Investing in Oil Company Stocks

The recent collapse in the price of oil from a high of $147 per barrel of oil to the current price of approximately $108 per barrel has caused a similar decline in the prices of most oil company stocks. Some companies in the oil patch are not dependent on the price of oil for their profits, while others have profits directly tied to the price of oil. For instance, the companies transporting oil depend mainly on transport volumes; whereas, companies dependent directly on oil production will see a decline in profits because their output of oil is worth less at lower oil market prices (unless those companies have hedged against a decline in price). Accordingly, understanding the different sectors of the oil market is important.

The oil industry is composed of three general types of companies: major integrated oil companies such ExxonMobil (XOM), ConocoPhillips (COP), BP Plc (BP), Chevron (CVX), and Royal Dutch Shell (RDS.A) that explore, transport, and refine petroleum and market refined products such as gasoline; oil transportation companies that own pipelines and transport facilities such as Buckeye Partners (BPL), El Paso Pipeline (EPB), Enbridge Partners (EEP), Energy Transfer Partners (ETP), Enterprise Product Partners (EPD), Magellan Midstream Partners (MMP), and ONEOK Partners (OKS), and pure exploration and production companies, such as Anadarko Petroleum (APC), Apache Corporation (APA), Chesapeake Energy (CHK), Occidental Petroleum (OXY), and Rowan Companies (RDC). It is also worth mentioning two major oil service companies that provide services to drillers worldwide: Halliburton Company (HAL) and Schlumberger Corporation (SLB).

In the short term, most of the integrated oil companies, the exploration and production companies, and the oil service sector will be under some price pressure as the “price bubble” in the oil market slowly deflates as oil demand declines. However, this decline in demand is temporary and will end when the major world economies again move into growth phase probably sometime in 2010. Thus, if one has a long-term investment horizon, some of the major oil companies can be good long-term investments. Chevron (CVX) and ConocoPhillips (COP) are well-diversified internationally and have a strong U.S. domestic market presence. BP Plc (BP) on the other hand is very weighted toward its Russia joint venture, and disruptions in that relationship which is a frayed relationship already could impact BP’s results.

Also, the exploration and production companies will likely be under price pressure for the near term as well. With the oil being pumped from the wellhead less valuable, there will be less profit and less exploration activity. All of the exploration companies will be under pressure for some time; however, if one wants exposure in this area, Occidental Petroleum (OXY) is a good choice because of its high dividend yield and low price-to-earning ratio.

The most promising sector of the oil patch is likely the transport companies. They are not directly dependent on the price of oil although they are dependent on the volume of oil being shipped through the pipelines. Most of the transport companies are structured as publicly-traded partnerships, which means they distribute most of their income as partnership distributions, keeping a small portion to maintain or upgrade their facilities. Most of these companies pay very high distribution rates, some of which is tax-free due to the allowed depreciation allowances on their pipeline equipment. The one drawback to these partnerships is that their distributions are not dividends. Accordingly, at the end of the year, the stockholders receive a K-1 for their share of the income of the partnership. This characterization of the partnership income adds a small complexity to one’s tax returns at the end of the year sometimes requiring an accountant’s assistance. However, if one is looking for high current income in the oil industry, these partnerships are difficult to beat. The best managed partnerships are probably ONEOK (OKS), Magellan Midstream Partners (MMP), and Enterprise Product Partners (EDP), all of whom operate in the U.S. and Canada.

Long-term trends favor investments in the oil sector, particularly the integrated oil companies and well-capitalized exploration companies that can survive a two-year downturn in the business. When world economies again move synchronously into growth mode, consumption of oil will rise, and the stocks of these companies will increase.