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Where Is the Long-Term Oil Cycle Headed?

The oil price has now declined by more than 40% from the June 2014 peak, creating havoc among the share prices of oil-producing companies. Many investors are considering taking advantage of the market weakness. However, it would be prudent for investors to consider lessons from the longer-term oil price cycle.

The oil price moves in long commodity cycles characterized by periods of price increases accompanied by heavy capital investment and expansion followed by lean investment periods and sharp price declines.

The graph below shows the price of crude oil expressed in real terms (that is adjusted for inflation) since 1970. The green line (a proxy for the long cycle), indicates that the oil price has gone through only two major up cycles since 1970 and one down cycle. A second down cycle seems underway, which, if history is anything to go by, could last for several years.

Oil Price

Source: The World Bank

The price of oil has been in a bull market for the past 14 years, only interrupted briefly during the 2008-09 financial crises. For the past 10 years, the Brent Crude price averaged $85/barrel, which was high enough for oil producers to make abnormal profits and spend considerable amounts on exploration and the establishment of new production capacity.

A number of market observers, including Morgan Stanley, have now indicated that they expect the oil price to reach $40-$50 per barrel in 2015. However, most analysts are still looking at an oil price recovery later in 2015 and 2016.

If the typical longer term oil cycle plays out again, the oil price may remain in the doldrums for a substantial period of time. Under such circumstances, investors will have to take considerable care with their energy producer selections. I have previously written about the sensitivity of the major Canadian integrated oil companies to movements in the oil price. Here’s a brief review.

Suncor Energy Inc (TSX: SU)(NYSE: SU) estimates that based on the 2013 financial sensitivities, a US$1.00 decline in crude oil prices would detract roughly 2.5% from annual profits, assuming that all other factors including refining margins, volumes, and the exchange rate remain unchanged.

Imperial Oil Limited (TSX: IMO)(NYSEMKT: IMO) estimates that based on the 2013 financial sensitivities, a US$1.00 decline in crude oil prices would detract 1.9% from the annual profit.

Canadian Natural Resources Limited (TSX: CNQ)(NYSE: CNQ) estimates that a $1.00/barrel decline in crude oil prices will shave 1.7% from the annual operating cash flow and 5.4% from the net profit.

The WTI crude oil price in 2014 should average around $90 per barrel compared to the current $61. It is clear that even the top quality integrated producers will deliver much lower profits under an extended period of lower oil prices.

Lessons from the long cycle…

Consensus forecasts for crude oil prices in 2015 have been scaled back from the 2014 levels but very few analysts extend the lower prices beyond 2015. However, if crude oil prices continue to decline into 2015 and remain at the lower levels for an extended period the impact on the profitability of the oil producers could be substantial.

Notwithstanding possible short-term profit opportunities, investors should focus their long-term energy holdings exclusively on the best quality producers, with low cost of production and solid balance sheets fully cognizant that profits will be under pressure for the foreseeable future and that dividends payments may be curtailed or suspended.

Energy companies will remain important for the overall economy but investors should find the right targets for investment.

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Fool contributor Deon Vernooy, CFA has no position in any stocks mentioned.

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