The Oil Market Is Going To Turn: Will You Be Ready?

Despite fairly hysterical press forecasts, oil prices didn’t collapse on Monday. In fact, after a brief wobble, Brent Crude returned to the $43 level at which it ended the previous week.

The fear was that the failure of OPEC to agree a production freeze in Doha last weekend would trigger another oil price collapse. In fact, OPEC’s failure to do a deal was predictable and irrelevant. Virtually all major oil producers are already producing as much as oil as they can. They aren’t in a position to increase production.

That’s not to say the oil price couldn’t slide again at some point over the next few months. It could. But if this happens, I believe it will be a short-lived dip that will signal the end of the oil bear market.

Here’s the big news

After more than a year of waiting, oil production is finally starting to fall. US oil production has fallen by about 500,000 barrels per day from last year’s peak of 9.5m b/d. The decline is now gathering pace and production is falling every week.

Production is also starting to fall elsewhere. In Russia and some OPEC countries, producers have been unable to spend the money needed to maintain production. I believe the oil market is approaching a turning point, when global stockpiles will start to shrink and the market will return to balance. We may even see a supply shortage at some point.

Investing for a recovery

In my opinion, the safest buys in the current market are the supermajors, BP and Shell. Shares in both firms have fallen by 15%-25% over the last year, but both have maintained their dividends. As a result, they offer yields of more than 7% and look cheap relative to long-term average earnings. Although there’s still some risk of dividend cuts, I think both stocks are likely to deliver gains over the next couple of years.

The second category of stock is what I’d call well-financed independents. Firms such as Faroe Petroleum and Amerisur Resources, which have plenty of cash and minimal debt alongside low cost production.

I think that downside risk is limited here due to these firms’ strong balance sheets and cash flow from production. However, there’s a risk that much of the recovery is already priced into the shares. Amerisur, for example, now trades on 18 times 2017 forecast profits.

My third and riskiest category is companies with good assets but too much debt. We’ve already seen a number of small-cap oil stocks collapse because of debt problems. The question is whether larger but heavily-indebted firms, such as Tullow Oil and Premier Oil, are now good buys.

Premier has net debt of more than $2bn, while Tullow’s net debt has risen to $4bn. Both companies will need to refinance some of their debt in 2017. I believe there’s a real risk that this could be problematic, especially for Premier. This might result in the firm having to raise some fresh cash — either through a rights issue, or by selling a stake in key assets.

My view is that these stocks remain too risky for equity investors, despite the improvement we’ve seen in the oil price this year. But I may be wrong.

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Roland Head owns shares of Royal Dutch Shell and BP. The Motley Fool UK has recommended BP, Royal Dutch Shell B, and Tullow Oil. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.