Can we profit from falling oil prices?
Companies that sell their products to industry are definitely worth a look
The huge fall in the price of oil has been the leading financial headline of the past several months. From a high of $ 100 just six months ago, it had fallen to $ 48 a barrel on Friday. Such a drop in price ( I’m trying to avoid the word “crash”) has rocked the foundation of the “new area” theory. The theory is — and I am simplifying here — that there is less and less oil in the ground and more and more demand, mostly from emerging markets. The consequence of this theory is that oil prices could only go up.
I am no expert in oil ( but I would appreciate it if you’d continue to read anyway). What this theory misses — in my opinion — is human ingenuity. New technology has made it possible to extract oil where it could not be extracted just a decade or so ago.
For example, the new shale oil regions in the western United States have flooded the market with new supply to a point where the U. S. is no longer dependent on oil imports and can envision a day when it will be one of the top exporters of oil in the world. This has reversed the oil imbalance, and OPEC has decided to let the prices drop to try to reduce competition from oil extracted from shale.
Many oil producers can’t make a profit at $ 48 a barrel, so many of them will lose money in 2015. Another consequence will be a sharp drop in capital expenditures, which will affect companies like Schlumberger that supply technology and services to oil producers.
I have no idea when oil prices will rebound ( and if so, to what level). What I am looking for these days are companies that will be indirectly affected by the “oil recession,” but on a small scale and, most importantly, on a temporary basis. So we can search for companies that sell products to oil companies to help them remain efficient. Even with a smaller budget, if the products are essential to oil companies to stay competitive, they won’t think of cutting purchases.
One example is Computer Modelling Group. The Calgarybased company develops and licenses reservoir simulation software to oil and gas companies. So in situations where oil is hard to extract, the company’s products enable engineers to create software extraction simulations. The company has a rock- solid balance sheet and has grown very fast in the last decade: Its Earnings per Share ( EPS) have grown 22 per cent annually since 2004. The stock is not cheap ( around 28 times estimated earnings), but it’s an outstanding company worth following closely.
We can also look for companies that have a low exposure to the oil market — let’s say 10 per cent of their revenues — and have seen their stock go down 20 per cent because of it. One example is Edmonton’s Stantec, a firm that provides professional consulting services in planning, engineering, architecture, interior design, landscape architecture, environ- mental sciences, project management and project economics for infrastructure. About 15 per cent of its revenues are linked to the oil industry. So let’s say that division experiences a 25 per cent drop in revenues ( which seems like quite a pessimistic scenario). This would translate into a three to four per cent drop for the whole company.
Stantec’s stock has lost close to 20 per cent of its value since September, which seems a little disproportionate compared with the potential financial effects from the drop in oil prices. Even with reduced EPS estimates for 2015, the stock trades at only 15 times forward earnings, which seems a very reasonable level.
Another company that has seen its stock go down lately is Union Pacific, the large railroad company in the western U. S. With Burlington Northern Santa Fe, UP is the main player in the rail transport in the west, a region that experienced a huge increase in the volume of oil transported by rail over the last few years. Even if the company released record earnings for its last quarter, the stock is down 13 per cent from its February high of $ 124.
The company is experiencing some weaker traffic performance these days: It has exposures to slumping crude and frack shipments, along with a less favourable agricultural products environment. I believe these are temporary factors and the longterm fundamentals of the company are very solid. The stock is trading at a reasonable P/ E of 16 to 17 times. It’s a valuation similar to the average company, although I believe its growth prospects are higher than average.