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The Hidden Factor Affecting Almost Every Canadian Oil Stock

As many market pundits predicted, the price of oil is once again flirting with January lows.

As I write this, WTI crude is currently trading at $47 per barrel, which is pretty close to lows of $44 set in January. Inventories were up 2.2 million barrels at Cushing, Oklahoma, which is just confirming the news we’re hearing everywhere. There’s a lot of oil out there.

In fact, according to the U.S. Energy Information Administration, U.S. crude supply is currently at an 80-year high.

No, that’s not a typo, much to the chagrin of energy bulls.

Production is starting to decrease in both Canada and the U.S., just not fast enough for demand to make a dent in the glut of inventory already in the system. The amount of crude out there should continue to go down in coming months as exhausted sources aren’t replaced, but it looks to be a long process. Investors who were hoping for a v-shaped recovery are now preparing for a future of holding their beaten-up oil companies for years, not just months.

Why it could get worse

There’s nobody who has been able to consistently predict the price of oil over the long term. Plenty of short-term commentators called this latest pullback, but oil is just too unpredictable to fully understand over years.

As investors, all we can control is the price we pay for a company and the amount of risk we take. Buying a junior producer is almost always riskier than buying one of the giants in the industry. And buying a company with a pristine balance sheet is usually a better bet than buying a company swimming in debt, even if the latter could have a better potential upside.

Most investors get this, which is why the largest companies in the sector have weathered the storm pretty well. Other investors looking for return have ventured away from the majors, including myself. There are plenty of medium and even small-sized oil companies with good operations and strong balance sheets.

But there’s one thing investors have to remember. It’s a small detail, but it’s becoming a bigger and bigger deal every day.

It’s the presence of U.S. dollar-denominated debt on the balance sheet.

A couple examples

Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) is one of those companies that offers huge upside potential if the company can weather this storm. Even after writing off nearly $2 billion in assets during the fourth quarter, the company still trades at approximately 25% of its book value.

The company also did a great job paying down its debt in 2014, decreasing the total amount outstanding from $2.46 billion at the end of 2013 to $2.15 billion today. That doesn’t seem like a lot, but based on a 5% interest rate, the interest savings of $15.5 million annually are very real.

There’s just one problem. According to the company’s third-quarter filings, some $1.6 billion of that debt is denominated in U.S. dollars. At least $660 million of it is hedged to Canadian dollars using a currency hedge. Its U.S. dollar exposure is approximately $1 billion net.

On December 31, the U.S. dollar was worth $1.16 Canadian. The U.S. dollar has since rallied, and is now worth $1.27 Canadian. Thus, Penn West’s U.S. dollar debt outstanding is now worth some 9% more than what it was worth two months ago. This translates to $90 million, give or take a few bucks.

Now, for Penn West, this isn’t such a huge problem. The hedge is enough to cover its near-term debt, and the Canadian dollar should rally when crude recovers. It’s more of a “keep-an-eye-on-it” problem.

Lightstream Resources Ltd. (TSX:LTS) is an example of a company where this really matters. It owes US$800 million in unsecured debt, which worked out to $928 million Canadian as of December 31. Now those same notes are worth more than $1 billion, and the company only has a market cap of less than $200 million. For Lightstream, the exchange rate is a material problem.

Just about every Canadian oil producer has U.S. dollar-denominated debt. As the exchange rate continues to go against them, it’s an issue investors have to keep an eye on. Remember, not all debt is created equal.

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Fool contributor Nelson Smith owns shares of PENN WEST PETROLEUM LTD..

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