Crude oil is one of the most valuable commodities in the global economy, used to create or transport nearly every product today. Fuel is the main derivative of crude oil that consumers envision when the oil industry is mentioned, but the applications of crude oil are much vaster. The oil industry is one of the most powerful branches of the global economy.

Oil companies are often defined as either upstream or downstream. Upstream accounts for discovery, extraction and production. Downstream companies deal with refining, delivering and marketing of petroleum products. The largest companies in the world straddle the entire market, with operations in both upstream and downstream areas.

Crude oil has seen massive price fluctuations over the past three years, and the impacts are passed down to the consumer. Crude oil tanked during the start of the global pandemic, with Brent crude oil futures prices bottoming at around $26 per barrel in April 2020. As the economy recovered, prices soared to over $114 per barrel in June 2022. As of mid-March 2023, prices have begun to pull back, trading at around $75 per barrel.

While crude oil demand has rebounded significantly since 2020, another recession could put a damper on demand. A heavy reliance on the macroeconomic environment makes the oil and gas industries cyclical. When the business cycle suddenly slows, supply outweighs demand and traders respond by sending the price of oil down.

Russian prices for both crude oil and processed petroleum goods were capped by Western countries starting in September 2022. OPEC+ responded by reducing oil outputs by two million barrels per day in October 2022. [OPEC+ is an alliance of the Organization of the Petroleum Exporting Countries (OPEC) and other oil-producing countries, including Russia.]

Some may argue that oil and gas suppliers are facing major headwinds from environmental restrictions and shifting consumer tastes. Even so, we are significantly far away from losing our global reliance on fossil fuels. Environmental restrictions may be imposed in some countries, but as the world becomes more globalized and developed, profits lost to environmental restrictions could be made up somewhat by increased demand in developing economies.

Key Oil & Gas Company Fundamentals

When evaluating oil and gas stocks, the main areas of focus for investors are growth, revisions to consensus earnings estimates and valuation.

Some common metrics used to evaluate growth include, but are not limited to, five-year annualized sales growth, five-year operating cash flow growth and year-over-year sales growth. Growing sales and operating cash flows often translate to increasing profits. But keep in mind that historical averages do not always guarantee future results.

Although earnings are often used to assess growth, the AAII Stock Evaluator (accessible on AAII.com by typing a company name or ticker into the search box) breaks consensus earnings estimates into its own category. Earnings strength is commonly evaluated by tracking previous earnings surprises and positive or negative revisions to analysts’ estimated earnings. The energy industry has seen significant fluctuations in earnings over the last year, with many analysts forecasting a drop in earnings over the next two years (on a year-over-year basis).

The term value stems from the word valuation and refers to a stock that is currently trading at a valuation, or price, lower than its perceived intrinsic value. Two of the most popular measures of value are the price-to-free-cash-flow (P/FCF) ratio and the price-earnings (P/E) ratio. For both measures, low ratios are preferred to high ratios.

There are also some niche multiples that analysts look at when comparing companies in the same industry. One common multiple used for oil stocks is enterprise value (EV) relative to barrels of oil equivalent (BOE) per day. The BOE metric was created to put oil and gas production on an equal basis, since many oil companies produce both, along with other fossil fuel products. If the EV/BOE multiple is high compared to the firm’s peers it is trading at a premium, and if the multiple is lower than its peers it is trading at a discount. However, this metric does not account for potential production, which may be significant for companies with large investments in new oil fields.

Highest-Scoring Oil & Gas Stocks

To choose a sample of oil and gas stocks to discuss, we looked at the top 20 common stock holdings—by assets under management (AUM)—in the three largest energy sector ETFs: Energy Select Sector SPDR ETF (XLE), Vanguard Energy ETF (VDE) and SPDR S&P Oil & Gas Exploration & Production ETF (XOP). We then ranked them by a composite score of the stocks’ individual A+ Investor Earnings Estimate Revisions, Growth, Quality, Momentum and Value Scores.

ExxonMobil Corp.

ExxonMobil Corp.’s (XOM) principal business involves the exploration for, and production of, crude oil and natural gas and the manufacture, trade, transport and sale of crude oil, natural gas, petroleum products, petrochemicals and a range of specialty products. The company’s segments include upstream, energy products, chemical products and specialty products.

ExxonMobil has strong growth characteristics, as shown by its Growth Grade of B (strong). The company has a sales growth rate of 10.9% per year on average over the past five years, slightly below the sector median of 12.0%. The company’s five-year annualized growth rate in net income of 23.1%, however, is above the sector median of 19.6%. ExxonMobil has enjoyed high growth in its earnings from continuing operations, increasing by 32.6% on an annualized basis over the past five years versus the energy sector median of 21.4%.

ExxonMobil has a Value Grade of B (rated a good value), based on a Value Score that ranks in the cheapest 21% of all stocks. The stock’s price-earnings ratio is currently 7.7, slightly above the 7.2 sector median and in the 22nd percentile of all stocks. The stock also has a price-to-free-cash-flow ratio of 9.8, above the sector median of 6.6 but in the 35th percentile of the entire stock universe. ExxonMobil produced 3.7 million BOE per day in 2022 and has a current enterprise value of $475.5 billion. This results in an EV/BOE per day ratio of 127,243.4. It is most useful to compare this number to other companies in the same industry: Chevron Corp.’s (CVX) EV/BOE per day ratio of 117,779.9 in 2022 could indicate that ExxonMobil is trading at a premium.

ExxonMobil currently has an Earnings Estimate Revisions Grade of C, which is average. The company reported a positive earnings surprise for fourth-quarter 2022 of 3.2%, and in the prior quarter reported a positive earnings surprise of 17.3%. Over the last month (as of mid-March), the consensus earnings estimate for first-quarter 2023 decreased from $2.71 to $2.64 per share due to two upward and four downward revisions by analysts. Over the last three months, the consensus earnings estimate for full-year 2023 declined from $10.93 to $10.65 per share. As previously stated, the energy industry is extremely cyclical in nature. For reference, in 2020 ExxonMobil posted a net loss of $22.4 billion and a net loss per diluted share of $5.26.

Marathon Petroleum Corp.

Marathon Petroleum Corp. (MPC) is engaged in the petroleum product refining, marketing, retail and midstream business in the U.S. The company operates through two segments: refining and marketing, and midstream.

Marathon Petroleum has a Value Grade of A, indicating deep value; its Value Score places it among the 4% cheapest of all stocks. The stock’s price-earnings ratio is currently 4.3, which is below the 7.2 sector median and in the cheapest eighth percentile of all stocks. The stock also has a price-to-free-cash-flow ratio of 5.0, ranking in the cheapest 17% of the entire stock universe. Because Marathon Petroleum does not have midstream operations, the more traditional ratio of enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA) can be used. Shares of Marathon Petroleum have an EV/EBITDA ratio of 3.4, which ranks in the cheapest 12th percentile among all U.S.-listed stocks. The sector median is higher, at 6.0.

Marathon Petroleum has a Growth Grade of A, which is very strong. The company has a sales growth rate of 18.9% per year on average over the past five years, above the sector median of 12.0%. Five-year annualized growth of 33.4% for net income is also above the sector median of 19.6%. Marathon Petroleum has enjoyed a high growth rate in its earnings from continuing operations, increasing 49.3% on an annualized basis over the past five years.

Marathon Petroleum currently has an Earnings Estimate Revisions Grade of B (positive), as analysts have revised their earnings forecasts upward. The company reported a positive earnings surprise for fourth-quarter 2022 of 17.3%, and in the prior quarter reported a positive earnings surprise of 10.5%. Over the last month (as of mid-March), the consensus earnings estimate for the second quarter of 2023 has increased from $5.94 to $6.00 per share. The change reflects four upward revisions and one downward revision from analysts. The consensus earnings estimate for full-year 2023 has increased over the last three months, from $19.56 to $20.07 per share. Marathon Petroleum’s earnings are expected to decline following the record earnings it realized in 2022. The company earned $27.97 per share in 2022 and $2.02 per share in 2021.

Valero Energy Corp.

Valero Energy Corp. (VLO) is an international manufacturer and marketer of petroleum-based and low-carbon liquid transportation fuels and petrochemical products. Valero Energy owns 15 petroleum refineries located in the U.S., Canada and the U.K.

Valero Energy currently has an Earnings Estimate Revisions Grade of B, which is positive. The company reported a positive earnings surprise for fourth-quarter 2022 of 14.7%, and in the prior quarter reported a positive earnings surprise of 4.4%. During the last month (as of mid-March), the consensus earnings estimate for the first quarter of 2023 decreased from $6.77 to $6.60 per share. The full-year estimate for 2023 has also declined over the last three months, from $23.68 to $23.49 per share.

Valero Energy has a Growth Grade of B, which is strong. The company has a sales growth rate of 13.4% on average over the past five years, above the sector median of 12.0%. Five-year annualized growth in net income is 23.2%, versus the sector median of 19.6%. Valero Energy’s earnings have grown by 42.5% on an annualized basis over the past five years.

Valero Energy has a Value Grade of A (deep value), based on a Value Score that ranks in the cheapest 5% of the stock universe. The stock’s price-earnings ratio is currently 4.3, below the 7.2 sector median and in the cheapest eighth percentile of all stocks. The stock also has a price-to-free-cash-flow ratio of 4.5, which is below the sector median of 6.6 and in the cheapest 15th percentile of the entire stock universe. Because Valero Energy is a midstream and downstream company, the EV/EBITDA ratio is more useful than the EV/BOE per day ratio. Valero Energy has an EV/EBITDA ratio of 3.1, which ranks in the cheapest 11% of all stocks.

Largest Oil & Gas ETFs

ETFs are an option for investors who want exposure to oil and gas stocks but are looking to diversify their holdings instead of investing in one or two stocks. ETFs don’t have backend loads or other restrictions on selling like some sector- and industry-based mutual funds can have.

When looking at ETFs, there are a number of metrics to pay attention to. Size—measured by AUM—is one useful metric because if an ETF fails to attract enough interest, it may be shuttered. Expense ratios for industry-specific ETFs are often higher than they are for broad market funds, but they should never be excessively high. The ETFs highlighted here—Energy Select Sector SPDR ETF, Vanguard Energy ETF and SPDR S&P Oil & Gas Exploration & Production ETF—were selected based on their AUM. Table 1 shows select data for the funds; additional data and grades can be found in the ETF Evaluator at AAII.com by typing a ticker or name in the search box.

Energy Select Sector SPDR ETF

Energy Select Sector SPDR (XLE) was launched in 1998 and is the oldest energy sector ETF. It tracks the S&P 500 index energy sector. It has 26 holdings, and the largest 10 holdings make up 74.3% of the portfolio.

Energy Select Sector SPDR is the largest energy ETF that we examined, with $39.3 billion AUM. The expense ratio of 0.10% is below the industry average, giving the ETF an A+ Investor grade of A. The ETF’s three-year annualized return is 28.7% and its five-year annualized return is 10.0%. These returns equate to grades of C and A, respectively. As of the end of February, the ETF was down 4.4% for the year. Energy Select Sector SPDR realized substantial gains of 64.3% and 53.3% in 2022 and 2021, respectively.

SPDR S&P Oil & Gas Exploration & Production ETF

The SPDR S&P 500 Oil & Gas Exploration & Production ETF (XOP) was launched in 2006. The fund seeks to provide exposure to the oil and gas exploration and production segment of the S&P Total Market index (TMI). This ETF is the only one of the three examined here that follows an equal-weighted approach, which provides the potential for unconcentrated industry exposure across large-, mid- and small-cap stocks. It has 62 holdings, with a 24.7% allocation to the largest 10 holdings. (Between periodic rebalancing, the best-performing holdings will account for a larger proportion of the ETF’s total portfolio.)

SPDR S&P Oil & Gas Exploration & Production has $3.7 billion in AUM. Its expense ratio of 0.35% is the highest of the three but still qualifies for an A+ Investor grade of A. The ETF’s three-year annualized return is 32.4% and its five-year annualized return is 2.0%. As of the end of February, the ETF has declined by 2.2% for the year. However, it had very strong returns in 2022 and 2021 of 45.3% and 66.9%, respectively.

Vanguard Energy ETF 

The Vanguard Energy ETF (VDE) launched in 2004. This index ETF seeks to track the MSCI U.S. Investable Market Energy 25/50 index. It has 115 holdings, and the top 10 holdings make up 66.4% of the portfolio.

Vanguard Energy is the second-largest ETF that we examined, with $8.1 billion in AUM. Vanguard Energy has an expense ratio of 0.10%, equating to an A+ Investor grade of A. Its three-year annualized return is 29.7% and five-year annualized return is 9.2%. These returns equate to grades of B for both periods. As of the end of February, Vanguard Energy has declined 3.8% for the year, after gaining 62.9% in 2022 and 56.0% in 2021.

Conclusion

While oil and gas companies performed extremely well in 2021 and 2022, whether these good returns will repeat this year is still unknown. The performance of such companies is very reliant on the price of crude oil. The pullback in oil prices from last year removes a tailwind that had been helping the sector, though China’s recent abandonment of its coronavirus policies should be positive for energy demand.

These types of companies experience cyclicality but also can provide some protection from inflation through their dependency on oil prices, and investors desiring this type of investment have a plethora of choices in both stocks and ETFs. 

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