For many investors, 2020 was a year to forget, especially those who had stakes in the oil and gas industry. The price of a WTI crude oil barrel reached a record low in April, sending the stock prices of oil companies tumbling. Macroeconomic conditions improved in the second half of the year, but the energy industry is still far from the pre-recession levels.
Investing in a business sector when there is a lot of pessimism could be a daunting task, but if done correctly, it could help investors generate stellar returns in the long run. After all, Warren Buffett (Trades, Portfolio) once said, "Buy when there's blood in the streets," suggesting the best time to buy a stock is when the market seems to be punishing a stock more than it should.
The key to this strategy is managing risks, as downtrodden industries have a higher risk of bankruptcy if things go wrong. In this article, we will take a look at some of the opportunities available in the beaten-down energy sector, with a focus on strategies to minimize downside risk.
The positive signs
The price of a WTI crude oil barrel surpassed $50 in the first week of January for the first time since early 2020, and this is certainly good news for investors.
There are many reasons to suggest that 2021 will be a much better year for oil stocks in comparison to the previous year. First, OPEC decided to remain cautious about increasing the oil supply on Jan. 4 and reiterated its belief that continued monitoring is required to stabilize prices. Even though production will be increased in January to account for the expected increase in the demand, I think there is plenty of drivers for the oil cartel to remain focused on pushing oil prices higher throughout 2021 to recover the massive losses experienced as a result of the Covid-19 recession.
Follwing is an excerpt from a press release about the OPEC meeting on Jan. 4:
"The Meeting, which reconvened following an initial round of discussions on 4 January, reaffirmed the continued commitment of the participating countries in the Declaration of Cooperation (DoC) to a stable market in the mutual interest of producing nations; the efficient, economic and secure supply to consumers; and a fair return on invested capital. In addition, the Meeting recalled the decision taken by all DoC participating countries at the 10th (Extraordinary) ONOMM on 12 April 2020 to adjust downwards overall crude oil production, the unanimous decisions taken at the 11th ONOMM on 6 June 2020, and the outcomes of the 12th ONOMM on 3 December 2020."
Economic growth projections remain optimistic for this year despite the ongoing threat posed by the pandemic. Upward pressure on the demand for oil resulting from economic growth and downward pressure on supply resulting from OPEC's decision to curb production is welcome news for oil giants, as the price of a crude oil barrel will likely increase under these conditions.
Second, the energy sector is the most undervalued market segment today, which makes it tailor-made for contrarian and value investors to shop for bargains. As illustrated below, Morningstar finds the most number of "5-star undervalued stocks" in the energy sector, whereas the tech sector seems to be the most overvalued.
Source: Morningstar
To add some perspective, coal outperformed crude oil in 2020, which is a telling sign that the market is mispricing the most-used energy source in the world. There seems to be an anomaly between the economic reality facing the oil industry and the market value of major oil and gas companies, and this is good news for bargain hunters who are looking for undervalued companies to invest in.
Third, major oil and gas companies and oil field services companies seem to have accelerated their plans to embrace digital transformation and a transition to embrace green energy solutions. This is a very positive development and could result in the market attaching high valuation multiples to companies that are actively pursuing sustainable business models.
Some oil supermajors have already announced their plans to achieve zero emissions by 2040, and most of these plans were announced in 2020. The timing can't be a coincidence. Many of these ambitious plans will begin to go into effect in 2021, and this will likely attract investors into those companies once again, even though many investors chose to remain on the sidelines in recent years because of the uncertainty surrounding the long-term outlook for this sector. The key here, then, is to look for oil majors who are investing in the future, not just the present or past.
The risks of investing in oil companies
One of the primary risks to this area of the market is the possibility of an unfavorable demand-supply curve. Under normal circumstances, it would be reasonable to assume that the sharp decline in capital investments will lead to significant underinvestment in oil and gas exploration fields, which in return will result in oil production not being sufficient to address the demand.
Such a scenario would be positive for oil prices. This time around, however, there is no clarity as to how demand will behave. For instance, Deloitte projects the demand for oil coming from the airline industry to remain 75% below the pre-recession level even in the best-case scenario in 2021, and the work-from-home trend followed by many more companies since the pandemic began have resulted in a 35% reduction in work-related travel from the pre-pandemic levels. Some of this will likely not be recovered, as many office jobs can be done just as effectively from home.
The above numbers go on to suggest that the expected decline in supply will be met with a sharp decline in demand in the coming years, which creates confusion about the directional movement of oil prices in the short to medium term. In case demand does not rise as expected, oil companies will continue to generate meager profits in the coming years, which makes investing in oil companies risky from a financial standpoint. It is best to look for players with lower debt to minimize this risk.
Takeaway
Oil stocks are cheap, and the energy sector is arguably the most undervalued in the market today. It's relatively easy to find reasons to invest in this beaten-down sector, but investors need to remain cautious as there are a lot of ways how oil stocks could continue to underperform the broad market in 2021 as well.
The best way forward, in my view, is to identify oil companies that are in a position to accelerate investments in 2021. Another key is to find companies that are not suffering from a massive debt burden.
For instance, Occidental Petroleum Corporation (OXY, Financial) needs to be avoided as the company is now forced to focus on reducing its debt burden in the coming years.
Suncor Energy, Inc. (SU, Financial), on the other hand, is well-positioned to leverage its operating efficiencies in 2021, assuming oil prices will remain above $50 per barrel.
There will be both winners and losers in the energy sector in 2021, and prudent investors stand to gain from the significantly undervalued nature of this business sector - if they can identify bargains that are not too weighed down by risks.
Disclosure: The author owns shares in Suncor Energy.
Read more here:
- Contrarian Investors Should Consider UK Stocks
- Book Value Is No Longer a Good Measure of Berkshire's Value
- The Current State of the Value vs. Growth Debate
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