Finding value in oil stocks

Volatility-weary investors are wondering if the party’s over for energy stocks. Despite the resiliency of the U.S., the global economy seems to be teetering. A surging U.S. dollar, the traditional headwind of commodities, is blowing hard in the face of crude. And this is at a time when supply interruptions are abating, with Libyan barrels returning to the market.

Financial markets are influential in the transactional volumes of the world’s most traded commodity. For instance, the current global demand for physical crude sits at about 93 million barrels per day. Yet the futures market trade, or the paper volume of oil (as defined by the six most active futures contracts), has become a staggering 1.73 billion barrels per day—almost 19 times the actual physical trade. On the NYMEX exchange, the net long position in light sweet crude oil futures has fallen 44% since the end of June (see “Crude oil futures net speculative position,” below). This move rivals the plunge in oil futures in 2011, when the net long position unwound by 61% from peak to trough. Yet, unlike during the credit crisis, today’s drops have not been accompanied by a decline in world oil demand. So the financial sell-off may still pressure the oil quote, regardless of the physical market supply and demand fundamentals.

Reality check on break-evens

In times of depressed oil prices, investors have taken solace in the fact that the economics of the marginal barrel will determine the clearing price for oil on the global stage. So, over time, oil prices will be determined by the highest-cost barrels of incremental production.

Read: There’s more to oilsands development than the price of oil

For the global oil business, ultra deep-water sources, and the capital-intensive barrels locked in Canada’s vast oil sands, are typically regarded as highest-cost. It’s an elegant, if not academic, argument.

While this may be true in the long term, countries that are most in need of higher oil prices—namely the world’s oil states where, for some, as much as 90% of government revenues depend on higher prices—will do what they can to boost prices.

In practice, this has been accomplished by the Organization of the Petroleum Exporting Countries (OPEC), a group of oil-producing states that sets quotas for its members. Despite the massive decline in oil prices of late, the much-anticipated Nov. 2014 OPEC meeting concluded without a cut in production quotas for cartel members. We think this happened because the organization couldn’t reach a consensus on cuts, and Saudi Arabia didn’t want to shoulder the burden alone.

Many of the world’s key oil-producing states have become accustomed to higher oil prices to fund social programs. Within this group, Saudi Arabia has a substantial stock of foreign reserves that would enable it to withstand lower oil prices for a sustained period without needing to borrow or tighten policy.

However, the same cannot be said for Russia, which is feeling this pinch acutely. And, at current oil prices, Nigeria would exhaust its limited oil savings well within a year; perennial basket-case Venezuela now risks a debt default (see “Budget break-even prices,” below).

Thus, the million-dollar question remains: How long can we expect oil producers to subsidize the consumption patterns of the world’s key consumers?

In the absence of meaningful action from OPEC, the calls from struggling members are bound to get louder. Oil prices will have to move higher over time, so investors should sit tight and use the current weakness in energy stocks to buy quality companies that can survive a few quarters of poor prices because they’ll go higher in time. Read: Has the crude price bottomed?

Security of supply

For several years now, there have been more unplanned supply outages around the world. Also, the decline in prices has systematically deteriorated oil’s geopolitical risk premium. We’re led to believe that today’s oil supply is secure, which is unusual.

But OPEC’s spare capacity is believed to be as little as 500,000 b/d—most of which is in the hands of Saudi Arabia. So prospects for misses on non-OPEC supply, and risks for production disruptions among OPEC members are not gone.

Mike Rothman, president of Cornerstone Analytics, has coined the term “dirty dozen” for the key oil producing states that are consistently problematic for the supply side of the equation. This includes countries such as Iran, Iraq, Venezuela, Nigeria and Libya. Case in point: the at-risk barrels are larger than the spare capacity (i.e., sustainable production that can be brought online within 30 days) and U.S. annual production growth combined.

Table: Budget break-even prices

Source: Deutsche Bank estimates
Fiscal break-even price (Brent, USD bbl)
	2006	2007	2008	2009	2010	2011	2012	2013	2014f	2015f
GCC	32.5	43.1	43.8	70.3	68.4	78.8	73.3	83.6	89.0	94.0
Bahrain	57.9	66.9	80.0	82.9	103.9	118.1	127.1	134.4	136.2	138.1
Kuwait	26.4	32.6	42.1	47.0	45.7	47.4	53.6	68.3	75.5	78.4
Oman	80.7	99.3	96.4	69.9	80.2	112.3	112.5	106.5	100.7	110.0
Qatar	43.4	41.8	49.1	27.2	61.7	80.1	65.5	60.5	71.3	76.8
S. Arabia	38.7	52.7	47.0	72.6	70.6	84.5	80.9	93.1	99.2	104.4
UAE	18.3	24.5	43.7	105.7	86.3	94.6	77.3	82.7	80.2	80.8
Nigeria	56.3	75.1	79.9	125.3	105.3	128.5	112.3	141.7	126.2	122.7
Russia	21.4	28.1	59.7	109.5	116.7	102.8	112.0	113.9	100.1	105.2
Venezuela	81.7	76.9	134.2	140.7	194.4	145.7	151.5	149.9	162.0	117.5
Brent price	65.4	72.7	97.7	61.9	79.6	111.0	111.7	108.9	106.5	103.3

Don’t sweat the noise

In an uncertain environment, investors should continue to focus on energy stocks with strong underlying business fundamentals. The oil quote is down, but not out. The winners through this cycle are going to be companies that can demonstrate superior cost structures, leading capital efficiencies and deep inventories of repeatable, low-risk development prospects.

Read: Don’t avoid the energy sector

We invest in companies that have wells that pay back in one year. Otherwise, companies will have to dilute shareholders by raising more equity and debt to pay for drilling. So, focus on firms with solid balance sheets and free cash flow generation. This is especially true of companies with leverage to a commodity that invariably overshoots the fundamentals, both on the upside and downside. Avoid companies that borrow money to pay an unsustainable dividend.

by Mason Granger, P.Eng., MBA, CFA, portfolio manager, Sentry Energy Growth and Income Fund.