Crude oil prices have rallied roughly 25% so far this year, pushing them past $60 a barrel. The recent surge in oil has it trading near its highest level in almost two years. Meanwhile, some analysts believe oil has further to run because most producers plan on keeping a tight lid on supply while demand should bounce back as vaccines roll out.
The recent surge in crude prices has given most oil stocks the fuel to rally sharply. The iShares US Oil & Gas E&P ETF — an ETF that holds nearly 40 oil stocks — has rallied more than 35% this year. Investors might be wondering if they’ve missed the rally in the oil market. Here’s a look at the case for and against buying oil stocks right now.
The case for buying oil stocks
While oil prices already rallied sharply from their bottom last year, they could have room to run. Analysts believe the delicate balance between supply and demand will tighten over the next few months as consumption rebounds, driven by warmer weather and steadily rising vaccination levels. Meanwhile, it will take producers some time to bring supply back online since it takes more than flipping a switch to restart shut-in oil fields and ramp up drilling programs. If producers fall behind demand, crude prices could continue rising until they can rebalance the market.
Most oil companies in the U.S. don’t plan to restart their drilling programs this year because OPEC is holding back so much supply to rebalance the market. That means they’re on track to produce a gusher of free cash flow. Instead of reinvesting that windfall on drilling new wells, most oil companies plan to use that cash to repay debt and reward their shareholders through higher dividends and stock buybacks.
Those capital return programs could help fuel strong total returns for their investors this year. For example, Devon Energy (NYSE:DVN) aims to return up to 50% of its excess cash each quarter to shareholders via a variable dividend program. The company just announced its first supplemental payout, which was nearly double its base dividend. Other oil companies are developing similar frameworks, which could enable them to become monster dividend stocks if oil prices cooperate. As more oil companies boost their shareholder returns, it could give their shares more fuel to rally.
The case against buying oil stocks
Oil prices have soared this year because OPEC and other non-member nations are artificially holding back supply to allow the economy to burn off a glut of oil sitting in storage tanks. However, with crude prices continuing to rise, they’re itching to restart their oil pumps and cash in on higher prices. If they bring on new supply too quickly, crude prices could tumble.
Further, while most U.S. producers plan to keep their production flat this year, some are going against the grain and ramping up their drilling programs now that crude is in the $60s. For example, Matador Resources (NYSE:MTDR) is boosting its drilling budget by 22%, which will enable it to produce 10% more oil this year. If more U.S. producers bolster their capital budgets to increase their production, especially as OPEC brings more of its output back online, crude prices could cool off.
Another factor fueling the rally in oil prices is the view that vaccines will give demand a shot in the arm. As countries fully reopen their economies, oil consumption should improve. However, several factors could affect these plans, which might cause demand to lag expectations. Issues like vaccine hesitancy, production and rollout problems, and new variants could cause case levels to remain high, preventing a full economic reopen this summer. If countries can’t get the virus under control, oil stocks will likely suffer.
Oil stocks aren’t for the faint of heart
Most oil companies and industry analysts are cautiously optimistic that oil prices will remain relatively high for the balance of the year. While potential headwinds like vaccine problems, variants, and rising supplies could affect prices, most oil companies plan to hold firm and cash in on the rally. Oil stocks could thus continue to reward investors, especially those like Devon Energy that are putting a priority on returning their windfall to shareholders. Still, given the unknowns and the potential for volatility ahead, investors should be very selective when considering oil stocks, focusing on those that can thrive even if crude oil prices take another dive since that’s always a possibility.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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