It’s hard to be an oil company right now…
Over the past few months, the price of oil has tumbled. The benchmark West Texas Intermediate (WTI) crude oil price is down more than 25% since it peaked in June.
Shares of oil companies have fared even worse. Shale oil leaders Continental Resources and Devon Energy are down an average of 26% in the same time frame.
As we told you last month, the downturn is creating an opportunity for investors to buy great oil companies at discounted prices.
[ad#Google Adsense 336×280-IA]But there are several giant oil stocks I urge you to avoid right now…
Oil giants like BP, Chevron, and Royal Dutch Shell are considered to be some of the safest oil stocks to own.
These companies operate all over the world and have diversified revenue streams.
They’ve also held up better than smaller shale producers during oil’s breakdown. BP, Chevron, and Shell are down an average of just 14% since oil peaked.
But today, the cracks are starting to show in these companies. And it’s likely shares are headed lower in the months ahead.
Let me explain…
As regular Growth Stock Wire readers know, big international oil companies are struggling to find oil and gas each year. BP (BP), Chevron (CVX), and Shell (RDS.A) are producing less oil and gas today than in 2010. Their production is down an average of 11% since 2010.
As a result, these companies are spending more each year to find oil.
The table below shows the cash generated from operations (cash left over after paying normal operating expenses) compared with capital expenditures (a broad measure of how much energy companies spend to find oil and gas) for BP, Chevron, and Shell last year.
In short, you can see these giants are spending huge amounts to find oil and gas – some more than the cash they bring in. According to the Wall Street Journal, Chevron and Shell spend three times more per barrel to produce oil than smaller rivals that focus on U.S. shale.
Because these companies are spending so much to find oil and are producing less of it, their profit margins have been shrinking.
You can see this by looking at their EBITDA (earnings before interest, taxes, depreciation, and amortization) margins. A company’s EBITDA margin is EBITDA as a percentage of sales.
In 2004, BP’s EBITDA margin was 16.2%. Last year, it was just 8.8%. Meanwhile, in 2005, Shell’s EBITDA margin was 15.9%. Last year, it was just 10.7%. Shell’s CEO also recently told the Wall Street Journal one-third of its assets earn a 0% return.
Chevron has done a better job maintaining its EBITDA margin, but its return on equity (ROE) – a common measure of profitability – peaked at 32% in 2004. It was 13.9% in the 12 months ended in September. This was its lowest ROE in the past decade except for the post-crash year of 2009.
With profitability shrinking, oil giants are scaling back. Many are selling assets to fund future major production growth efforts and get rid of less profitable areas of their businesses.
BP sold more than $50 billion of assets from 2010 to 2013. The company used much of this to fund liabilities related to the 2010 Deepwater Horizon oil spill in the Gulf of Mexico.
Chevron and Shell sold $9 billion and $18 billion of assets, respectively, from 2010 to 2013.
While these efforts may help oil giants increase their profitability in the future, the real salvation for these companies so far has been from the soaring profit margins of their U.S.-based refining operations.
Refining operations turn oil into gasoline and other oil-based products. Refining becomes more profitable as crude oil becomes cheaper since oil-refined products tend to fall in price slower than crude oil.
So while European refiners have suffered from high oil prices the past few years, the glut of cheap oil coming from shale areas in Texas and North Dakota have helped U.S. refiners.
In August, U.S. refining margins (the difference between the price of crude oil and the value of the oil products a refinery produces) were nearly $20 per barrel, as opposed to single-digit margins in Europe.
Big refining margins helped the overall profit margins of big oil companies like BP.
But that’s coming to an end now.
Refining margins in the U.S. have crashed to around $5 per barrel. This will cause refining margins to shrink – and will put even more pressure on big oil companies and their share prices.
The bottom line is to be careful with oil giants right now.
Good investing,
Brian Weepie
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Source: Growth Stock Wire