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Could Worst be Over for Struggling Energy Sector? Q2 Earnings Seen Plunging

Once again, Energy sector earnings are expected to be the worst in the S&P 500 as the COVID-19 crisis pushed crude prices to all-time lows.

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5 min read
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Key Takeaways

  • Energy sector earnings are seen falling nearly 150% year-over-year
  • A difficult environment of weak demand and low prices for crude persists
  • Industry saw wave of bankruptcies, and now faces potential rise in OPEC production

You can say this for the energy sector: It’s hard to imagine things getting much worse than they did in Q2.

We’re talking about a quarter where the price of U.S. crude oil averaged $28 a barrel, the lowest for any three-month period in nearly two decades. In one strange confluence of events, crude oil even traded negative for a brief period. This is something never seen before.

Crude rebounded to back near $40 a barrel by the end of Q2 and remains right around there as of mid-July, still not enough to rescue the sector from what are likely to be horrific earnings results. As of last week, research firm FactSet pegged the average Q2 earnings per share loss for S&P 500 Energy firms at 149.9% vs. a year ago.

Keep in mind that Energy wasn’t exactly tearing up the pea patch even in 2019, before COVID-19 came along. So we’re talking about a sector that, for lack of better words, can be called bruised and battered.

That goes across all sub-sectors of Energy, though losses are projected to be worse for some parts than others. Four of the five sub-sectors are predicted to report earnings losses of 100% or more, FactSet said. These include Integrated Oil and Gas (-170%), Oil and Gas Exploration and Production (-161%), Oil and Gas Refining and Marketing (-150%), and Oil and Gas Equipment and Services (-114%).

The overall projected decline of nearly 150% is the worst for any of the S&P 500 sectors in Q2, according to FactSet. It’s also a far worse decline than the Energy sector has suffered in the stock market—though it’s definitely the weakest performer there year to date, too. As of earlier this week, Energy was down 41% year-to-date vs. just under 2% for the S&P 500 Index (SPX).

FIGURE 1:. TAKING SOME DOWN-TIME. The Energy sector (IXE—candlestick) has had a far worse year than the S&P 500 (SPX—purple line), but actually has come back farther from its March lows than the SPX, possibly due to the allure of Energy sector dividends for some investors. Data source: S&P Dow Jones Indices. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

No Hiding from COVID for Any Sub-Sector

COVID-19 has been a calamity for the U.S. and global oil patch, and no one sub-sector has escaped. Sometimes you see a bit of divergence in upstream vs. downstream Energy companies when times get hard, with refiners, for instance, getting assistance from easier margins when the price of crude falls. Not this time.

Two of the biggest U.S. oil refining firms—Marathon Oil (MRO) and Valero Energy (VLO)—have lost half or more of their stock market value so far this year. Meanwhile, companies known for having major upstream oil businesses, meaning exploration and drilling, like ConocoPhillips (COP), Chevron (CVX), and ExxonMobil (XOM), haven’t performed well either in 2020, though their stock market losses are a bit less steep than the refiners mentioned above. Plus, XOM and CVX sit on a load of cash and have continued to pay a healthy dividend (see more below).

Investors couldn’t escape the pain by moving over to oilfield services companies like Schlumberger (SLB) or Halliburton (HAL), either. Those stocks also took a blow, though, like some other Energy firms, they saw a bit of a comeback in June as crude prices steadily rose back toward $40.

That won’t make much of a difference in their anticipated Q2 earnings results, if analysts are right. For those who have strong stomachs, here are some of the EPS expectations for individual companies: HAL is seen down 134%, COP is seen down 158%, XOM is seen down 198%, and VLO is seen falling 186%. Those are according to 3rd party analyst consensus estimates.

Pandemic Leaves Trail of Bankruptcies

Not all the sector’s companies even made it through Q2. At least 24 oil and gas companies filed for bankruptcy from April through June—nearly twice as many as during the first three months of the year, according to Haynes and Boone LLP, an international law firm based in Texas. Four of those companies filed in the last two weeks of June. One of those was Chesapeake Energy, which had been a pioneer in the U.S. fracking industry.

Analysts told the media that one thing many of the bankrupt energy companies had in common was high levels of debt. That’s why investors should consider taking extra care venturing into this sector. Debt remains a problem for many oil and gas firms, so make sure you closely check the financials before making a buy.

Some investors lately have been jumping into the shares of bankrupt companies in both Energy and other sectors, but that’s not something an inexperienced trader should probably risk. The potential downside is just too steep.

Enough about the past. Is there anything these companies can do to lift hopes?

A lot remains outside their control. There’s not much they can do about the price of oil except to slow production, and that’s already happening. By early July, U.S. daily production had sunk to around 11 million barrels a day, according to the Energy Information Administration (EIA). That was down from record peaks earlier this year above 13 million, but still nearly double the production seen in much of the decade from 2000 to 2010.

Also, a two million barrel per day reduction doesn’t really make much of a dent in a world where 100 million barrels a day get produced. It’s also expensive for producers to shut down and then restart production, so production tends to fall far more slowly than prices.

U.S. producers have little control over what overseas producers do. The Organization of the Petroleum Exporting Countries and allies, known as OPEC+, has been cutting oil output since May—by a record 9.7 million barrels per day after the coronavirus crisis destroyed a third of global demand, Reuters noted recently.

After July, the cuts are due to taper to 7.7 million barrels per day until December, although a final decision hasn’t happened. In other words, the suffering U.S. energy industry faces the prospect of more crude coming at it from overseas. The price of U.S. crude has chopped around the $40 in recent weeks as investors weighed the ramifications of a possible OPEC+ production hike versus the prospects of economic recovery.

There are signs that OPEC and its allies plan to start tapering the cuts next month, Reuters reported. It’s been hard historically to keep the entire group in check, as many of their economies depend on crude sales and need cash flow even if the oil gets sold at low prices.

What to Listen For

Speaking of low, many analysts see $50 a barrel as near the lowest level where many U.S. fracking firms can make.a profit. Crude hasn’t been above that since early this year. Many OPEC countries, however, can make money at levels far below that.

It’s always possible that OPEC, led by Saudi Arabia, could use a situation like this to try and tear the heart out of the U.S. industry. The fight between Saudi Arabia and Russia earlier this year over output cuts seemed to raise that possibility.

Consider listening closely to Energy company earnings calls for what executives say about whether the reopening of the U.S. economy in May started to bring back demand. By some reports, U.S. daily vehicle traffic is back to nearly where it was before the crisis, and many airlines have begun adding more flights.

However, the huge growth in new virus cases lately calls a lot of that in question. So does bad news for the Energy industry like United Airlines’(UAL) recent announcement that it might furlough thousands of workers. An announced plunge in Delta’s (DAL) Q2 revenue and profit doesn’t bode well for the Energy sector, either. Airlines are still suffering, and the recent uptick in virus cases around parts of the country hasn’t helped.

If you’re looking for any silver lining, maybe it’s the performance of the sector since it hit the year’s lows back in March. Energy is up 63% since then, which outpaces the S&P 500’s (SPX) 44% rise over roughly the same period from its low. Some investors, evidently, have been taking a chance in the beaten-down sector. Some of that buying interest might reflect investors trying to find yield in this low-interest environment. The Energy sector has the highest dividend yield of any S&P 500 sector at an average of 6%, according to research firm CFRA.

That might sound alluring, but remember that high yields sometimes aren’t a great sign. If a company’s stock price declines sharply, its dividend yield may automatically increase if it maintains its current dividend. But this can signal something of a value trap, because the company lost a lot of market cap as its share price declined.

Another thing to watch out for are companies that tap into debt to maintain their dividend payments—a potential negative sign that their cash flow may be trickling.

Getting back to the fundamentals, lower U.S. crude output might be one positive. Another  positive might be this hot summer weather across much of the U.S. It’s possible that could lift demand for natural gas, which, like crude, has been in the dumps most of the year. Yep. It’s come down to hoping for a heat wave.

Good Trading,
JJ
@TDAJJKinahan

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    Key Takeaways

    • Energy sector earnings are seen falling nearly 150% year-over-year
    • A difficult environment of weak demand and low prices for crude persists
    • Industry saw wave of bankruptcies, and now faces potential rise in OPEC production

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