Traders Are Flocking Back to Oil: What’s Fueling the Optimism

Key Points

• Oil prices have started to break out of their channel in recent quarters, making traders flock back into the momentum.
• Three ways to play out this breakout are presented for investors to consider moving forward, each with different upside dynamics.
• For conservative investors, there is a way to diversify and lock in a dividend above today's inflation rate.

After a few months of lackluster price action in the energy sector, most investors have shied away from some of the best names in the sector, especially those in the crude oil industry. Whether the news about the current oil demand makes sense or not, investors need to think of the energy space as one of the most under-owned market corners today.

Even Paul Tudor Jones said in a recent CNBC interview that commodities today are severely under-owned. Judging by the price action in other commodities, investors can safely deduce that oil has the most upside, given how low it has traded over the recent quarters. However, this doesn’t mean all oil names are good buys right away.

There are those that hold oil, and there are those that help produce oil. Given how low production is today as a result of falling inflation, investors should look into those that already hold oil. This is why Warren Buffett decided to buy up to 29% of Occidental Petroleum Co. NYSE: OXY and why investors can look to giant Exxon Mobil Co. NYSE: XOM. For diversification in the value chain, investors can then consider the Energy Select Sector SPDR Fund NYSEARCA: XLE.

Why Occidental Petroleum Earned Warren Buffett’s Seal of Approval

Investors need to first understand the two main pillars of Warren Buffett’s strategy so that they can reverse engineer why he picked Occidental Petroleum stock out of all the choices in the sector. His main objective is to find companies with high profitability and, secondarily, those that trade at an attractive enough discount to make them a Buy.

Occidental Petroleum’s profitability can be judged primarily by its gross margins, which were as high as 61.8% as of the past 12 months. This high capital retention from each sale allows management to operate efficiently enough to maintain a net income margin of 16.3%.

That’s the foundation for capital flows, but then management needs to take that bottom line and attempt to reinvest it into the business to activate the compounding wealth effects of a profitable business. The answer to this is found in a company’s return on invested capital (ROIC) rates, where Occidental Petroleum brings in a high of 17.7%.

When it comes to the pricing of the stock, the main value comes from the current price-to-book (P/B) multiple of 2.0x compared to the rest of the energy sector’s average 3.7x valuation today. The mix of high profits and discounts may have driven analysts from Raymond James to place a $77 price target on the stock, calling for up to 51.3% upside.

How Exxon Mobil’s Scale Drives Its Upside in Cycle Recovery

Now that oil prices are rallying by over 3% this week, investors can look to the biggest names in the space to get their potential investment dollars over the line. Considering Exxon Mobil’s $523.6 billion market capitalization and international sales exposure, this is one stock to consider as the business cycle starts to shift upward.

With the United States Federal Reserve (the Fed) starting to cut interest rates again and other central banks worldwide following the same path, the business cycle for the world’s biggest economies will probably bottom and shift back to expansion. Whenever this happens, demand for oil follows, and that’s why Exxon Mobil is back in play.

Knowing that scale and reach will be major advantages in the coming cycle for oil, analysts at Scotiabank decided to boost their ratings to Sector Outperform coupled with a price target of $145 a share in Exxon Mobil. This means the stock would have to stage a rally as big as 21.5% from where it trades today.

A double-digit upside in a company this big isn’t common, so the fact that analysts are willing to place these targets as the stock already trades at 95% of its 52-week high amplifies the importance of these current analyst views.

How The XLE ETF Provides a Safety Net Against Oil Market Volatility

Exxon and Chevron Co. NYSE: CVX are the largest Energy Select Sector SPDR Fund holdings. However, there’s also a sense of diversification through the oil value chain to still give investors the possibility of upside apart from an average performance inherent in an ETF.

Because of these features, more institutional buyers have justified expanding their positions in this ETF, particularly those from Hamilton Capital, who recently boosted their holdings by 5.7% as of November 2024. This new allocation brought the group’s net investment up to $297.5 million today, giving investors another reason to lean into the sector.

Ultimately, when and if oil prices go higher, they’ll be synonymous with higher inflation, and that’s where this ETF and its dividend come into play. Today, shareholders are offered a $3.22 a share payout, which translates to an annualized dividend yield of up to 3.4% to outpace inflation rates today.