Near-term prospects look grim for oil stocks

Fundamentals point to further oil-price reductions.

Kirk Paulus 30 March, 2015 | 5:00PM
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It's difficult to find a compelling argument to invest in the oil sector when so many underlying fundamentals are pointing to further oil-price reductions. Oil will once again have its day, but it will take time for the stock market to adapt to the new price dynamic.

Driving the deteriorating fundamentals for oil stocks is a worldwide oil glut, exacerbated by the decision by Saudi Arabia to maintain production and allow prices to plunge. The Saudis are unlikely to change course, since low oil prices meet their financial and political objectives.

Above all, the Saudis are defending their global market share. Prices that were above or near US$100 per barrel of oil equivalent had the unintended consequence of making shale-oil production and new fracking techniques more economically feasible. This, in turn, led to a huge increase in U.S. production. Along with becoming the world's largest oil producer, the U.S. now also has the capacity to be a net exporter. Oil is flowing at such a high rate into U.S. storage facilities that they're now reaching their capacity.

Because of Saudi Arabia's stance, the price of oil is unlikely to rise beyond the US$60 range. Certain shale operations have break-even points close to the US$80 range, and even the lower-cost wells require prices near US$60 to break even. Making shale-oil production uneconomic, or at least less profitable, clearly benefits the Saudis over the long term.

Secondly, the Saudis seek to weaken fellow oil exporter Iran, their principal geopolitical rival in the Middle East. This would not be the first time the Saudis have used oil prices as an economic weapon against Tehran.

Elsewhere, there are prospects for increased oil supply that would put further downward pressure on prices. For example, production in the war-torn countries of Nigeria and Libya could stabilize. Another possibility is a multilateral nuclear deal between Iran and western countries that would result in the lifting of economic sanctions. This would enable Iranian oil to again flow freely, further flooding the market.

On the demand side, economic growth has been lacklustre worldwide. China, one of the biggest consumers, has effectively met its oil-reserve requirements and as a result has cut back on its purchases. Also having a potential future impact are western sanctions against Russia. These sanctions have had the unintended consequence of pushing the Putin regime to make price concessions to finalize a $400-billion natural-gas deal with China. It's reasonable to assume that this trade relationship could expand into oil exports, with Russia supplying the future needs of the Chinese economy at below-market prices.

Oil-price crashes are nothing new. In 2008, oil fell to the price ranges we are currently experiencing. However, back then there was a relatively quick and sharp rebound to the US$100 range. A similar rebound seems much less likely this time around, given the underlying geopolitical dynamics and lack of global demand that precipitated the current downturn.

Some producers are still weathering the current storm because of oil-price hedging over periods from six months to two years. In time, these hedging contracts will expire, leaving producers fully exposed to market prices and needing to adjust their spending accordingly. With billions of dollars in project cancellations already announced, major producers have acknowledged today's harsh reality. Only the most promising projects are likely to be pursued in the near future.

Equity investors who are unable to avoid the sector altogether, for whatever reason, should look to  Imperial Oil IMO.  This is due to IMO's relative attractiveness compared to its peers in the oil patch, rather than on an absolute basis. Simply put, IMO's fundamentals have deteriorated less than those of other oil stocks.

Imperial Oil's price to 2015 estimated earnings is 26.7, far pricier than the much more modest ratios the market was seeing even six months ago. Currently, IMO looks good only when compared to the sector's shockingly high median forward P/E of 63.

Furthermore, Imperial Oil's book value is forecast to grow by a meagre 5.2% this year. This actually looks quite good versus the industry median of -3.9%. The low numbers for reinvestment are unsurprising, given the billions of dollars in cancelled projects. Also, brokerage analysts' expectations for the industry, as reflected in the percentage cut in 2015 earnings estimates over the last 90 days, are appallingly poor at -55.7% for the median Canadian oil/gas company. IMO "beats" this by having only a -38.2% revision.

When the market dynamics change, it will be best to adjust your portfolio, not put your head in the (oil)sand. The oil sector will eventually improve and will be picked up early in analyst expectations and improving fundamentals. In the meantime, the market outlook for all oil stocks, both large and small, has greatly deteriorated. For that reason, a great deal of caution should be exercised in evaluating investment opportunities in the Canadian oil sector. Let the numbers and hard facts guide your investment decisions.

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About Author

Kirk Paulus

Kirk Paulus  Kirk Paulus is an equity data analyst with the CPMS division of Morningstar. He holds a Bachelor of Business Administration degree from the Schulich School of Business at York University. He can be reached at kirk.paulus@morningstar.com but cannot provide individual advice.

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