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Some Oil Stocks May Be 'Uninvestable' During the Price War

Saudi Arabia, the de facto leader of OPEC, failed to reach a production cut agreement with non-OPEC Russia on March 6, causing both countries to ramp up production. As a result, oil prices fell more than 24% over the weekend.

After seeing a 6.06% year-over-year increase in January, the ICE/BofA High-Yield Energy Index, which measures the performance of the high-yield corporate bonds of U.S. Dollar-denominated energy stocks, plunged 20.20% in the first couple of weeks of March as a global oil price war began. Energy sector debt is changing hands faster and at cheaper prices as fewer investors are willing to take on the risk of these bond issuers going bankrupt.


In an interview with CNBC on Wednesday, Shaia Hosseinzadeh of Onyxpoint Global Management said that this situation could make the sector "uninvestable."

"This sector for the better part of 30 years has been funded by the bank community with very cheap financing ... and that market has mushroomed to about $200 billion," Hosseinzadeh said.

While now may look like the time to buy energy stocks at rock-bottom prices, common stock investors may want to take a close look at debt before deciding to purchase shares of an energy company in this environment. For years, this sector has been the biggest issuer of high-yield debt in the U.S. While January brought a wave of relief for debt-ridden oil companies as high yields attracted more investors, analysts mostly considered this a small window of opportunity resulting from a delay of the problem.

"We'll see how long this window lasts, but I think everybody is trying to take advantage," Sreedhar Kona, a senior analyst at Moody's (MCO), said in January.

The combination of oil oversupply and slowing growth in global oil demand as the market becomes saturated means that this price war is more about market share than anything else. The world's major oil producers are trying to squeeze out weaker competitors in order to increase their customer bases, and the first companies to go will be the ones who can no longer pay their creditors when cash flows slow down.

While overall global oil production levels are increasing as countries compete for market share, financially weak producers are cutting down on expenses related to expansion and dividends, which could lead to permanent loss of customers and investors. Thus, in order to identify financially strong oil producers, investors may find it helpful to look at cost-cutting efforts alongside existing debt levels.

For example, Apache Corp. (NYSE:APA) cut its 2020 capital expenditure estimate from between $1.6 billion and $1.9 billion to $1 billion to $1.2 billion and reduced its quarterly dividend by 90% to 2.5 cents. The company also announced on Thursday that it would completely halt its pumping activities in the Permian Basin in order to limit "exposure to short-cycle oil projects."

GuruFocus gives Apache a financial strength rating of 3 out of 10. The cash-debt ratio of 0.03 and Altman Z-Score of -0.42 indicate that the company could be at high risk of bankruptcy in the next two years. The interest coverage of 1.04% suggests Apache was barely able to pay its creditors in the previous full quarter.

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Murphy Oil Corp. (NYSE:MUR), which has a GuruFocus financial strength rating of 4 out of 10, has also taken steps to cut costs. Though it has kept its dividend the same, it plans to reduce capex by 35% for the year.

"Under current conditions, we believe this capital reduction program allows for financial flexibility and preservation of our longstanding dividend," the company's President and CEO Roger W. Jenkins said. The capex reduction plan includes delaying projects under development and ceasing operating activity in the Eagle Ford Shale in the second half of the year.

With a cash-debt ratio of 0.09, interest coverage of 2.16% and an Altman Z-Score of 1.26, Murphy's financial strength is weaker than 70.63% of industry competitors, according to GuruFocus data.

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Meanwhile, Cabot Oil & Gas Corp. (NYSE:COG), which has a GuruFocus financial strength of 5 out of 10, has not yet announced any capex or dividend cuts as of the writing of this article. While the cash-debt ratio of 0.16 is about average for the industry, the Altman Z-Score of 3.56 means that the company is not in danger of bankruptcy, and the interest coverage of 15.95% indicates that it is in a good position to pay off its creditors.

As a result, the share prices of this company have defied the downward sector trend and lost only 4.88% since March 6, though this is still undervalued according to the Peter Lynch chart.

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Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research or consult registered investment advisors before taking action in the stock market.

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This article first appeared on GuruFocus.