Oil Stocks: Is Bad News Signaling Good Opportunities?

As a deep value manager with a long time horizon, I often see opportunities in the midst of gloomy headlines. While crude oil hit a new 12-year low of around $26 a barrel in January1, I view this sector as one of my top long-term opportunities.

That’s not to say the road ahead will be smooth, however. I believe that over the next six months or so, we’ll likely see some bankruptcies hit the oil patch — especially among smaller companies. But in my view, that’s a healthy development that will allow companies with strong balance sheets to pick up good assets at fire-sale prices.

Why have oil prices fallen?

When evaluating the energy sector, it’s critical to understand why oil prices have fallen so far, so fast from their $100-per-barrel range in mid-2014.2 Rising US production and falling Chinese demand are both important factors, but what’s really pushed the market off the rails is Saudi Arabia’s determination to drive competition out of the market — even if that means operating at a loss.

Traditionally, Saudi Arabia and other members of the Organization of the Petroleum Exporting Countries (OPEC) have cut their production as a way to prop up falling oil prices. But throughout 2015, as oil prices plummeted, Saudi Arabia kept its oilfields pumping: In November 2014, Saudi Arabia pumped 9.584 million barrels a day of oil, and in November 2015, it upped its production to 10.130 million barrels a day.3

Are these oil prices sustainable?

Saudi Arabia has approximately $700 billion in currency reserves4, allowing it to bear current lower prices for a few more years. But in my view, they can’t keep flooding the market with $26 oil forever without suffering consequences. The government said in December that it plans to gradually cut subsidies that people receive on oil, water and electricity — over time, moves like this could lead to pressure on the government to stop producing oil at a loss and help firm up oil prices.

From a purely economic standpoint, oil prices are based on how much money it costs to get that barrel out of the ground. The industry has made a lot of efficiencies, no question, but at the end of the day there is a certain cost to extracting oil that must be accommodated — we believe the price per barrel should come back to the $60 to $70 range in the longer term.

Stock prices reflect investors’ fear

But before that happens, I believe investors should be prepared for another year or two of very low oil prices. In addition to Saudi’s “flood the market” strategy, the Chinese government’s currency devaluations are also putting pressure on commodities. Does that mean avoiding the energy sector altogether? Not for my team. Invesco Comstock Fund has an average holding period of about five to seven years, so we’re willing to buy stocks that others are ignoring — or fleeing — when we believe that their prices don’t reflect their fundamentals. We’re looking for energy companies with good assets and strong balance sheets that can weather an extended oil price downturn. Lots of fear is priced into the market, right now. For deep value managers like us, that signals opportunity.

1 Source: “Oil prices fall to new 12-year lows,” Wall Street Journal, Jan. 20, 2016. (Light, sweet crude for February delivery reached $26.20 on the New York Mercantile Exchange on Jan. 20, a 12-year intraday low.)

2 Source: US Energy Information Administration, Jan. 6, 2015.

3 Source: “Saudi Arabia won’t change oil production policy,” Wall Street Journal, Dec. 30, 2015.

4 Source: “How Saudi Arabia benefits from low oil prices,” Investopedia, Nov. 2, 2015.

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