Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

If you spent 2015 invested in energy stocks, you probably also spent much of the year in the fetal position. Yet the cramps are likely a little less pronounced if you happened to mostly own Exxon Mobil. Its stock fell by a relatively mild 15.7 percent against a loss of almost 37 percent for the SPDR S&P Oil & Gas Exploration & Production ETF, or nearly half if you indulged in the peculiar form of masochism known as owning the United States Oil Fund. 

Shelter From The Storm
Performance in 2015, indexed to 100
Source: Bloomberg

So with the glut in oil and gas markets set to persist in 2016, should you seek refuge in Exxon again? Probably not.

Exxon is to your portfolio what Coldplay is to your music collection: a ubiquitous money-spinner likely to get a nod of approval from your grandmother. Exxon's scale, brand recognition and reasonably steady performance makes it a popular choice, especially when you're feeling whiplashed and just want to hunker down. (Incidentally, if you actually like Coldplay, then please forgive me and just substitute another artist for the analogy. Kenny G, perhaps?)

That makes Exxon a remarkably passive way to invest in energy this year, which is problematic whether you believe oil prices are set to stay low or are due to finally turn.

If oil disappoints again in 2016 -- and analyst forecasts are roughly a third higher than Brent crude futures indicate -- then Exxon certainly offers safety but isn't immune.

A big factor in Exxon's resilience has been its downstream refining, marketing and chemicals businesses, which tend to enjoy a tailwind when oil and gas prices are lower because those represent some of their biggest costs. You can see how their importance to Exxon's bottom line has risen here:

Down Comforter
Exxon's Downstream and Chemicals divisions have surged as a proportion of total net income
Source: Bloomberg

Net income in Exxon's refining and marketing division virtually doubled, year over year, in the third quarter, helping to offset some of the roughly 80 percent drop in upstream profits. Don't expect a repeat of that when Exxon reports its next set of results early in 2016: The benchmark 3:2:1 refining crack spread (a proxy for margins) has dropped by more than a third in the current quarter compared to the previous one.

Summer's End
The generic 3:2:1 crack spread points to leaner refining margins in the quarter that just ended
Source: Bloomberg

Meanwhile, in the upstream business, Exxon faces significant pressure not just when it comes to oil prices but also its natural gas business. Based on 2014's numbers, roughly a fifth of the company's production consisted of gas from the U.S. and the Netherlands. The former faces another year of weak pricing, while the latter is being squeezed by a cap on production at a large Dutch gas field due to earthquakes.

Yes, Exxon's total return last year, including its sacrosanct dividend, of negative 12.8 percent was much better than the SPDR E&P ETF's negative 35.8 percent. Yet Exxon still lagged behind the S&P 500's total return of a positive 1.4 percent.

So if it is scale, diversity, and dividends that you value and you think energy is due another bad year, then why not just own the market rather than Exxon?

On the other hand, if oil does bottom out and begins a recovery sometime in 2016, Exxon also isn't necessarily the best energy stock to own because it isn't as levered to crude prices. If you look again at the chart of the stock's performance this year, you will notice that it didn't really participate in the spring rally, staying pretty flat while crude jumped about 40 percent from its March low point.

That's the price you pay for Exxon's integrated model and ability to generate higher downstream profits when the upstream division is suffering. Relatively higher exposure to U.S. gas prices also doesn't help. Last year, Exxon's stock had a correlation coefficient with Brent crude of 0.527, among the lowest of any major Western oil company, according to data compiled by Bloomberg.

If oil recovers, it will show up first in the shares of smaller E&P stocks, which would actually be hindrance to Exxon at the strategic level, too. With its Russian ambitions curtailed by sanctions, Exxon likely could use an acquisition of a large E&P company such as Anadarko Petroleum to reaffirm its growth prospects. That would best be done while oil prices are low and executives at potential targets are feeling anxious. 

If oil prices take another leg down toward the $20s in the first quarter, then financial strength will be all that matters. And Exxon, with net debt of less than 20 percent of equity at the end of September, will of course be a steady ship.

Exxon isn't the only oil company with a decent balance sheet, though. Rivals such as Occidental Petroleum, Pioneer Natural Resources and Diamondback Energy have relatively healthy debt-to-equity ratios, and they also offer higher leverage to any recovery in oil prices, as well as being potential takeover targets.

They are three of sixteen E&P stocks in the SPDR ETF, excluding pure royalty companies, that have debt-to-equity ratios of less than 50 percent, according to data compiled by Bloomberg. Notice in the chart below, using a custom index, that while they fell by about 23 percent in 2015, they didn't lag behind Exxon by nearly as much as the ETF did as a whole.

A Creditable Performance
Shares of E&P firms with lower leverage have held up better on average than the wider sector
Source: Bloomberg

With some E&P companies likely to stare into the abyss in 2016, just owning a basket of them will leave investors exposed to the risk of sudden losses. Equally, though, taking the passive route of simply owning Exxon likely won't prompt any fireworks by the time New Year rolls around again. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net