Is the battered oil sector making a worthy comeback?
The price of a barrel of oil is in recovery after suffering an unprecedented two-year nosedive.
With crude prices rising above $50 per barrel and signs that the worldwide oil glut may be easing, you may be seriously considering investing in the oil sector.
The big question: Is oil really on the rebound?
Volatility Rules the Markets
Since the oil rout began, investors have taken it on the chin and volatility has shaken the markets. Even recent good news about oil was followed by more market turmoil.
A stronger dollar prompted oil investors to sell off in favor of commodities less dependent upon that currency, and bond yields fell. Oil prices dropped yet again.
Still, per-barrel prices are higher now than in January, when they plummeted to about $26. The sector isn’t out of the dumps just yet, but there’s a definite upward trajectory.
For investors, this could signal a not-too-distant future where oil prices again reach the $100-per-barrel mark.
For oil-sector stocks, values will rise, right along with oil prices.
The Re-Emergence of Oil
Ironically, the oil slump of the past 24 months will fuel the oil revival. Falling oil prices created a debt-laden class of “zombie” companies: Producers who frantically borrowed money to keep pumping, even as oil income dropped.
Debt levels are now so high that companies paid out 86% of their operating income just to service their debt in the first quarter of 2016. Worse yet, only $5 billion of the debt is due this year.
Next year will see over $25 billion come due—many companies won’t survive, even with a big rise in oil prices.
As more players leave the stage, production will slow. Companies are already slashing exploration capital expenditures in an effort to recoup losses. Analysts predict that producers will continue this two-year capex reduction into next year as well.
At the same time, the world’s oil reserves are being drawn down. The International Energy Agency noted in May that stockpiles decreased in February for the first time in 12 months. By the end of the year, the Agency estimates reserves will “shrink dramatically.”
When Will the Revival Begin?
Though heartening, the recent run-up in oil prices is only temporary, as worries about the global economy grip investors. Some observers opine that per-barrel prices could fall to $25 or even $10 before prices begin to stabilize.
The idea that oil would eventually find its price floor and rise again is nothing new. Last July, analyst Gary Ross of PIRA Energy Group predicted a return within five years to $100-per-barrel, and the Organization of Petroleum Exporting Countries itself weighed in a few weeks later, saying a barrel of oil would reach $80 by 2020.
More recently, Ross, who forecasted the 2014 dip in oil prices, told CNBC that prices are still too low, and “prices are going up.”
Even OPEC is feeling upbeat. The cartel’s newest report sees global growth improving over the next six months, bringing with it a higher demand for oil.
Is this really oil’s renaissance? Hedge funds are betting on it in a big way.
What’s selling? Options contracts that pay if oil prices surpass $100 a barrel, based on predictions that supplies will contract in the next few months.
The Oil Boom Comes Full Circle
The debt-ridden oil and gas sector faces more pain with mounting bankruptcies. Law firm Haynes and Boone’s Bankruptcy Tracker shows how the industry’s unmanageable debt in the wake of falling oil prices is fueling mounting bankruptcy filings.
Though the uptick in oil prices might seem like a boon to the sector, it’s unlikely that the moderate price recovery will help severely indebted companies. Many producers are so close to collapse that $45 to $50 per barrel won’t help.
With reserves dwindling and producers exiting the business, shortages will follow.
How can you take advantage of the coming price explosion?
Look to larger, healthier energy companies; smaller producers have been hit the hardest. Don’t worry too much about earnings just yet… most players in the sector have taken a hit over the past two years.
As per-barrel prices rise, the effects will eventually show in earnings reports.
Also consider the debt level of the companies you research. Lower debt indicates overall financial health and will make it easier to quickly ramp up production when oil prices take off.
In the current climate of high debt-equity ratios, Exxon Mobil’s (NYSE:XOM) ratio of .91 looks especially attractive. This petroleum giant manages to keep investors happy and is currently trading near its 52-week high.
Though revenues have dropped over the past few quarters, XOM beats analysts’ diminished estimates almost every time. The company also pays out a healthy annual per-share dividend of $3.00.
Chevron Corp. (NYSE:CVX) has a ratio of 1.09 and is a dividend powerhouse, paying investors $1.07 per quarter per share.
Despite some significant troubles with Nigerian rebels destroying wells in the Niger Delta, the lion’s share of its Nigerian production is located offshore, and impact on the company’s production is minimal.
Though the company recently cut dividends, its comfortable free-cash position should enable it to engage in investor rewards via buybacks, according to BAML.
Volatility will likely continue for some time, so use it to your advantage: Buy your stocks of choice during price dips.
When oil prices soar, you’ll be glad you opted in when others were cashing out.