Buying the Winning Team

It’s almost Thanksgiving. Plenty of people will be hitting the road soon. And for many, the first stop will be the gas station.

There, they’ll be faced with a decision…

Do you stare at the ground? Or do you face the music and watch the numbers on the pump go up… and up… and up?

To many, that’s painful. You don’t just seem powerless. In many ways, you are.

If gas prices double, you’re stuck. The drive to work or the grocery store isn’t magically getting any shorter. And it’s a long walk to Grandma’s for the holidays.

In my younger years, higher gas prices annoyed me like everyone else. But not anymore. I own enough shares in oil and gas companies that the dividends cover my annual fuel bill.

And yes, I did the math. In a roundabout way, pumping gas means I’m paying myself.

And you might be surprised at how little capital is required if you invest in the right place. And if oil prices go higher, odds are so will my dividends.

I made the decision long ago to never be subjected to high gas prices. The solution? I bought a stake in the winning team.

The energy markets are something I’ve followed closely ever since I completed my graduate studies in petroleum engineering at UT Austin.

Today, I’m breaking down three types of energy investments to help you combat rising gas and energy prices. And yes, I’ll tell you my favorite area of this market right now.

But first, a brief tour of the behemoth that is the global energy market.

Super-Major

There are many ways to gain exposure to the energy sector.

First, you can buy what Wall Street calls the super-majors. This traditionally includes Exxon Mobil (XOM), Chevron (CVX), and four European energy titans. I always try to be objective. So, I’ll also include Saudi Aramco, China Petroleum & Chemical, and PetroChina. All three fit the same definition.

To be a super-major, the company needs global drilling, production, and refining expertise.

One benefit of investing in the super-majors is they form an effective oligopoly. That means a limited number of firms compete for market share. The cost of entry is so high that only a few governments can really compete with the super-majors.

These firms have truly huge balance sheets, many years of oil and gas reserves, and diversified global operations. That enables reliable dividends. Exxon, for example, has increased its dividend for 42 consecutive years.

Super-majors are also less reliant on commodity prices compared to other oil and gas investments. Sticking with Exxon, the company has a worldwide refining capacity of 4.6 million barrels of oil per day (4% of the total). Margins in that business often rise when oil falls.

The reason is that refined products, like gasoline, have “sticky” prices. Gas stations and other vendors lower prices as slowly as they can get away with. That’s why when crude oil prices fall 10%, prices at your local gas station barely budge. It can take weeks, sometimes months, before they align. During that window, refineries make above-average profits.

That’s no coincidence because it serves as a great “hedge” for falling oil prices.

On the negative side, super-majors are large and complex. As a result, they can be slow to adapt. They must also spend enormous amounts of money every year just to maintain reserves (the amount of recoverable oil and gas in the ground they have rights to). Exxon will spend about $25 billion in 2024 alone.

E&P

Exploration and production (E&P) are up next.

These energy companies don’t bother with operating refineries or trying to sell gasoline at branded stations like Exxon or BP. Instead, they are dedicated to finding, producing, and selling hydrocarbons. That includes oil, natural gas, and natural gas liquids.

Source: Worldoil.com. EOG Resources drilling operation, 2024.

On the plus side, this makes them greater beneficiaries of higher commodity prices. A 50% increase in oil prices often results in a much higher percentage in an E&P company’s profits. If you want to make a bet on higher oil prices without the risk of trading crude oil futures, an investment in a quality E&P company is a great option.

On the other hand, E&P companies can be riskier. A lot riskier. If prices fall dramatically, they have no other business line to lean on.

When oil crashes, a long list of E&P companies always go bankrupt. 2020 was the most recent crash. When that happened, 45 E&P companies went under in North America alone. Many have weak credit ratings. But there are a few, like EOG Resources (EOG), that have strong A- or comparable investment-grade ratings.

They won’t have the intense upside potential of a smaller drilling company. But they are also a lot more likely to survive a downturn.

These companies come with lower dividend yields and more volatile share prices. Still, there are a handful with good dividend track records.

Money in the Midstream

Lastly, let’s touch on the midstream segment.

These companies own and operate the pipelines, ports, storage facilities, and other infrastructure that allow hydrocarbons to be transported all around North America and, in some cases, the whole world. Enterprise Products Partners (EPD), for example, owns over 50,000 miles of pipeline and can store over 300 million barrels of oil and natural gas liquids at its facilities.

Source: Enterprise Products Partners System Map

Some of the larger midstream players even export liquefied natural gas (“LNG”) overseas. Midstream companies can be structured as master limited partnerships (“MLPs”) or traditional C-Corps. So, make sure you understand the difference.

The main benefit of investing in midstream companies is their high and stable yields. Enterprise Products Partners currently pays a 6.9% dividend yield (more than double Exxon’s) and has increased its dividend for 27 straight years.

But like any investment, there are downsides. Since midstream companies generally charge based on flow volumes instead of value, their revenue doesn’t immediately rise (or fall) with energy prices.

Instead, it’s contract based. And fees charged to use their pipelines generally increase at a rate closer to inflation. In many ways, they are more like real estate or infrastructure companies than energy. That said, there is a strong correlation you should understand.

If oil prices rise, drilling activity does, too. And when you have many E&P companies bidding to use a pipeline, the rate the owner can charge increases. Remember, it can take 10 years or more to build a new oil or gas pipeline. So, while midstream companies aren’t the best bet on short-term moves in commodity prices, a long-term increase certainly improves their business. And unless oil production permanently declines in the areas their pipelines service, their revenues are usually stable. That’s how companies like Enterprise Products Partners have not only paid, but increased, their hefty dividends throughout countless commodity cycles.

With all that being said, one of these categories easily takes the title of most attractive in my view.

My Favorite Energy Sector Right Now

All the areas we covered today have great potential, but there is a big difference between them right now. Exxon Mobil now trades at double its pre-pandemic high. At 15 times earnings, that’s 50% more expensive than its long-term average. The same applies to its close peers.

The better drillers aren’t quite as pricey, but they are very sensitive to crude oil prices. With oil still trading below $70 a barrel, their current share prices are too optimistic. My favorite in today’s market are the midstream players. Top-quality companies like Enterprise Products Partners are trading at pre-pandemic highs instead of 50% or 100% above them. Now, it’s true that we don’t expect as much capital gains from midstream players. But using EPD as an example, it’s trading at just 11 times cash flow, which is a 15% discount to its long-term average. Enbridge (ENB), Williams Companies (WMB), and Cheniere Energy (LNG) are other top energy infrastructure companies to consider.

Regards,

Stephen Hester
Chief Analyst, Wide Moat Research