The Secret Lies in the Margins

Mallorie Beckner By Mallorie Beckner, Energy & Resources Digest Research Team

With oil prices still recovering, some producers are better than others at maintaining a high profit margin.

And one producer in particular stands above the rest. But before we get into that…

Let’s dig into the fundamental equation that runs the oil market.

Profit margins are percentages derived from net income and net sales. In other words, the profit margin ratio is the percentage of sales that are left over after expenditures. Naturally, oil prices directly play into profit margins. The higher the price of oil, the more the price of production will be covered.

It’s extremely expensive to produce oil. Exploration, well development, equipment, and refining all come with a hefty price tag. So, when oil prices increase, companies make more money to cover these costs and still make a profit.

Now that oil prices are up from their low of $26 per barrel a year ago, profit margins across the oil industry are starting to look up.

And it’s largely because of supply and demand.

Right now, oil supply is decreasing.

OPEC cut its oil production by 890,000 barrels per day down to 32 million bpd in January. This cut was brought on by the plunge in oil prices from an excess in oil production.

At the same time, oil demand is increasing.

With the economy getting stronger and the unemployment rate relatively low, more people are needing oil to fuel the vacations they can now afford. According to the EIA, total world consumption of petroleum and other liquids was 96.47 million barrels per day in 2016. That number is predicted to grow to 98.09 million bpd in 2017 and 99.55 million bpd in 2018.

With both of these supply and demand factors in play, despite the pullback we saw earlier this month, oil prices should continue to rise.

It’s good news for the margins of oil producers. But it could all change in a heartbeat…

OPEC is a fickle beast and production cuts could be short-lived. In addition, the interest rate will likely cause a pullback in commodities. Both scenarios are bearish for oil prices.

All the more reason to focus on margins…

Energy investors need to target companies with high profit margins so they can make money regardless of where oil prices head next.

This chart looks at three of the oil supermajors – Exxon (NYSE: XOM), BP (NYSE: BP), and Chevron (NYSE: CVX) – and their profit margins as of last quarter.

 

As you can see, difference between Exxon’s 3.17 and BP’s 0.97 is shocking.

BP’s margin has been the most volatile of the group. It’s also the lowest.

Exxon’s margin has been the least volatile, and it currently the highest.

And this is great news for Exxon shareholders. The more a company profits, the more likely it is to raise its dividend. A higher profit margin corresponds with higher free cash flow.

Last quarter, Exxon actually had a higher free cash flow than dividends paid for the first time since oil crashed. This means the company actually had money left over, even after paying out all its dividends – a sure sign of increased earnings and growth.

 

BP, on the other hand, not only has a low profit margin, but also a free cash flow that is significantly lower than their dividends paid.

 

So, given that Exxon has the highest margin and the highest free cash flow, this company is likely to make energy investors the most money – regardless of where oil prices head next.

Profit margins are a useful tool to find the best buys in any industry. They show the profitability of a company, and how much room a company has to withstand a sudden downturn.

And most companies are transparent with their profit margins, especially the big ones.

When determining the profitability of a company, use the secret tool that is profit margins.

Good investing,

Mallorie