4 Sep

Energy Stocks: Operational Metrics, Valuation, Outlook

WRITTEN BY Rekha Khandelwal, CFA

We discussed the basics of the energy industry in the previous part of this series. We also discussed the types of energy companies and the energy sector’s key indicators, including crude oil and natural gas prices. Let’s now discuss the key metrics to look at when analyzing energy stocks.

Production volumes, production costs, and finding and development costs are the key operational metrics to consider when analyzing upstream operations.

  • Production volumes: Companies generally report their production volumes as BOE (barrels of oil equivalent), which makes comparison across years and companies easier. Companies measure natural gas production in Mcf (million cubic feet) or Bcf (billion cubic feet). For easy comparability, one can convert natural gas and liquids production volumes to oil-equivalent barrels.
  • Production costs: Investors analyze production costs for oil-equivalent barrels. A lower production cost per BOE indicates the better operational performance of a company.
  • Finding and development costs: Finding or exploration costs are the costs associated with identifying and proving a location that may contain oil and gas reserves. Development costs are the costs associated with developing a reserve for production. They include the costs of drilling development wells and installing facilities needed to start production. Investors usually analyze finding and development costs on a BOE basis.

Midstream and downstream metrics

Transport volumes, storage volumes, and fractionation volumes are key metrics to consider to understand the performance of midstream energy stocks.

  • Transport volumes: These volumes primarily show the volumes of oil and gas transported on a company’s pipelines.
  • Storage volumes: These volumes represent the volumes of oil, gas, and NGLs (natural gas liquids) stored in a company’s storage facilities. Higher transport and storage volumes result in higher revenues for a midstream operator.
  • Fractionation volumes: NGLs fractionation is the process of separating the mixed NGLs that were extracted during production. The NGLs should be separated from natural gas and are usually sold separately.

The refining margin is the key operational metric used to evaluate a refinery’s performance.

  • Refining margin: This margin indicates the difference between a refinery’s refining revenue and its cost of product sold divided by its throughput volumes. Refinery throughput represents the total barrels of crude oil and blendstock inputs in the refinery for a particular period.

Energy Stocks: Operational Metrics, Valuation, Outlook

S&P 500 energy stocks

The S&P 500 Index (SPY) includes 28 energy stocks. ExxonMobil (XOM) and Chevron (CVX) are the two largest US energy companies by market cap. The above table lists the S&P 500 energy companies. It also lists their market caps, one-year total returns, and PE and forward PE ratios. As the table shows, all S&P 500 energy stocks except ConocoPhillips (COP), Oneok (OKE), and HollyFrontier (HFC) generated negative total returns in 2018. Forward PE uses the earnings estimates for the next year.

Energy Stocks: Operational Metrics, Valuation, Outlook

Decreased weighting

The energy sector’s weighting in the S&P 500 Index is down significantly in the last ten years. The sector accounted for 13.3% of the total index in 2008. It now accounts for 6.1%—less than half of its weighting in 2008.

The steep fall in energy stocks primarily caused the sector’s decreased weighting in the S&P 500 Index, which is a market-cap-weighted index. The energy sector represented just 5.3% of the index in 2018. That represents a fall of roughly 12% from 2017. The sector now accounts for 4.4% of the S&P 500 Index.

Energy sector valuation

The energy sector is currently the most undervalued of all the S&P 500 sectors. Energy sector stocks are trading at an average PE of 13.5x compared to the market’s PE of approximately 20x.

Energy Stocks: Operational Metrics, Valuation, Outlook

The graph above shows the calculated sectoral PE ratios. The fall in energy sector stocks made the sector attractive. The energy sector is the worst-performing sector in the last ten years.

Outlook for energy stocks

Though the energy sector’s valuation is attractive, investors aren’t much interested in it. Crude oil oversupply resulting from increased production is a major concern for investors, as it affects energy sector stocks. Moreover, the uncertain macroeconomic outlook continues to affect oil prices and, in turn, energy stocks.

The sector may consolidate in the coming years. Only the most efficient operators in the segment will likely survive. Occidental Petroleum’s (OXY) acquisition of Anadarko (OXY), Marathon Petroleum’s (MPC) acquisition of Andeavor, Enbridge’s (ENB) acquisition of Spectra Energy, and Ensco’s acquisition of Rowan Companies are a few notable recent mergers in the energy space.

In addition to earnings growth, investors also want to see capital and financial discipline among energy companies. Therefore, companies return capital to shareholders via dividends and buybacks instead of investing in inorganic expansion. Companies also aim to reduce their debt to strengthen their balance sheets. Public markets are largely uninterested in energy companies. However, private equity players are active in the sector.

Changes in corporate structure, especially in the midstream segment, are another trend in the sector. Companies are increasingly finding that the MLP structure isn’t as relevant or useful as it was earlier. Many MLPs are moving back to the C corporation structure.

Energy companies can’t control oil prices, but companies that can grow in any energy price environment will do well in the long term. Players that are dealing with inefficiencies—whether controllable or uncontrollable—will go bankrupt or be taken over.

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