The behemoths of the oil industry, Exxon Mobil Corporation (NYSE:XOM), Chevron Corporation (NYSE:CVX), Total SA (ADR) (NYSE:TOT) and Royal Dutch Shell plc (ADR) (NYSE:RDS.A) (NYSE:RDS.B) all recently reported a pretty dire second quarter. Profits and operating cash flows fell across the board to such an extent, that one analyst was prompted to ask Chevron Corporation (NYSE:CVX)’s management on the conference call, if the company could continue to sustain its dividend and buyback operations at their current rate.

Oil industry

Oil sector looking undervalued

However, the resulting panic from these results has left the sector looking relatively undervalued to the rest of the market. For instance, the 10 largest major integrated oil & gas companies on the market, trade at an average trailing-12 month P/E of 9.6, compared to the S&P 500 (INDEXSP:.INX)’s ratio of 18.97. Moreover, the sector offers an average dividend yield of 4.5% as well as buybacks, which appear well covered as the average debt to equity ratio in the sector is around 30%, although this figure falls to around 15%, on a debt to asset basis.

What’s more, big oil is now trading at a price-to-book valuation that has only been reached on roughly six other occasions in the past 50 years. Indeed, valuations are certainly the lowest they have been during the last five years:

Oil Price to book ratios

Falling returns on investments

Having said all of that, despite these low valuations, big oil does have some problems. The most important and perhaps the most concerning of these is the industry falling return on investment as exploration and production costs rise faster than operating cash flow from operations.

Oil companies operation cashflow

Companies that managed to increase capital returns

In fact, Total SA (ADR) (NYSE:TOT) has been the only company out of the four majors shown above to increase its return-on-capital employed during the last year. (Actually BP plc (ADR) (NYSE:BP) (LON:BP) also managed to increase its return-on-capital employed during the last year but this was mainly down to higher income from its trading division and a negative income figure during comparable periods last year.)  Royal Dutch Shell plc (ADR) (NYSE:RDS.A) (NYSE:RDS.B), Total and Exxon Mobil Corporation (NYSE:XOM) have all noted declines in capital employed, despite levels of CAPEX spending being maintained or even increased.

Investors would be right to express concern if this trend carries on for much longer without any real change in direction. However, there is also an opportunity for profit as the low levels of gearing on each company’s balance sheet leave plenty of room for acquisitions.

All in all, big oil valuations are currently at five-year lows and investors need to decide if the risk is worth the reward. That said, global monopolies with as much firepower as Exxon Mobil Corporation (NYSE:XOM) should be able to rapidly turn themselves around although, there are cases where their deterioration has only accelerated (Gazprom).