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Are Oil Stocks a Good Investment?

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So far, oil stocks have been volatile in 2020. All of the major oil and gas stocks are trading with significant YTD losses despite the bounce from their April lows. Oil prices have fallen sharply this year. The global oil demand plummeted due to the coronavirus pandemic. Initially, on the supply side, the OPEC+ block was reluctant to cut production. WTI turned negative in April for the first time in history. 

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Many investors wonder if they should buy oil stocks now. First, we will discuss whether oil stocks could rebound. Investors need to understand the oil and gas industry’s structure. 

The oil and gas industry can be broken down into three main parts.

  • Upstream energy companies are involved in oil and gas exploration.
  • Midstream energy companies move the oil and gas to downstream refineries where crude oil is refined to products like gasoline.
  • Downstream companies convert the extracted crude oil to “usable” products like gasoline and diesel.

Most energy companies are present in one part of the energy value chain. However, there are some integrated energy companies, like ExxonMobil and Suncor, that are present across the entire value chain from extracting to transporting and refining oil. The risk-return dynamics are different for energy companies based on their position in the value chain. 

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Which oil stocks to invest in

Generally, upstream energy companies are the most volatile. They have the highest correlation to energy prices. An investor who can tolerate high risk and volatility should consider upstream energy stocks. So far, the SPDR S&P Oil & Gas Exploration & Production ETF, which invests in upstream oil and gas stocks, has fallen 45 percent in 2020. Many upstream energy companies including, Chesapeake Energy, have filed for bankruptcy this year amid low energy prices.

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The COVID-19 pandemic saw oil prices plummet in April 2020.

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Midstream companies are less volatile and work somewhat like a utility. Usually, these companies pay a healthy dividend. Many of the companies are structured as an MLP. If you want to invest in oil stocks for dividends, you should consider adding midstream companies to your portfolio. Enbridge, TransCanada, and Kinder Morgan are some of the leading midstream oil companies.

For downstream oil stocks, the key driver is the refining crack spread and not necessarily prevailing oil prices. Crack spreads have fallen in 2020 due to the sharp fall in energy demand amid the pandemic. As crack spreads tumbled, so did downstream oil stocks. For example, Marathon Petroleum has fallen 36 percent YTD. If you want to bet on the refining crack spread, you should consider midstream energy stocks. 

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Will oil stocks rebound?

Energy stocks have been among the worst-performing sectors in 2020. Crude oil prices have to rebound for oil stocks to recover. Crude oil prices, like all of the other commodities, tend to be a function of underlying demand and supply. The demand side of the equation has been particularly weak this year due to the pandemic.

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OPEC expects the global crude oil demand to grow by a record of 7 barrels per day in 2021. Also, OPEC raised the demand outlook for 2020. Increased oil demand would help oil stocks rebound. The coronavirus vaccine trials look encouraging. Global economic activity should resume to near-normal levels after there’s a vaccine for the deadly virus. Crude oil prices could rise over the medium term due to the recovery in global oil demand. Oil stocks should rebound after crude oil prices revert to more normalized levels of ~$60 per barrel.  

Given the current slump in oil stocks, there could be a rebound over the medium term. Since oil stocks may remain volatile in the near term, investors should cautiously build their positions in oil stocks. Over the long term, global crude oil demand will likely fall amid the shift to electric vehicles. Although electric vehicles are a minuscule percentage of total vehicle sales right now, their share keeps rising steadily. Tesla, a U.S. electric vehicle maker, has a higher market capitalization than Toyota Motors—the world’s largest automaker. 

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While President Donald Trump says climate change is a hoax, most other countries are taking steps to control emissions. The European Union plans to spend $1 trillion over the next few decades to be carbon neutral by 2050. China, the world’s largest automotive market, is also taking several steps to increase electric vehicle adoption. More electric vehicles sales are negative for crude oil prices and oil stocks.

Although Tesla CEO Elon Musk compared gasoline cars to “steam engines” last year, they will not be in museums anytime soon.

The shift towards electric vehicles could be much more gradual than what the markets expect. Currently, electric vehicles are priced significantly higher than comparable internal combustion engine cars. Unless electric cars achieve some sort of price parity with gasoline cars, they could have a hard time outselling gasoline cars.  

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