Why the Energy Patch Remains a Risky Bet

Don’t bet on a recovery in oil and heavily levered energy stocks such as Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) any time soon.

Matt Smith

Former investment manager and market junkie, Matt has 20 years of experience. He hails from Sydney Australia where he earned a Master of Business Law from the University of Sydney and Master of Arts in International Relations from the University of New South Wales. He has been helping investors achieve their goals for over a decade. When not studying the markets, he can be found relaxing with his dogs and practising Spanish.

Published April 4, 2016 12:56 pm EDT

The sustained weakness in crude has lasted for far longer than many analysts and industry insiders predicted. Prices have slid under US$30 per barrel earlier this year as oil inventories and output grew.

Despite the recent rally triggered by hopes of a production freeze, there are signs that crude prices will remain depressed for the foreseeable future.

Let me explain.

Now what?

The sharp collapse in crude was a wake-up call for an industry that thought the good times would continue indefinitely. It forced the oil industry to focus on reducing costs and increasing the efficiency of its operations. This has caused operating costs to fall considerably over the last year, and many companies have variable or cash costs per barrel that are far lower than the price of crude.

Shale oil giant Continental Resources, Inc. has been able to reduce its cash costs to about US$8 per barrel, giving it some of the lowest cash costs per barrel in the U.S. energy patch. Other shale oil majors such as Whiting Petroleum Corp. and Pioneer Natural Resources have also significantly reduced their costs to now be under US$15 per barrel.

As a result, those companies will keep the spigots open and pump crude for as long as the price of crude remains above their cash costs per barrel.

This certainly doesn’t bode well for any sustained drop in U.S. oil production in the foreseeable future. Even with U.S. oil output now 2% lower than it was at the start of the year, it is still higher than it was at the height of the boom in mid-2014.

Canadian energy companies have also made considerable strides in reducing costs. Crescent Point Energy Corp. (TSX:CPG)(NYSE:CPG) has reduced its cash costs to US$17 per barrel, and Baytex Energy Corp. (TSX: BTE)(NYSE: BTE) has reduced its costs to US$16 per barrel. Even oil sands companies have managed to sharply reduce their operating costs, which is an impressive feat given that oil sands typically have higher operating costs than light, tight oil or conventional crude.

For these reasons, Canadian oil production continues to grow. The National Energy Board estimates that Canadian output will increase by 33,000 barrels daily by the end of the year. These factors don’t bode well for any sustained rally in the price of crude for a world awash with oil and experiencing a supply surplus of 1.5-2 million barrels daily.

So what?

These reasons, along with near-record U.S. oil inventories and growing output from Iran, mean that oil prices will remain lower for longer, which doesn’t bode well for those companies battling to survive in the current harsh environment.

Two companies that appear particularly vulnerable are Penn West Petroleum Ltd. (TSX:PWT)(NYSE:PWE) and Pacific Exploration and Production Corp. (TSX:PRE) as they’re weighed down by massive debt loads and declining cash flows.

It increasingly appears that Pacific Exploration will not survive; Penn West may breach its financial covenants once they return to their original levels later this year. For these reasons, investors should avoid those energy stocks that are heavily levered and have high cash costs.