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Why Gulf Keystone Petroleum Limited Is Not A Contrarian Buy

The oil price has been falling like a stone since the summer of last year. But during January it seemed to have found a bottom, and has since then bounced slightly higher.

There is likely to be some volatility in oil markets over the next few months, but it seems unlikely that oil prices will rise to the levels of a year ago. Most oil producers have now accepted that oil prices will be a lot lower over the next few years than they have been in recent years.

Gulf Keystone Petroleum looks cheap

I have already written about how this will affect the oil majors such as BP and Royal Dutch Shell. But what about small caps such as Gulf Keystone Petroleum (LSE: GKP) and Soco International? The share prices of these companies have already fallen a lot – could they now be contrarian buys?

Well, on the face of it, Gulf Keystone Petroleum looks like a buy. After all, the share price peaked at 430p in 2012. The shares are now priced at under 50p. Surely if you buy now, any recovery in the oil price will push the share price higher?

Check the earnings per share progression of this business and you will understand why this is unlikely:

2011: -5.15p

2012: -5.91p

2013: -2.24p

2014: 1.72p

2015: -2.60p

There’s no need to even mention the P/E numbers, as the broad picture is that this is a loss-making company. Even when the oil price was at record highs, it made no money. So what will happen when oil prices are low?

….but it could get a lot cheaper

Investing in small caps has always been much riskier than investing in blue chips. But the greater growth potential of small caps meant that the returns could be a lot higher.

The difficulty with oil and mining small caps is that you are adding the volatility of small caps to the cyclicality of resources companies. The result is that these firms are cyclical in the extreme: so if commodity prices are high they will rocket, but if commodity prices are low they will plummet.

This is the reason why I tend to give these companies a wide berth. It is no coincidence that almost all of these firms were created during the era of high prices of the past decade. When the oil price was reaching record highs, investors were rushing to buy every oil stock under the sun, and share prices kept rising. When the oil price is falling, the share prices of these type of businesses will fall a lot faster than the oil majors.

That’s why Gulf Keystone Petroleum, and other resources small caps, are not contrarian buys.

Sometimes, knowing which shares to avoid is just as crucial as knowing which shares to buy if you want to make your fortune in the market.

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Prabhat Sakya 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.