As Oil Continues To Fall, Is It Wise To Go Hunting For Bargains?

How much lower can the price of oil go? That’s a question many investors and traders are asking around the world right now, and the answer is… nobody knows. 

In theory, the price of crude shouldn’t fall below its production cost — no one wants to sell their production a loss — but with production costs so varied all over the world, it’s almost impossible to try and figure out at what price the producers will, as a united front, cut production to boost prices.

Loss making

According to Morgan Stanley, the average global break-even cost of production for Brent crude is around $50/bbl — that includes Saudi production and offshore projects. Russia’s average production cost is around $50/bbl, while the average cost of production for North American shale, oil sands and Arctic producers is approximately $65/bbl, $70/bbl and $75/bbl respectively. So, many of these projects are uneconomic at present. At time of writing, Brent is trading at $55/bbl. 

And the sell-off in oil has been reflected in the share price of any company that has a connection to the commodity. Over the past six months, the S&P Commodity Producers Oil & Gas Exploration & Production Index has fallen by 30% and there could be further declines to come. 

New normal

Some analysts are now stating that $50 oil is the new normal, there’s no reason to suggest that the price of oil could return to $100/bbl. Past performance does not guarantee future results.

Still, these declines in the price of oil have thrown up bargains but investors need to be careful.

Indeed, the valuations of companies that look cheap at present may not fully reflect the underlying oil price. With every $1 fall in the price of oil, the more unreliable City forecasts become and it’s difficult to bottom-fish.

Everyday City earnings forecasts are becoming increasingly out of date. It’s almost impossible to place a reliable valuation on oil producers. 

A few bargains

That being said, the sell-off across the sector has turned up a few bargains, although plenty of research needs to be done before making a trading decision. For example, any prospective investment must have a clean balance sheet and low production costs, to minimize the fallout from the current price slump.

Furthermore, any oil service company should have a strong balance sheet and strong order backlog, both of which will put the company in a strong position to ride out the slump. Diversified players such as Amec should fare better than most

Integrated players such as BP and Shell should also fair well. The integrated nature of their operations means that the refining divisions will pick up the slack as production operations suffer. 

Diversification is key

There are oil bargains to be found there but you've got to be careful where you look. The best investors will hunt out only the best opportunities but first they'll build a core portfolio and use a basket approach. Simply put, a basket approach combines a selection of risky stocks with a core portfolio of defensive dividend paying companies. Using this method allows you to reduce risk and sleep soundly at night.

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.