Is There Value in the Oil Patch?

A look at the market's most beaten-up sector

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Apr 20, 2020
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Over the past few weeks, the price of oil has plunged. This has sent the share prices of oil producers falling in turn.

Some of these declines are staggering. There are several hundred shale oil and gas companies that have seen their share price fall 80% or more this year. Some oil service companies have seen a similar performance.

Only a select handful of businesses have managed to escape the carnage. Unfortunately, it doesn't look as if the pain is going to come to an end anytime soon.

Oil price declines

At the time of writing, oil is trading at a negative price in some markets. Producers are paying traders to take the "black gold" off their hands. The big question is, are there opportunities for value investors among the carnage?

The answer to this question may not be so simple. Some companies might look attractive compared to their acreage and asset value. However, there is a good chance these businesses may be a value trap, in my view.

One of the key differentiators between a value investment and a value trap is the nature of the issues the business is facing. Cyclical issues can lead to attractive long-term investment opportunities. On the other hand, structural problems can identify a value trap. Evidence suggests it is highly likely that the oil industry is facing severe structural issues.

After the recent price declines, according to an analysis by oil consultancy Wood MacKenzie, 75% of oil projects don't even justify the cost of capital at an oil price of $35 per barrel.

As the oil price has fallen further since these comments, it is highly likely that even fewer projects now justify the investment. What's more, the cost of capital for pure-play oil producers has exploded. The yield on the Bloomberg Barclays High Yield Energy bond index has jumped past 20% in recent weeks. There are few, if any, companies in the world that can survive with a cost of capital at 20%.

The shift away from hydrocarbons is also having an impact on the cost of capital. Investors are much more open to funding green projects because there's so much more clarity on the outlook for these companies.

Falling energy prices, climate change policies, shift in consumer behavior and the falling cost of renewables means the green energy sector has a much brighter future, both from a climate and economic perspective, than oil and gas. In some regions, green energy products are actually more economical than oil and gas. The falling oil price will only accelerate this trend.

The price action of green bonds tells us a lot about this trend. The Bloomberg Barclays U.S. Green Bond Index was down 2.5% for the year to the end of March, far less than the 5.1% drop seen in the investment-grade corporate debt benchmark.

Renewable energy stocks have also outperformed their oil and gas peers. Brookfield Renewable Partners L.P. (BEP, Financial), for example, is roughly unchanged year-to-date.

The bottom line

Overall, it looks as if many companies in the oil and gas sector are now value traps. I do not think that hydrocarbons will disappear from the world's energy mix anytime soon. However, the trend away from hydrocarbons towards cleaner fuels is only accelerating. The recent price action in oil and the rising cost of capital for the sector will only accelerate this trend. Some companies might be able to survive, but many will fail.

Trying to distinguish which will fail and which will succeed is a tough task and one that could prove impossible for most investors. With so much uncertainty, it might be better to avoid the sector for good at this time.

Disclosure: The author owns no share mentioned.

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