looks like a terrible place to invest today. Unless, of course, the company you buy has the financial strength to keep investing in any environment and the track record to prove that it can and will do just that. Which is where Exxon and Chevron come in. These two industry giants have long histories of navigating the oil industry's ups and downs with relative ease. One place to see that is in their dividends, with each having increased their disbursements annually for more than three decades. Clearly, these companies know how to deal with industry downturns while still rewarding investors.

XOM Dividend Yield data by YCharts

That is largely because they don't focus on short-term gyrations, instead looking to the long-term supply/demand dynamics of the industry. They know that a company has to have the financial strength to muddle through the downturns, often investing during the weakest moments, so that they can thrive during the upturns. To that end, Exxon and Chevron have two of the strongest balance sheets in the energy sector, with financial debt-to-equity ratios in the 0.15 times space -- which would be a low number for any industry. Essentially, they have the financial strength to take on extra debt during a downturn without putting their long-term viability at risk.

That basically means that Exxon and Chevron can outlast smaller players that take on greater financial risks by leveraging up their balance sheets. But this process is taking longer today because of the low interest rate environment. However, there's a good side to this because it is creating a huge opportunity for dividend investors who are willing to think long-term along with Exxon and Chevron. To put a number on it, their dividend yields, at 5.7% and 4.6%, respectively, are near their highest levels over the last 20 years.

No easy fix

At this point, there's no clear solution to the problems facing the energy sector. The typical boom and bust cycle is stuck in a bust rut because it's too easy for financially weak companies to raise cash. However, if history is any guide, weak names will eventually get flushed out of the system and the largest and strongest companies will survive. That, in turn, will allow them to thrive when demand outstrips supply again, leading to rising oil prices. The coronavirus, recently named COVID-19, might be the industry shock that helps that happen, since it has dramatically reduced demand from China and led to a renewed oil downturn. Only time will tell.

What's pretty clear, however, is that Exxon and Chevron should survive the COVID-19 hit in stride. With any luck, the smaller and financially weak names in the industry won't. And the boom/bust cycle can get back on a more typical track. If COVID-19 doesn't do the trick, something else eventually will. That said, if you are an income-focused investor, now would be a good time for a deep dive into Exxon and Chevron, before investors finally stop throwing money at weak drillers.

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Reuben Gregg Brewer owns shares of ExxonMobil. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.


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