Tuesday, July 21, 2015

Needling through the Haystack

For stock investors looking at oil companies to invest in, strong financials can be hard to find amidst a crisis of low oil prices. Often times, it's tempting to take a short position and make profits on small drops in prices. Volatility and bad sentiment threaten any hopes of finding a long position, but that doesn't have to be the case. Value can be found in some securities who show strong financials, especially after quarterly reports are released.The companies that have strategic executives and established infrastructure can beat their peers in a slump, then explode with growth as prices rise again. Any investor that can find a blue chip covered in the dust of job cuts, low revenue, and high debt has the potential to make a lot of money on a long position during troubled times.

In my analysis, I will differentiate potential value stocks by their respective market capitalization. Stocks with different market cap, or market share, tend to act differently. For example, Google and Apple market capitalization tell the story of a successful tech company that exploded with growth at some early point. Large cap stocks like these show fewer tendencies for huge increases and, instead, are safe, steady securities that have low beta (volatility) and lower rates of returns. At the same time, investing in large cap stocks have lower risk and less potential for sell-offs as investors typically retain their faith in profitable corporations that have proven their worth especially in poor economics conditions. Mid-cap stocks can show the same characteristics of their bulkier counterparts, but smaller market share allows room for growth. For this reason, these moderately sized companies can be some of the safer, but more profitable, stocks to buy into. While this may be true, more research and scrutiny is needed simply because they are not as well known as large caps. Many mid cap securities could show stagnate growth or even negative returns during recessions, but a vigilant analysis can find the value in businesses that have yet to prove their worth. This, actually, is the prioritizing goal when trying to identify the diamond in the rough in small cap stocks. Though these stocks are often new and completely unknown, the potential for growth can be astronomical. Take investors who first put their money in Apple during their initial public offering in 1980. Lucky gambles don't find these gold mines, but rather a careful approach to research and discernment. Because while insane profits can come from these bets, so can extreme loss. It goes without saying that small cap stocks have the reputation of being volatile and risky. In fact, most flop in the first year. A successful portfolio manager with objectives of high rates of growth would dampen potential loss and risk in small cap stocks with subsequent investments in large cap or secure mid cap stocks that can realize a smaller, but more secure gain. This goes back to diversification and its duty in reducing risk. As one should shield themselves from industry movements by diversifying between types of stocks, further security can be assured with the diversification of the size of stocks.

Large Cap ( $10 billion+ )

In the oil and gas sector, the three large-cap stocks that make most of the headlines and do most of the earning are Exxon-Mobil (XOM), Chevron (CVX), and BP (BP). Each with market shares over $100 billion (Exxon is over $300 billion), their stocks are perhaps the most followed in the oil and gas industry. Their specific sectoral classification is listed as integrated oil services meaning that all processes involved are kept under the company name. These corporations explore, drill, extract, transport, and finally refine the crude oil into finished products. Because of this, XOM, CVX, and BP serve as makeshift benchmarks for how an established, successful oil and gas company should operate during specific time periods. While their financials will vary, general movements can be teased out from the complexity of the data. This will be especially helpful when comparing performance with the volatile path that crude prices have been following. So as life and the universe never cease to fail us, patterns emerge.
From Yahoo Finance

A chart comparing the returns of the three stocks (BP as thickest, XOM as second thickest, and CVX as third) reveals similarities in the directional price movement. The comparisons are not without small blips of deviation, but for the most part, a trend can be realized with the arrows showing its ebbs and flows over the past month. The only real deviation is a sharp increase in BP’s price at the beginning of July followed by a quick correction to the arrow directed flow. In my opinion, this only deviation is the case of exaggerated movements in the price of BP. After a sharp fall (or a deceptively sharp fall as the security’s price rose and fell to prices above XOM and CVX giving the illusion of a larger loss), investors saw an opportunity to try and buy back into a long position propelling the stock into a bullish increase. But instead of a sustainable increase, the corrective movement cut any chance of a recovery in half, returning rate of change levels back to those of its two counterparts. Volatile stretches like these bring into question the sentiment surround BP along with its security against whips in prices and day to day gaps. In the long run, they fared worse than both XOM and CVX in their reactions to the selling event caused by the Greek financial crisis and the nuclear deal with Iran losing 6.65% of their value in a month’s time. CVX did not do much better losing 6.45% of their value, but it traced my trend’s path a lot closer with XOM. Another deviation could be pointed out at the very end of the chart where XOM remains three percentage points above CVX and BP in performance, but if one looks closely, a downtrend is still visible. I attribute the disparity in performance up until today to the stronger value that Exxon-Mobil has established with its towering market share. If there is any stock that investors will keep their good faith in, it is in XOM’s impressive performance and extremely low volatility. In fact, the movement trends exhibited by its stock price are so dampened they are hardly visible unless pointed out. The story it tells can be verified in Q1 financials for 2015.

Revenue is obviously a key financial that for an integrated oil service as loads of capital are needed to keep operations at full capacity in order to supply more crude for selling, and the cycle continues from there. A washing machine can only wash so many clothes as its rotating drum can hold, so an oil business can only churn out as much finished petroleum product as its coffers allow. Understandably so, all three company’s produced reports of 23% decreases in revenue as a result of depressed oil prices and, thus, cheap gasoline sales. But investors shouldn’t run for two reasons. One, oil is a very inelastic quantity, and when prices shoot back up, revenue surpluses will be large enough to make up for quarters like these. Two, this figure actually isn’t too unfamiliar as the three oil giants posted similar negative returns in the last quarter ranging from 16-27%. With lower revenue, Q1 financials on income should tell the same story as costs remain consistent with rigs continuing to extract oil in the hope of future profits. It does. XOM experienced an 18.4% drop in their bottom line, and CVX saw a similar drop to 13%. To reiterate, lower crude prices were inevitably going to lead to these figures, and investors should be able to realize this. On the other hand, weak financials and unstable price levels should be easy to identify as well. BP’s posted 23.4% decrease in revenue is accompanied by a 500% increase in income! So what happened here? Looking at the back end of the financial statements for 2014, income growth dipped almost 100% for BP compared to significantly lower numbers reported by XOM and CVX. This weak showing in the financial column shows investors that BP was not ready to handle the drop in oil prices. Despite the anticipation of lower prices to sell at, production continued at normal capacity. Weak financial numbers is enough to send sentiment spiraling out of control which translates to volatile security movements that search for a value that needs constant correction. BP’s earnings per share numbers showed a -463.57% drop after the 2014 drop in crude prices to a crushing -$0.15. All the while, EPS numbers for Exxon and Chevron remained above the dollar level holding at -25% drops. These two companies show cyclical movements that short and long term crude price trends would predict, but BP is characterized by volatility. Not only is its stock volatility, but it has become increasingly expensive to own. With the price-to-earnings industry average for the past twelve months at 26.43, Exxon and Chevron settle at below half that (12.28 and 10.25 respectively). BP’s is nearly four times its competitors at 41.77. This just goes to show how expensive volatile stocks can be. Large cap stocks should be aiming to keep P/E ratios at least above the industrial average because they already have established infrastructure that is not added into costs. Higher P/Es resemble starting capital costs for small cap companies that are looking to take market share with extra expenditures and this growth.

In concluding my short overview of the three largest integrated oil services as large cap stocks, my analysis and predictions remain hopeful for Exxon and Chevron as stable, low growth stocks with desirable beta values. Chevron may be a little cheaper, but Exxon provides any investor with returns and dividends almost immune to risk. On the other hand, BP’s volatility and financials leave me to question their ability to find growth in this year of low oil prices. As earnings reports come out this week, it will be interesting to see if BP can improve their numbers and restore strength to price movements that can help keep them at low beta levels.

Mid Cap ( $500 million-$10 billion )

Strong mid cap stocks can be hard to find in the oil and gas industry. Most of them, in order to retain market share and profitability, will restrict operations to one section of the process or concentrate their business on a particular region. Nevertheless, they still remain competitors with a significant market share and should be considered as viable securities. But now is the testing of strength. Low oil prices will squeeze revenue and profits out of oil companies that are operating on the margins or with high amounts of debt. Therefore, stable mid cap stocks that can grow out of the valley will have stable revenue and income with decreases that may reflect trends that XOM and CVX show, but they will not be able to rely on cash to support losses so expenditures will most likely be reduced. This could hurt mid cap companies in the end if they are not able to take advantage of revenue and profits that come from rising crude prices at which to sell stockpiled resources. But once again, analysis of financials can sift through strong and weak numbers that either depict value or do not.

Western Refining Inc (WNR) is an El Paso, Texas based company that focuses on refining and marketing the finished product of their crude oil inputs. Regionally, its operations are concentrated in the Southwest of the United States. Because it is based in Texas, WNR most likely processes the light, sweet WTI crude of the Permian basin. Various fuel products are produced at its two refineries that feed into hundreds of service stations that end in the market. WNR’s performance on the market has been quite impressive over the past year. With price trends reflecting the recent crude drop off, the only major depression on its stock in late 2014 was followed by a breakthrough to a new high (accompanied by a positive earnings report). Currently, the price hovers about three dollars below the high it established in April. A closer look at the month reveals a positive price trend with an earnings report lurking. The financials, interestingly enough, don’t predict anything beyond the already established peak. Revenues, like Exxon and Chevron, are slowing down due to the impending price squeeze with 2015 Q1 losses at 23% for the quarter. Income, unlike Exxon and Chevron, exploded. An increase of 63.25% (after a -47.03% decrease in 2014 Q4) hints at a significant down scaled in refining activities in an attempt to shield themselves against the low oil prices. Unfortunately, this could lead to a decrease in crude stockpiles which would ruin WNR’s opportunity to take advantage of higher oil prices in the future. So while WNR seeks to maintain healthy financials with EPS only losing -17.16% at 1.11. In my opinion, this mid cap stock has money that it can put towards long term investments such as stockpiles and refineries as its earnings already come by pretty cheap with a price-to-earnings ratio of 8.01 which beat Exxon and Chevron. For WNR to come out of the slump with growth, I would like to see some financial numbers that test the margin.

A similar story can be told for CVR Energy (CVI), Delek U.S. Holdings (DK), and Alon USA Energy (ALJ) which benefited from oil prices with high stock prices then experienced a significant drop after the decline in mid-2014. Along with the similarities in stock price movements, their quarterly revenues mirror each other pretty well. CVI, DK, and ALJ all show negative revenue growth in the first quarter of 2015 revealing the costs of low oil prices. Naturally, business make less when prices decrease, and this makes sense so investors should understand. Where deviations occur are on income statements. Delek U.S. Holdings was the only mid cap stock to show a decrease in profits. One might note that this is bad for DK, and we could expect them have performances lower than other companies that maintain profits, but I want to argue otherwise. If Delek maintains a loss while continuing to stock up on cheap oil, it could experience profitable quarters in the future of higher crude prices much like large oil corporations with plenty of capital are looking to do. In fact, Delek’s transportation and storage capacity (8.1 million barrels) gives it a unique opportunity for growth. Analysis of CVI and ALJ would be redundant as it would be a repeat of WNR’s predictions. Although deeper analysis would bring out more complexities in the data, a topographical outlook reveals the similarities that an entire industry faces.

Small Cap ( $0 - $500 million )

The last of our forays into various integrated oil companies takes us into the rather anonymous world of small cap stocks. These corporations have market shares at or under half a billion dollars and usually consist of start-ups or regional companies looking to go bigger. In this category, financials tend to be the most reliable way to analyze for value as small cap stocks typically don’t have extensive exposure to the market just yet.

JP Energy Partners LP (JPEP) is a refining and marketing business with major storage capabilities and pipelines in Cushing, Oklahoma and Texas. Its assets are mostly concentrated in the Permian basin, thus, its costs are indicative of the changing WTI price. Following the decline of prices, its stock plummeted losing a third of its value where it remains oscillating at a support level of $12. The financials tell a story we know all too well. Revenues trailed off with prices with a 23% decrease, but an 877% increase in income. This was a result of negative income the previous quarter forcing cutbacks on operations that could hurt a rebound out of the slump. What’s more earnings-per-share recently got out of the negative in the first quarter attempting to show some value for investors to buy into. That’s not what should scare an investor away though. After a quick look at long-term debt, an observer will note that it’s over three times the value of 2015 Q1 income! That is the danger with small cap stocks. In industries that require large amounts of capital, small companies can rack up too much debt trying to gain market share. During a slump, profits and revenue will become slim endangering the ability to repay any debts that might be called in. Investors should definitely watch out for pitfalls like this when looking to find a diamond in the rough.

Dakota Plains Holdings (DAKP) has been a highly traded small cap stock that investors see as a cheap way to make a quick buck, but it hasn’t always worked out. The transporting and storage company saw a huge drop in its stock price at the end of 2014 with no recover to date. Its price level has dropped to less than a dollar and refuses to rebound above $2.00, but speculation still surrounds the security as volume levels have reached as high as 1 million in late March. Nevertheless, speculation and herd behavior doesn’t determine value, good financials do, and that’s just what we can find on the income statement. Over the past two quarters, DAKP showed revenue growth of over 32% in spite of plummeting crude prices. This can probably be explained by increased fracking traffic in the Dakotas in which DAKP is concentrated. That’s great, but the 2015 Q1 shows a decrease in the bottom line, why is that? It is no accident that profits are lower despite higher revenue. Costs of production showed a 32% increase as well indicating that Dakota Plains Company has taken a bullish outlook on oil prices in an attempt to capture windfall profits in the event of a recovery in the oil market. I think this is the right approach in the current market conditions, operation at the margins where others are cautious so as to steal market share. At the same time, DAKP has considerable long term debt that amounts to almost half its capitalization even though it dropped by 50% it in 2015 Q1, so investors should be wary, but with a market cap of $62 million, I think this stock has a lot of growth in it.

Solid financials like these are ideal in identifying that successful small cap jackpot. In a sentence, successful companies are companies that take advantage of the market conditions instead of letting the market conditions take advantage of them. This follows for all cap stocks and should be heeded in research and analysis for every strategy centered around finding bargains and growth stocks that have the highest probability of posting the highest gains.

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