Earnings are humming along, with gains of more than 10 percent now expected for the S&P 500 in the second quarter. There's one potential fly in the ointment: Big Oil. ExxonMobil, Chevron and other Big Oil names will begin reporting on Friday. Something unusual is happening: because oil never rallied in the second quarter as anticipated, analysts have been continuing to take down estimates for oil company earnings, and also continue to lower them for the third and fourth quarter.
This normally wouldn't be an issue, but Big Oil is expected to be an unusually large part of the earnings gain we are expecting for the index in the second quarter. In fact, the earnings gains are very lopsided, concentrated in three sectors:
Q2 earnings: who's contributing the gains
The rest: 25%
Source: Thomson Reuters
Those numbers for energy have been dropping like a rock for months: Energy was expected to contribute about 40 percent of the expected gains for Q2 just a short while ago.
That means there is more pressure on the other sectors to take up the slack.
How did this happen? It happened because no one — not analysts, not strategists, not astrologers — can get the price of oil right. They can't even get the direction of oil right.
I'm not kidding. In January, when oil was well over $50, analysts confidently predicted it would average around $56 by July, according to FactSet.
Wrong! Not only did it not go up toward their target price, it promptly went straight down, bottoming around $42 in June.
Regardless: it's been bad news for oil stocks, which are closely correlated to the price of oil and, depending on the company, to natural gas as well (which also dropped).
Beginning in April, analysts started scrambling to reduce earnings estimates for Big Oil. Here's what the estimate looked like for ExxonMobil:
Exxon: Q2 earnings est.
April 1: $0.99
July 1: $0.89
That's a 15 percent drop in expectations, a steep decline for such a big company. And analysts kept dropping their estimates in July, even after the quarter ended, which tells you that they are pretty clueless about the implications of such a big drop in oil on earnings and capital spending.
And they're doing it for the third quarter estimates as well: they started at $1.07 on April 1, and are now down to $0.85, a 22 percent drop.
It's even worse with Chevron, where estimates have come down nearly 25 percent:
April 1 $1.13
July 1: $0.97
And you can see what this is doing to their stocks: with the S&P 500 up 10 percent this year, Exxon and Chevron are both DOWN 10 percent for the year.
All in all, 25 of the 34 energy companies in the S&P 500 have seen mean EPS estimates come down in the month of July, according to FactSet.
Aside from the price of oil, there's a broader problem for Big Oil: production growth is flat to declining for many of the big names, including ExxonMobil. For a multinational company like ExxonMobil, it's getting harder and harder to replace the oil that is pumped out of the ground with new oil.
Paul Sankey, a well-respected oil analyst at Wolfe Research and a regular guest on CNBC, downgraded ExxonMobil last week, saying "Based on historical volume performance, XOM is at risk of shrinking on a sustained basis."
One specific problem for Exxon, Sankey points out, is that it has lost a big driver of production growth: Russia. A huge joint venture with Russian oil giant Rosneft never panned out because Vladimir Putin invaded the Ukraine and the subsequent sanctions made it impossible for Exxon to move forward with development plans.
Still, there are some bright spots. ExxonMobil has its massive chemical operations (about 30 percent of revenue) which have done well. Refining operations should also be strong.
But Big Oil's biggest asset — and the reason it has kept the interest of a good part of Wall Street for the past couple years — is high dividends, funded by debt.. ExxonMobil pays a 3.8 percent dividend yield, Chevron 4.1 percent, far in excess of the S&P's 1.9 percent yield. Those dividends still are safe, but judging by the reaction this year it's clear that the stock is not going to move anymore on a dividend boost. It's going to move on a commodity boost.
So what will ExxonMobil and Chevron say? The key issues will be production and capital spending. With oil below $50, the main hope is discipline on spending.
We see this already in the smaller companies that have reported. Hess, Anadarko Petroleum and ConocoPhilips all said they would reduce capital expenditure plans for the year.
Besides spending discipline, the hope for the bulls rests on the weight of history. First, both Exxon and Chevron have only fallen short of the consensus estimate three times in the last three years, and with estimates cut so drastically the bet now is they will hit the EPS target. Production and capital expenditures may be a different story.
But the biggest help may be the lack of enthusiasm for the entire energy sector. Lindsey Bell, Investment Strategist for CRFA Research, summed up the state of the entire analyst community in a note to clients yesterday: "[We] remain on the sidelines because we think earnings will be unimpressive, especially regarding guidance, despite numerous top line beats."
Of 18 analysts tracked by FactSet, only 5 have a Buy, 7 have a Hold, and 6 have a Sell.
Given the "Buy" bias on Wall Street, that unenthusiastic endorsement that may end up being Big Oil's biggest asset.