Is Every Oil Company A Buy Right Now?

Crude oil prices have been extremely volatile of late. After falling sharply by more than 60% in a short period of slightly over six months, oil prices have risen by over 30% from their lows over the last few weeks. In hindsight, the sharp decline in oil prices makes sense because of slowing demand growth and surging tight oil production in the U.S., but the billion dollar question is, what will they do next, and how would that impact the valuation of oil companies. Could there be a V-shaped recovery in global oil prices that could drive significant short-term gains in oil-linked equities? It has happened in the past when oil prices increased sharply in 2010 and 2011, following the slump in 2008-2009 due to a dramatic slowdown in economic activity all around the world. The NYSE Arca Oil & Gas Index (XOI) declined by more than 47% between May 2008 and February 2009, led by a near 65% drop in oil prices, due to a slump in demand. However, the index rose by almost 24% over the next 12 months as oil prices recovered. The chart below shows the movement in XOI and monthly average Brent crude oil prices, both normalized with their May 2008 levels as the base (100). ^[1]

So could the above scenario repeat again, and do current oil prices offer an opportunity to gain by investing in oil-linked equities in the short term? We believe that this is probably not going to be the case. The reason why we think so is the fundamental difference between the cause behind the steep decline in oil prices now and then.  While in 2008-2009, it was the sharp slowdown in global demand growth that sent oil prices plummeting; currently it is the oversupply of oil that is the cause of concern. Back then, almost all major governments stepped in with stimulus packages to revive demand growth, which drove the demand for oil products higher by almost 2.7 million barrels per day in a single year (2010). ^[2]  However, currently, the Organization of Petroleum Exporting Countries (OPEC), which acts as the swing producer for crude oil, has been extremely vocal about refraining from curtailing any supplies, to retain their market share. Also, even with the massive number of oil rigs being rendered idle in the U.S., as companies defer development of tight reserves, global oil production is still expected to grow at almost the same pace as demand, leaving little scope for improvement in the current oversupply situation. ^[3]

That said, we do expect oil prices to recover from current levels in the second half of this year, and average around $70 per barrel for the full year. However, significant revenue pressures and margin erosion in the first half is expected to more than offset the impact of sequentially higher oil prices later this year, and result in negative upstream earnings growth (year-on-year) for most oil companies. In addition, since most of the pricing gains are expected to come on the back of oil companies in the U.S. compromising on volumes growth, by deferring drilling and completions, the net impact of higher oil prices (during the second half) on their earnings growth would be mitigated. Therefore, we do not expect oil-linked equities to provide significant returns in the short term, under normal geopolitical conditions. This also is reflected in our price and earnings per share (EPS) estimates for these securities.

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1. Europe Brent Spot Price, eia.gov [↩]
2. World Oil Supply and Demand, iea.org [↩]
3. U.S. Oil Rig Count Falls To Lowest Since Dec. 2011, reuters.com [↩]