Energy patch’s Black Friday sale
The timing for me to moderate a panel at the Calgary CFA Society’s annual oil and gas forecast breakfast this week couldn’t be any better given the latest action in the markets with WTI oil prices falling below $70 US a barrel and energy stocks being pounded to levels not seen since the 2008 financial crisis.
Not surprisingly, Canadian producers are taking their usual view that price corrections are normal and nothing to be worried about. We appreciate this optimistic thinking, but, being risk managers, we prefer to take a more pragmatic approach when looking ahead.
We see three potential scenarios playing out that we summarize as the Ugly, the Bad and the Good.
The Ugly: Oil prices continue their descent.
There are those who say the cure for low oil prices is low oil prices. The recent price collapse will no doubt have a huge impact on future cash flows, but we think the production response could take longer than many expect.
The industry in the U.S. is for the most part flush with cash and many have implemented hedging programs to provide a nice buffer against falling oil prices.
The ugly scenario is where oil prices continue to decline and production continues to increase.
The Bad: Oil prices remain at current levels.
The longer prices remain at or below current levels, the greater the probability of a material reduction in capital programs, growth targets and dividends among producers. This could be why stock investors have reacted by selling first and asking questions later.
However, this sell-off has been so pronounced that producer stocks are now factoring in lower oil prices than the forward curve, which historically has proven to be a great time to buy stocks.
For the contrarians willing to play this, we think Canadian producers look more attractive compared to U.S. ones, since a portion of the downside in oil prices is being mitigated by the falling Canadian dollar.
Those with weaker balance sheets have been hit the hardest, so we would recommend sticking to the top-quality companies as they offer a much better risk/ reward ratio in the event of further near-term downside.
The Good: Oil prices have hit a floor and start to recover.
Overall, we view the latest selloff to be pure and simple capitulation by investors overreacting to negative news and calls for oil to fall below $50 US a barrel.
Sure, oil prices could continue to drift lower in the next few weeks, but we think there is a real dichotomy in the market that many have been disregarding.
In particular, there are pundits touting how inexpensive the broader equity market is, given the rapidly growing economy, but also calling for recessionary-level oil prices. Which is it, folks?
The ratio between the S&P 500 and oil prices has now exploded to more than three times, the highest it has been in more than 10 years and over three standard deviations from its mean.
Therefore, if one buys into the economic growth thesis, then the current sell-off in oil could represent one of the best opportunities we’ve seen in the past decade — creating our own Black Friday sale in the energy patch.