Oil and gas are arguably two of the most important commodities to monitor. The world depends on oil and gas to power its economies, and even with the rise of the electric car, demand for oil and gas does not seem to be slowing down anytime soon.

We believe energy companies are an attractive investment opportunity. In the Big Oil Vue we are focused on the following:

Integrated oil companies that are large global enterprises with decades of operating experience in innumerable economic, geographic, and pricing environments. The integrated oil companies also tend to pay out hefty dividends to shareholders. The average running yield of Chevron (NYSE: CVX), BP (LON: BP), and Total (EPA: FP) is 5.9%.

Exploration and production companies (E&Ps) that are more growth-oriented and complement the total return profile (dividends + capital appreciation) of the largest oil companies.

Oil service companies that are also growth-oriented and offer many technologically sophisticated software based solutions to their customers.

At this point in time, the industry is in recovery mode. Energy was the worst S&P 500 sector in 2014 and 2015, as oil prices plunged from above $100 in 2014 to below $30 a barrel in 2016. Even before the Organization of Petroleum Exporting Countries (OPEC) announced their production deal at the end of 2016, several analysts were already expecting oil prices to recover slightly to $60 a barrel in the next several months. Fundamentally, things are looking up as well. Dividend coverage has improved and balance sheets are largely preserved.

Over the past two years, the sector has lowered its sustaining dividend coverage from $55-75/bbl to $35-$55/bbl, through a combination of sustaining CapEx deflation and opex reductions. We have also seen a major focus on the balance sheet, via growth CapEx cuts and asset sales.

The group’s financial performance continues to improve and there is potential for the group to improve to >8% ROE in 2017. Three highlights from recent 3Q 2016 earnings reports support the view that the turnaround strategy remains on course: (1) low asset impairments, (2) improved project execution, and (3) signs of accelerating deflation in the offshore that would improve the competitiveness of Big Oil’s resource inventory.

More importantly, Big Oil looks to be overcoming the challenges faced with large legacy flagship development projects. Key 2016 project start-ups such as Kashagan and Gorgon LNG will make a material contribution to production and cashflow for Chevron and Royal Dutch into 2017 as growth ramps-up and capex dials down.

The long-term outlook for oil

The International Energy Outlook 2016 Reference case projects significant growth in worldwide energy demand over the 28-year period from 2012 to 2040. Total world consumption of marketed energy expands from 549 quadrillion British thermal units (Btu) in 2012 to 629 quadrillion Btu in 2020 and to 815 quadrillion Btu in 2040—a 48% increase from 2012 to 2040 (Figure 1-1). Note how non-OECD (essentially the developing world) will drive consumption from 2020 onward.

Economic growth, along with accompanying structural changes, also strongly influences world energy consumption. As countries develop and living standards improve, energy demand grows rapidly. For instance, in nations experiencing fast-paced economic growth, the share of the populace demanding improved housing requires more energy to construct and maintain. Increased demand for appliances and transportation equipment, and growing capacity to produce goods and services for both domestic and foreign markets, also lead to higher energy consumption.

Energy, which has gotten a lot of press this year as oil and stocks have been highly correlated, has been somewhat of a diversifier in times past. Energy stocks returned on average+11.08%/year from 1974 to 2015, but the correlation of returns to the broad market was only 43%.

Three top big oil stocks

BP PLC (LON: BP)

BP (British Petroleum) operates as an integrated oil and gas company worldwide. It has two main divisions: Upstream and Downstream. The Upstream segment engages in oil and natural gas exploration, field development, and production as well as midstream transportation, storage and processing. It also markets natural gas (including liquefied natural gas, and power and natural gas liquids).

BP owns and manages crude oil and natural gas pipelines; processing facilities and export terminals as well as LNG processing facilities and transportation, and has a NGL extraction business. The Downstream segment refines, manufactures, markets, transports, supplies, and trades in crude oil, petroleum, and petrochemicals products and related services to wholesale and retail customers. It offers lubricants and related products under the Castrol, BP, and Aral brands to the automotive, industrial, marine, and energy markets. BP also owns 20% of Russian government controlled Rosneft, a global integrated oil and gas company.  BP is headquartered in London, the United Kingdom.

BP’s long term upstream growth pipeline has the sector’s most attractive mix of financial headroom and returns. For example, despite Macondo cash commitments, an impressive rate of change in capex and balance sheet de-gearing to 2020 should lead to further cost deflation and a structural change that should move costs lower through technology and innovation.

BP is expected to deliver robust production growth (3.3% 2016-2020E) to the end of the decade and has optionality beyond 2020 to neutralize base declines. Its strong project optionality and disposal upside (targeting $3-5bn followed by a $2-3bn run-rate pa), suggests it has plenty of levers with which to adapt and manage its profile.  BP is set to deliver strong growth in DACF/share 2016-20E yet trades at a below sector average EV/DACF multiple.

Chevron (NYSE: CVX)

Chevron, headquartered in San Ramon CA, is the one of the world’s largest oil companies. Around 85% of the company’s invested capital is in the upstream oil & gas (E&P) business spread globally, and has key exposures to Kazakhstan, US, Australia and SE Asia. The remainder of the business is across global oil refining and marketing operations, biased towards the Pacific Rim, and in a petrochemical joint venture called CPChem. It operates through two segments-Upstream and Downstream.

The Upstream segment consists primarily of exploring for, developing and producing crude oil and natural gas; processing, liquefaction, transportation, and regasification associated with liquefied natural gas; transporting crude oil by major international oil export pipelines; transporting, storage and marketing of natural gas; and a gas-to-liquids project.

The Downstream segment consists primarily of refining crude oil into petroleum products; marketing of crude oil and refined products; transporting crude oil and refined products by pipeline, marine vessel, motor equipment and rail car; and the manufacturing and marketing of commodity petrochemicals, plastics for industrial uses and fuel and lubricant additives.

Analysts believe that CVX has an attractive global asset base, with the potential for top-tier production growth and margins versus global integrated peers. While free cash flow(FCF) is currently negative as the Australian LNG investment phase peaks, a potential multi-year improvement could be ahead as these projects move into production mode and capex comes down materially. While sentiment has improved over the past few months, project execution will still a key issue for investors. Big-project growth from Gorgon LNG, Wheatstone LNG, deep water Gulf of Mexico (GoM) and West Africa should drive improving FCF into 2018, allowing the company to fully cover capex and dividends down to $US50/bbl.

Exxon Mobil (NYSE: CVX)

Exxon Mobil Corp. engages in the exploration, development, and distribution of oil, gas, and petroleum products. It operates through the following segments:  The Upstream segment searches for and produces crude oil and natural gas. The Downstream segment manufactures and trades petroleum products. The Chemical segment manufactures and markets petrochemicals. The company was founded by John D. Rockefeller in 1882 and is headquartered in Irving, TX.

XOM is the largest and the most defensive of the super majors. Its size (XOM is the sixth largest company in the world by market cap) and scale, together with a top-tier FCF/dividend coverage ratio and below-average financial leverage makes the shares far less volatile than its peers. Along with an integrated business model that should allow it to maintain its organic growth/mix shift strategy over the next several years, one additional lever to watch for XOM is acquisitions, as the opportunity to add inorganic reserves could grow as the cycle continues to play out.

XOM has also quietly expanded its US shale portfolio, particularly in the Permian Midland basin. Though still a relatively small part of production volumes, it has provided a blueprint for XOM’s growth plans in US shale. Costs have come down significantly in both the Bakken and Permian, which has enabled additional commercial locations. However, at 2015 rig levels, XOM only has 9 years of drilling inventory, signalling a need to add acreage.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.