Throughout the fall in the price of oil in the last year, almost all of the experts have got it wrong. When it was sitting pretty above $100 per barrel this time last year, many commentators were stating that due to high demand the oil price would keep on soaring over the medium term. Now that it has fallen spectacularly, most industry commentators are predicting that the price of oil will not rise much higher than its present level and that companies in the sector should prepare themselves for a challenging period.
Profitability
Of course, a lower oil price means reduced profitability and significant impairments. This is to be expected, since the income producing potential of even the best asset base will inevitably be hurt by a depressed oil price. Furthermore, a lower oil price and subsequent reduced profitability means that the valuations of oil companies have come under severe pressure in the last year, with few stocks in the space seeing anything but increasing pessimism in investors’ attitudes.
In fact, the likes of Premier Oil (LSE: PMO) and Genel (LSE: GENL) have both seen their share prices slump in the last twelve months. In the former’s case, the impairment of assets has been a major driver, with Premier Oil dipping into loss-making territory. Meanwhile, Genel has been penalised by the market due to its considerable exposure to Iraq/Kurdistan, with there being uncertainty regarding payments for exported oil. As such, shares in Premier Oil and Genel have fallen by 45% and 35% respectively in the last year.
Looking Ahead
However, both stocks, as well as sector peer, Dragon Oil (LSE: DGO), are expected to become more efficient and hugely more profitable next year. For example, Premier Oil is forecast to return to profitability in the current year before increasing its bottom line by an incredible 96% next year. Furthermore, Genel’s bottom line is due to return to the black in 2015, followed by an increase in earnings per share of 76% in 2016. Meanwhile, Dragon Oil is set to see its profit fall by 45% this year before growing by 41% in 2016.
As such, investor sentiment in all three companies could pickup as they begin to post much better figures than the market is currently pricing in. For example, all three companies trade on very appealing valuation multiples, with Premier Oil and Genel having a price to earnings growth (PEG) ratios of just 0.2, while Dragon Oil also offers excellent value for money via a PEG ratio of 0.4.
So, while there could be more pain ahead for the oil sector, and the forecasts for Premier Oil, Genel and Dragon Oil may fail to be met, there appears to be a very wide margin of safety built in to their respective valuations. This means that they could offer superb rewards and less downside than you may expect, thereby overcoming a sluggish oil price.
