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- How I Buy Oil Stocks
I wouldn’t put my worst enemy’s money into most oil stocks.
How’s that for an intro?
I should probably explain. The sector is largely uninvestable because it suffers from three massive risks.
The first risk is the one everyone can identify. The price of oil is always an issue, and everyone who says they can predict it is lying. Without strong oil prices there are hundreds of North American energy producers who are the financial equivalent of zombies, who are constantly looking for their next cash infusion. That can either come as a high interest loan or some sort of shareholder unfriendly equity deal — and that’s if times are okay. That help never comes when times are bad, and bankruptcy is the inevitable outcome.
Hedging is a way for oil producers to at least minimize this risk, but most never even consider the motion — because if they do, they’ll miss out on that sweet stock price appreciation if the commodity goes to the moon.
Imagine going to work every day and not having any idea what price you’ll be able to sell your product for. Ugh. No thanks.
The second issue is exploration risk. Most oil companies are forced to replace their reserves every 5-7 years, an activity that has all sorts of hidden risks. Technology used to identify oil reserves has gotten pretty impressive in the last 10-20 years, but the exercise still has no guarantees.
Prices also play a role here. An oilfield that’s profitable at $90 oil is marginal at $70 oil and a disaster at $50 oil. But once the upfront cost is paid a company will continue to drill, choosing a crummy return on their investment rather than zero cash flow.
Finally, we have management risk. Oil company execs are relentless optimists — they have to be to survive in such a world. So their default solution to everything is to drill, baby, knowing that better times are just around the corner. It doesn’t matter if oil is $40 or $140 per barrel, higher prices are coming soon. How? They just know, dammit. They can feel it in their spleens, or other such nonsense.
They then work backwards from that conclusion, posting all sorts of optimistic looking charts that predict the next oil super cycle is just months away. Don’t believe them? It’s right there! In the chart!
Working for an oil company is the equivalent of showing up at a barber shop every day. It doesn’t take long until you get pretty bullish on haircuts.
Put the three together, and it’s not a great combination. I’m quite bearish on 95% of oil companies, getting to the point where I don’t even consider them as investments. They say a good fisherman fishes where the fish are, and a good investor invests where the profits are. And, for the most part, the energy sector doesn’t provide any profits.
Canada’s largest energy ETF, the iShares Capped Energy ETF (TSX:XEG) has returned less than 7% per year since its inception in 2001, and most of that return has come over the last few years as oil has come back into fashion again. From 2001 through 2020 it was pretty much flat, and that’s even including reinvested dividends.
I doubt most investors were patiently reinvesting their dividends, especially as oil grinded lower from 2013 through 2020. The return without reinvesting dividends was below 6% per year.
This might come as a surprise to y’all after reading the first 500 words of this piece, but your author is an oil investor. I have approximately 5% of my net worth invested in three different oil companies.
Let’s take a closer look at those companies, and how they avoid checking off those terrible boxes we discussed earlier.
How my framework helps identify good oil stocks
Usually when I look at a stock, I use my framework to help identify it as a good investment.
Remember, I’m generally looking for:
Boring companies
Which have solid balance sheets
That deliver tons of predictable cash flow
That pay sustainable, ideally growing dividends
Which are trading for bargain prices
Most oil stocks don’t check off those boxes. They’re often quite levered. The volatile nature of the commodity ensures that any cash flow generated isn’t very predictable. And oil companies are notorious for paying dividends that are sustainable at $90 per barrel and then cutting them when oil inevitably falls to $60 per barrel.
In short, oil (and most other commodities, actually) doesn’t really mesh well with my investing approach.
And yet I still own some.
I thought it was important to own at least a little bit of oil because it serves as a hedge for my consumption. Every day I hop in my car and drive somewhere. I buy goods that were transported using refined oil products. I heat my house with natural gas, and the electricity that powers my home also comes from natural gas.
A small degree of hedging sure makes paying more for energy a lot easier.
This is where it gets tricky. I identified that I wanted to own some oil. But, as I mentioned at the top, most oil companies are trash. So I set out to find a way to own oil in the least offensive way possible.
One way to do that is to own the various pipeline companies, but I view them more as utility operators. They contract with big producers to transport the oil and natural gas we need, and in exchange get steady cash flow. There’s no upside if oil does well.
Oil service companies are another possibility, but they’ve traditionally taken sector downturns squarely on the chin. Basically they’re like oil companies, but with more volatility to lower prices, since all drilling immediately dries up when the price of oil tanks.
Most conventional oil companies are out because they suffer from at least one of the three deadly sins I mentioned off the top.
That left just one solution. Canada’s oil sands companies.
Oil sands operators don’t have much exploration risk, since they’re mostly concerned with mining their massive reserves. Most of the cost to produce is borne up front in building the mine, so oil prices aren’t as impactful to the bottom line. Most oil sands operators have done a nice job shoring up their balance sheets in the last five years, too. They also tend to own significant downstream operations (oil refineries, gas stations) that deliver predictable cash flow no matter what oil is doing.
In short, Canada’s oil sand giants minimize the three big risks that keep me away from the sector. They don’t eliminate those risks completely, but they get about as close as you can get while still getting exposure to the sector.
Intermission
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Choosing individual companies
Once I narrowed down where I was comfortable getting oil exposure, it was then time to try and pick the best oil stocks in that part of the sector. And then I had to figure out when was the right time to buy.
So I did what any competent analyst would do. I looked at each oil sands company individually and judged their merits.
Imperial Oil (TSX:IMO) was an easy choice, and it was the first oil stock I bought in 2019. It has world-class oil sands assets, some of Canada’s best downstream assets, and perhaps most importantly, the best balance sheet among all its peers. Plus the company had an enviable record of both consistent share buybacks and dividend growth, a record that has continued ever since I bought it.
Buying Imperial Oil was a no-brainer, and it continues to be my largest oil holding today.
Next up was Suncor Energy (TSX:SU), which had a few more warts compared to Imperial. Its management wasn’t great and activist investors were getting involved. They called for the company to sell off its gas station assets, which I disagreed with. I thought the downstream assets were the crown jewels, quite frankly. So I’m glad that never happened.
Suncor is also a monster producer in the oil sands, plus it had a smattering of other conventional oil assets. It did a nice job buying up cheap assets in the latter part of the 2010s. And the company really got serious about improving its balance sheet after the COVID oil swoon in 2020.
And, perhaps most importantly, the company brought in Rich Kruger as CEO. Kruger was the man who led Imperial Oil in the 2010s after a long career with Exxon Mobil, Imperial’s largest shareholder. Kruger has already done a nice job of turning Suncor around in the short time he’s been there, and I’m confident he’ll continue to do an excellent job.
Finally, I also bought Canadian Natural Resources (TSX:CNQ). Canadian Natural is led by Murray Edwards, who has perhaps the finest energy business mind on the planet.
CNQ takes a rational approach to energy production. It focuses its attention on projects that will deliver the highest return on invested capital. It’s also serious about returning capital to shareholders, including laying out exactly how it plans to balance dividends, share buybacks, and debt repayment.
It’s refreshing to have such transparency, especially from an oil company.
Canadian Natural also has some of the best assets in the oil sands, and a relentless focus on cost controls is helpful, no matter what the price of oil is doing. It has production where its break-even costs are between $20 and $30 per barrel.
One of the only ways to have a moat in energy production is to be the low cost producer — and CNQ delivers on that front.
Now that I’ve identified which oil stocks I continue to like today, let’s take a quick look at when I want to add to them.
When to buy?
I generally like to buy stocks when they’re flirting with 52-week lows, or there’s some other piece of bad news impacting the name.
Such a move can backfire, but I’ve found that as long as you’re buying quality it’s a pretty good way to ensure you’re buying at a good price.
Oil is slightly different however. I’m definitely looking for 52-week lows, but I’m also looking for something else. I want to see oil investors capitulating.
I’m constantly amazed at how people who follow the oil market intimately don’t know their own limitations. They believe they have the ability to predict prices. They then use that false precision to make bets on the market.
Eric Nutall is perhaps the best example. The man is a relentless oil bull, and the fund he manages has done incredibly well since 2020. But outside of that run, his record is meh at best. You’d be better off flipping a coin than listening to his short-term predictions on oil.
But then again, what do you expect? The man is a professional oil cheerleader. Asking an energy fund manager if he’s bullish oil is like asking a cook if he’s bullish on food.
What I want to see is maximum pessimism, and Twitter (or X, if you’re a narc) is the best way to see it. It’s one of the few reasons I haven’t quit Twitter, actually. That app remains the best way to get investor sentiment in real time, and nothing else is even close.
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