The Real Price of Low Oil Stocks – Don’t Get Stuck in a Value Trap
With the price of oil down nearly 50% from its highs, investors are recommending buying oil stocks in hopes of a rebound. While this may seem like an opportunity to jump on, from our point of view it’s too early in this continuing oil story to step in and buy at these levels.
Earnings for oil companies likely hit their cyclical peak in 2014. As the reality of lower of oil prices settle in, oil producers will likely reduce spending on projects for a while. This translates into reduced earnings for the oil sector. So, even though PE ratios look low for the sector, earnings estimates are likely to decline substantially which will increase PE ratios in the future.
As many may already know, Saudi Arabia has a massive advantage in the oil sector, with marginal costs of production at around $20 a barrel. While Shale producers’ marginal cost of production is around $50 a barrel. As a result, the Saudis have no incentive to cut production until oil drops well below $40 a barrel, whereas at the same level, Shale producers risk facing bankruptcy. With these factors in mind, we believe the Saudis would welcome this development, which would reduce global supplies and enable the Saudis to gain market share once again.
In order for oil to become something of interest to us at Ideal Asset Management, prices would have to drop significantly below $40 a barrel and oil stocks would have to drop more than 20% from current levels.
Looking ahead, it is unlikely that OPEC will cut production before the summer driving season begins, when, typically, oil prices rally in anticipation of the summer driving season. If oil prices fail to rally in the summer and the price of oil approaches $30 a barrel, then OPEC would be forced to take action. Until then, the risk of oil dropping is too great to be investing in oil stocks.
All ideas expressed in this article are the opinions of Ideal Asset Management LLC.
Before trading on any of the advice in this article, consult with your financial advisor to
make sure it suits your financial goals
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