The outlook for crude is growing increasingly negative. Not only have crude prices slipped to six-year lows, but many analysts now believe they are here to stay. This increasingly negative outlook has triggered a rout in the energy patch, with a number of oil companies seeing their share prices cut by half or even more over the last three months. It has also forced many of those companies to slash their dividends as they battle to preserve their balance sheets and maintain cash flow.
How long will these depressed oil prices remain and what action should investors take?
What is triggering the rout in crude?
The key driver of depressed crude prices is a global supply glut, triggered by growing U.S. shale oil production and declining demand from some of the world’s largest economies.
Over the last four years, U.S. light oil production has more than tripled because of the shale oil boom. Despite lower crude prices causing producers to shut down non-commercial production, U.S. oil production is still expected to grow at an annual average of 5% between now and the end of 2016. This, along with OPEC refusing to cut production, will further exacerbate the existing supply glut.
The flipside of this equation is that global demand for crude has continued to wane with the economy of China, the world’s largest net importer of oil, continuing to slow. For the full year 2014, China reported GDP growth of 7.4%, the lowest in two decades. More concerning is that China’s economy is expected to slow even further, with the IMF predicting GDP growth of 6.8% in 2015 and 6.4% in 2016.
In addition, it looks as though the Eurozone has been caught in an intractable economic decline. None of this bodes well for increased demand for crude in the foreseeable future. As a result, this supply glut is likely to continue for the short to medium term.
So what?
A number of analysts, myself included, predict that crude prices will remain under US$65 per barrel for at least the next 12 months. This view is in line with that of global investment bank Goldman Sachs, which has predicted that the 12-month futures price for crude will remain below US$65 per barrel. However, this price is still above the breakeven cost per barrel for many shale oil producers, with these costs ranging between US$46 and US$69 per barrel depending upon the shale formation. I would not expect to see U.S. shale production wind down rapidly unless crude prices fall further than they have.
It is more than likely that at this price, Canada’s oil sands operators will be forced to wind down production with the breakeven cost for new projects ranging between US$54 and US$90 per barrel.
Now what?
These low prices make those oil companies operating in the energy patch with high debt loads and ongoing production issues especially vulnerable and I believe investors should avoid companies with those attributes. This includes Canadian Oil Sands Ltd. (TSX:COS)(NYSE:COS), because of its mountain of debt and the recent trimming of its 2015 production guidance due to yet another unexpected production outage at the Syncrude project.
Lightstream Resources Ltd. (TSX:LTS) has cancelled its dividend altogether because of its high debt load and is now heading towards penny stock status. Surge Energy Inc. (TSX:SGY) will also struggle in the current operating environment because of its huge pile of debt and high degree of leverage, which have already forced it to slash its dividend by 50% in order to preserve capital.
Companies with low levels of debt and strong balance sheets like Crescent Point Energy Corp. (TSX:CPG)(NYSE:CPG) are well positioned to weather this current storm. This is because Crescent Point has a very low degree of leverage with net debt at 1.3 times cash flow and has hedged around 50% of its 2015 production at an average price of $90 per barrel.
Investors need to focus on the financial health of oil companies, particularly their balance sheets, when making investment decisions in the current difficult environment. For those companies with distressed balance sheets and high operating costs any further sustained fall in crude prices will more than likely take them to the point of failure.
