It Could Get Worse for Oil

On July 24, 2014, Oasis Petroleum (NYSE: OAS) hit an all-time high at $58.09 a share.

Yesterday, the stock changed hands for $12.

If you follow oil stocks, then this six-month chart probably looks familiar…

Oil stocks have been in freefall for three weeks now as oil prices collapse to five-year lows. And it may not get better anytime soon.

Oasis Petroleum is one of the darlings of North Dakota’s Bakken shale oil field. It’s a well-run company.

Over the last 12 months, Oasis brought in $1.4 billion in oil sales, a healthy 26% gain from the year before. In 2015, it will pump 10% more oil, around 18.2 million barrels.

Analysts currently think revenues will grow slightly next year. I think Oasis will be lucky if revenue is flat, and there’s a real danger it will decline, sending profits plummeting.

Oasis has hedged close to 50,000 barrels of daily oil production, roughly 25% of its total capacity. Assuming a reasonable hedge price of $90, Oasis can take in around $1.3 billion if it can sell the rest of its production at $70 a barrel. Earnings would not grow at all.

But that’s better than some. Bakken pioneer Continental Resources (NYSE: CLR) is expected to see earnings shrink 10%. And smaller oil companies like Goodrich Petroleum (NYSE: GDP) are struggling to survive.

Goodrich is expected to bring in ~$265 million over the next year. Problem is, the company has $600 million in debt and just $2 million in cash. 

Goodrich has $275 million in debt due in 2019. But it’s losing money now, and it doesn’t have enough cash on hand to fund operations for long. It will either have to take on more debt or sell a bunch of stock and dilute the company’s value. There aren’t any good choices for Goodrich, which is why the stock has fallen from $30 to $3.

It’s All About the Money

Globally, the 40% decline for oil prices may be cutting annualized oil revenue by as much as $1.5 trillion. OPEC’s share of that is $590 billion. In the U.S., oil producers may take in $290 billion less.

These are big numbers. And they can’t be offset with bond sales or secondary offerings of stock.

Since 2010, American oil companies have raised around $500 billion in bonds and loans. Banks, hedge funds, and mutual funds are on the hook for that cash.

JP Morgan estimates that if oil stays at $75 for the next two years, default rates on high-yield bonds could hit 12%. If oil prices hold at $65, default rates could launch as high as 40%. 

Now, the dollar amount of oil bonds and loans — ~$500 billion — is nowhere near the ~$13 trillion in mortgage debt outstanding in this country. And even if oil defaults hit the 12% level like they did during the financial crisis, it won’t push the country into recession.

In fact, the IMF just raised U.S. GDP growth for 2015 from 3.1% to 3.5% because the savings consumers will enjoy on lower gasoline prices are seen as a net benefit for the economy.

Still, some funds will get hurt.

There’s one other takeaway from the IMF that we need to discuss: It does not expect oil prices to rebound strongly anytime soon. 

Oil Prices

Oil prices hit a five-year low yesterday. They’ve broken through three years’ worth of support levels, as you can see…

Yeah, they rebounded some, but don’t be fooled… oil prices are not going to put in a strong move higher anytime soon.

The Energy Information Agency (EIA) now says it expects oil prices to average $62.75 in 2015. And futures that guarantee delivery in 2017 are pinned to prices around $70.

Now, you’ll notice that these price estimates are within the range that JP Morgan says will lead to default for some companies. That’s what happens when you get over-investment.

It would have been crazy to say this a couple years ago, but at this point, there is simply too much oil on the market. The global economy is not growing fast enough to push demand higher.

In order for prices to rise, companies must curtail production. Conoco has already announced a 20% cut in its capex budget. But many smaller companies simply can’t cut production because they have debt to pay off. And with lower prices, these marginal producers actually have incentive to pump more oil to offset the lost revenue.

It’s a bad situation, and it is likely to have political fallout, too.

Iran is already talking about a massive conspiracy between the U.S. and Saudi Arabia against the Muslim world. Russia is likely to become more belligerent as oil prices crush its economy. Venezuela says it will cut 20% of spending, and the IMF says the Venezuelan economy will shrink 6% in 2015 and inflation might hit 120%.

And you know what that means: its government will collapse.

At some point, OPEC will cut supply. There’s just no way Saudi Arabia can vote against its fellow members for long. If I had to guess, I’d say we might get an emergency meeting in February where supply cuts will be accepted. That, in turn, will almost certainly change the price outlook.

There’s no need to rush in and buy oil stocks right now. But the time to scoop up some cheap shares is coming pretty soon.

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

The Wealth Advisory on Youtube

The Wealth Advisory on Facebook

A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.