Energy Stocks Remain Undervalued Despite the Recent Rally

Why Exxon Mobil and Chevron are good picks for contrarian investors

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Mar 10, 2021
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The International Monetary Fund has provided a revised forecast on oil prices, estimating an average price above $50 per barrel in 2021. As of March 8, the Dow Jones U.S. Oil & Gas Index had a value of $434.46, indicating a one-year return of 26.18%. This confirms that energy stocks, in general, have recovered sharply after reaching historic lows in early 2020.

In the last quarter of 2020, the rise in oil prices was fueled by the distribution of the Coronavirus vaccines, which improved the outlook for the global economy. An upward trend in oil prices will drive the leading players in the industry to carry out more expansive drilling operations, which in turn could help these companies report strong revenue and earnings growth in the coming periods as long as they do not overshoot again and end up with another mass global oversupply.

According to the U.S. Energy Information Administration, in January, the price of a Brent oil barrel averaged $55, which is up 10% since December 2020. In addition to the vaccines, the rising prices had a lot to do with Saudi Arabia's move to cut oil production by 1 million barrels per day, which was in addition to the amount agreed on by OPEC earlier last year.

The average price of gasoline in the U.S increased to $2.33 per gallon in January from $2.20 in December last year. The EIA's forecast for the average price of gasoline in 2021 and 2022 is $2.44 and $2.46 per gallon, respectively. The average price of diesel increased to $2.68 per gallon from $2.58 in December as well.

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As oil prices surge, there are a couple of companies in the industry showing potential to provide sound returns to investors. My picks would be Exxon Mobil Corporation (

XOM, Financial) and Chevron Corporation (CVX, Financial).

Since the commencement of the vaccine rollout in December, Exxon Mobil stock has accelerated from $41.22 to $60.46 per share, but there seems to be more upside considering the fact that a full recovery from the recession is yet to occur. Chevron seems to be another good pick for investors to gain exposure to the energy sector, and even

Warren Buffett (Trades, Portfolio) seems to be bullish on the prospects for Chevron going by his continued investment in the company.

OPEC+ remains focused on supply cuts

Earlier in the year, the Organization of Petroleum Exporting Countries (OPEC) along with other non-member allies decided to reduce the output of oil, and this has put upward pressure on oil prices and energy stocks. It appears to be that members and non-members of OPEC are continuing to strongly comply with the recent decision in a bid to tighten the oil market, creating the possibility of a supply deficit in 2021 but also lessening the risk of oversupply.

According to the EIA, the estimated production of oil in the current year is expected to experience a downward spiral resulting in 11.1 million barrels per day. From 2019 to 2020, the production has dropped from 12.2 million to 11.3 million barrels per day, and this downward trend is very likely to continue this year as well.

Many OPEC members rely on the production of crude oil to drive their economic growth, so lower prices in the market are seen as an adverse development that could threaten the strength of their economies. Because of this, OPEC has a very strong interest in stabilizing oil prices ahead of foreign competitors.

An economic rebound will stimulate the demand for oil

With the anticipation of a global economic recovery, the consumer demand for the commodity is driving the price of oil higher which is likely to create a shortage in supply later this year. The largest economies in the world, including the United States, China and Europe, are among the major distributors of vaccines to the public. India is also expected to report stellar economic growth this year, which should lead to an increase in the demand for the commodity.

The expected recovery of the travel industry in the second half of this year should also help oil prices as the cruise industry and the airline industry are large buyers of gasoline products. Understandably, the demand for oil coming from these two business sectors reached record lows last year, but things are likely to turn around later this year.

There's a strong negative correlation between commodities and the strength of the U.S. dollar as well. When the dollar weakens, it gives more support to oil prices because it is traded internationally using the greenback. Founder of Vanda Insights Vandana Hari argues that keeping the dollar weak throughout 2021 would be in the best interest of the U.S economy as it would lift oil prices higher.

Is oil overvalued?

Contrary to the popular belief that oil has more runway for growth, some analysts believe oil prices might stabilize at the current level. Siebert Williams Shank analyst Gabriel Sorbara believes even if OPEC continues to limit the supply of oil, a lack of certainty in continued demand will stop oil prices from increasing in the future. However, he believes the market performance might be dominated by other macroeconomic factors discussed earlier in this article. In a research note to clients, Gabriel wrote:

"A weakening dollar, inflation risks and money flows (including continued rotation into small-caps and value stocks) could all add fuel to the momentum and drive commodity prices and the sector higher regardless of fundamentals."

Investing in companies that are involved in oil drilling or other related business sectors makes more sense than investing in a fund that tracks oil prices as it would help mitigate the threat of stable commodity prices.

Takeaway

Oil prices are soaring in response to the economic recovery, the increasing demand for oil, and the extension of supply cuts by OPEC. Both Exxon and Chevron are known to reward investors handsomely with dividends and stock buybacks, and rising oil prices will help both these companies avoid dividend cuts in the foreseeable future. More importantly, the energy sector continues to be the most undervalued sector from a Shiller price-earnings perspective, presenting contrarian investors with an opportunity to exploit.

Disclosure: The author owns Exxon Mobil shares.

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