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By many measures, the Oil and Gas exploration industry has been the worst-performing industry over the past decade. It was also the best performing sector on Monday and closed nearly 11% higher on the back of the Houthi attack on Saudi Aramco.
If you are bullish on oil, now is the time to buy explorers as earnings are likely to rise substantially on higher oil. If you are not bullish on oil, now is the time to buy explorers as valuations like this do not exist in any other industry.
While Aramco is racing to get its pipeline back online, the disruption may last longer than expected. Even more, any hope of constructive talks with Iran is probably off the table and I would not be surprised if we see further escalations in the Strait of Hormuz.
5% of the world’s oil supply is offline due to one attack; 21% of the world’s oil comes through the Strait of Hormuz. The entire oil system today is perhaps the most fragile segment of the global economy. One individual or group makes a single mistake (i.e., anyone fires a weapon), and a very significant portion of the world’s oil is offline.
If supply is cut for any length of a month or two, oil prices could very quickly rise to all-time highs or higher because the world cannot reduce energy consumption. If you commute to work, you must pay for gasoline no matter how high the price.
With tensions in the Persian Gulf on the (unsteady but unending) rise and U.S. rig counts on the decline, it may be a great time to buy oil. In my opinion, the best way to do so is through oil and gas explorers or the ETF (XOP) as the companies offer a leverage effect to oil and are extremely undervalued.
The SPDR Oil & Gas Explorers ETF
Before we get into the nitty-gritty, let’s go over the basic details of the XOP ETF. The fund has been in existence since the summer of 2006 and is trading at a lower price than when it was launched. It has a relatively low dividend yield of 1.5%, but that will likely rise when oil prices inevitably recover. It also has a low expense ratio of only 35 bps.
Despite the fact that the fund has failed to deliver positive returns for most of its history, it does have a strong $1.7B in AUM. Let’s take a closer look at the fund’s price vs. its AUM to see if there are any important trends among fellow investors:
Data by YCharts
I love this chart. Despite the collapse in oil prices, AUM was consistently rising until this year when it has turned sharply lower. In my opinion, up until 2018 investors were too optimistic about oil and were buying these companies for their value opportunity. Since oil crashed again last fall, investors have finally thrown in the towel.
When the majority of investors give up hope, it is finally time to be hopeful. A similar pattern is seen in (USO) wherein (primarily retail) investors bought the crude oil ETF during the collapse and have been cutting losses ever since:
Data by YCharts
Of course, contrarian views to investor sentiment are not enough to make for a good investment. The fundamentals must also support higher prices. Let’s get into the crude fundamentals.
U.S. Supply Likely to Reverse to the Downside
Recently increased U.S. crude oil production over the past decade has been the primary driver of lower global oil prices. U.S. crude production has increased nearly threefold since the recession and has made the U.S. the largest player in the market. Accordingly, U.S. production is the most important factor when assessing/forecasting crude prices.
In my opinion, the best leading supply indicator for the U.S. is the Baker Hughes operating rig count. Take a look at how U.S. rig count leads U.S. crude production by about 18 months and how the rig count lags crude prices by about three months:
Data by YCharts
As you can see, when crude falls and profit margins for producers become negative, rigs go offline and production falls which inevitably creates a shortage that increases crude prices, restarting the cycle. Following the sell-off in oil last year, rigs have been on the decline while production has been climbing. There is a high probability that U.S. production will stagnate over the coming months.
While U.S. rigs will likely rise following the disruption at Saudi Aramco, there will be a significant lag time where a huge shortage is likely.
Coincidentally, OPEC oil production has already been on the decline, further exacerbating a likely shortage:
Data by YCharts
Of course, the huge elephants in the room are Saudi Arabia and Iran. I believe the fundamentals supported higher oil prices (I’ve been long USO since two months ago) without any further escalation in the Middle East. That said, I also expect the escalation to continue as attempts to halt it have all been utter failures. Put simply, there is no telling how high crude can go if the escalation continues and, particularly, if it continues to be a huge strain on supply.
I expect oil prices to reach $70 by year-end without escalation. With supply-constraining escalation, it could easily rise to over $100 per barrel again.
Now that the macro picture is out of the way, let’s dig into XOP and the companies within it to highlight how great the buying opportunity is.
Cannot Get Much Cheaper Than This
There are 63 companies in XOP that have a weighted average “P/E” ratio of merely 5.4X. Of course, that was high because oil was higher last year so, according to SPDR, the forward weighted average “P/E” ratio of the fund is 11.3X. That said because oil prices just popped back up, the true forward P/E ratio is probably more like 7X. Even better, the fund has a price-to-book ratio of merely 0.72X.
Let’s look even closer at those companies. Here is a snapshot of the key financial statistics of all of the holdings:
Note, “Typical” denotes harmonic mean for valuation data and median for others.
(Data Source – Unclestock)
Admittedly, these companies are not as easily valued as most. Many do no generate positive earnings and thus have artificially high “P/E” ratios. In my opinion, the best metric in this situation is “Price to sales relative to the five-year average”. A given company’s price-to-sales ratio usually does not vary as much as its price-to-earnings or “EV/EBITDA” ratio so, if it is historically low, then the companies are likely undervalued.
As you can see, the typical explorer is 50% undervalued from this standpoint. Of course, the current ratios are low for most and, for some, debt ratios are signaling possible bankruptcy on the horizon.
That said, investors have more than priced these risks into the companies and have pushed their valuation far below fair value. If oil prices rise, these companies will probably rise much faster.
Looking through this list, Occidental (OXY), Marathon (MRO), and Apache (APA) appear to be the most undervalued when price and risk metrics are taken into account. On the other hand, Exxon (XOM) does not look very attractive.
Intermarket Exposure and the Bottom Line
As investors in the fund know all too well, XOP is a risky investment. Although all the fundamentals seem to point to outperformance, important risks remain. The fund has been volatile and has broad exposure to many assets.
Using least squares we can find how much a percent change in one asset is likely to impact XOP. This is akin to “beta” but for an array of assets.
Here is the exposure I found for XOP:
(Data Source – Google Finance)
As you can see, the fund has decently high exposure to equities and crude oil. This is understandable as the oil itself has high exposure to equities and XOP is an oil-based equity fund. Interestingly, XOP also has positive exposure to junk bonds and negative exposure to bonds in general. This is likely because most explorers’ debt are “junk” status, but it also means that widening corporate credit spreads are likely to be a boon on equity prices.
Risks considered, XOP still looks great at the current level. The fund will likely fall if a recession strikes, but I imagine it will fall far less than many expect as I don’t see oil consumption declining as much as it did in 2008. Interest rates are a risk, but the probability of higher crude prices more than mitigate that risk.
Overall, I expect very strong performance for the fund over the coming months. I imagine it will trade back to the $40 level by mid next year, delivering significant returns to investors. If recession fears become reality, I expect it to remain above $15 unless credit spreads widen too far. For me, XOP is a clear “buy”.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in USO,XOP,MRO,APA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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