There are any number of theories explaining the sudden drop in crude oil prices after two years of stability: America’s increasing supply, the world’s faltering demand, an undeclared price war being waged by Saudi Arabia, the rising U.S. dollar. What we know for sure is a barrel of West Texas Intermediate (WTI) has plunged around 40% over the course of 2014 to the neighbourhood of US$55. The S&P/TSX Capped Energy index has followed suit.
Canadian oil companies rightly should have been spared from some of that carnage. Most produce heavy crude, which was discounted to begin with and is down only 18% since the summer. Many also hedge their production, selling at least part of their output under contract at a fixed price into the future. But this is a sentiment-driven sector, says Les Stelmach, a portfolio manager with Franklin Bissett Investment Management. When oil prices fall, so do stocks in the sector, even if their income is not directly affected.
While some investors may have the impulse to drive away—fast—Ryan Lewenza, a portfolio manager with Raymond James, thinks now’s the perfect time to invest your savings at the gas pump into more energy stocks. The integrated producers—companies that both produce and refine oil—are trading at 6.4 times cash flow, down from the eight times they were trading at in June. “Investors are overestimating this weakness, and they’re selling before assessing,” he says.
Lewenza thinks oil prices will bounce back, mostly because global demand growth will resume. Canadian companies, which sell oil priced in U.S. dollars but pay costs in loonies, will also benefit from a rising greenback and, ultimately, that more resilient heavy oil price, adds Stelmach. “These things tend to even out,” he says.
Indeed, the industry has a recent history of price dips and rebounds to look back on. In 2011, WTI went from US$112 to $82. In 2012, the price yo-yoed from US$109 to $77. Each time, energy stocks fell and got back up again. In 2011, for example, stocks fell 34% between April and October, but then climbed 27% between October and February.
Of course, there’s a chance that oil prices will stay around US$60 for an extended period or even continue to drop, especially if there’s another economic crisis or a worry that one is about to occur. Since Canada is a relatively high-cost basin, lower prices can be magnified in company margins. Particularly vulnerable are energy dividend stocks, whose payouts may need to be adjusted downward. Some, such as Canadian Oil Sands (TSX: COS), have already been driven down under speculation of a dividend cut.
Lewenza likes the large-cap integrated producers. They enjoy economies of scale and capture margins all along the supply chain to consumers’ gas tanks, so they’re less exposed to crude price volatility. They also tend to have low payout ratios. Look for ones that maintained or increased their dividends during past price dips.
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Stelmach favours low-cost producers of all sizes, as long as they have little debt. “If a company is highly levered going into a downturn, the bank won’t extend additional credit,” he says.
Unlike earlier this year, high-quality names can be had for reasonable prices. That will position you well for when oil prices recover—whenever that may be.