Pessimism is once again ramping up in the oil market. John Kilduff recently stated that the year’s lows of $26.05 are back in play should OPEC fail to reach a production-cut agreement at the end of November. RBC’s head of commodity strategy Helma Croft says sub-$40 is to be expected should OPEC fail.
What does this mean for Baytex Energy Corp. (TSX:BTE)(NYSE:BTE)? Baytex fell under $2 per share (down from $5.19 today) last time oil fell below US$30, and, certainly, a failure of OPEC to agree to a production cut could have bearish implications for the stock price. Investors have reason to be optimistic, however. Even in the worst-case (and, as will be shown, unlikely) scenario, Baytex has minimal downside.
What is the worst case for Baytex? It’s is that OPEC can’t agree to cut its production by 700,000 bpd (from 33.2 million bpd in August 2016 to 32.5 million bpd). OPEC is currently producing a record 33.6 million bpd, and if OPEC were to somehow hold these levels through 2017, the end result would be a market that is once again oversupplied by up to one million bpd. This is bad news for prices.
While it is impossible to say how low oil prices would go in the short term, what is clear is a drop into the low $30s would be temporary, and, in the most bearish possible case, oil would likely average $45 per barrel for the year. In 2015, oil averaged $48 per barrel, and the oversupply was greater than 1.5 million bpd for the entire year. Even in the most bearish scenarios, 2017 would not see this.
It is important to remember that low oil prices also have consequences, and a prolonged period of oil in the low US$30s would see U.S. production decline once again and put immense pressure on OPEC producers, leading to a similar price spike seen earlier in the year.
What would $45 oil for the year do to Baytex shares? Baytex would generate about $190 million of cash flow in this scenario. Using enterprise value to debt-adjusted cash flow (a popular valuation measure), and assuming Baytex trades at a multiple of 9.5, Baytex would be worth $4.71 per share. This assumes Baytex doesn’t add to its debt in 2017.
OPEC needs to come up with a deal
While the market may be bearish on OPEC coming to a deal, it shouldn’t be. OPEC’s three main producers, Saudi Arabia, Iraq, and Iran, simply can’t afford not to come up with a deal. Saudi Arabia’s oil minister recently stated that coming up with a deal is “imperative.”
None of these three producers can actually increase production much from current levels, especially if oil prices drop further. It would make little sense to trade potentially $10 per barrel in upside from a deal for marginal production increases.
Saudi Arabia is especially motivated, given the dire straits of its economy and its need for significantly higher oil prices to fulfill the “Saudi 2030” vision and have a successful IPO for Saudi Aramco. Saudi Arabia is currently producing at 10.6 million bpd, and, due to falling seasonal demand and maintenance, this is likely to fall around 400,000 bpd by the end of the year (half of the agreed upon OPEC cut) even if there is no deal.
While Iraq is seeking exemption from the deal with a desire to increase production, analyst Helma Croft stated that Iraq’s production-growth ambitions are unlikely (the country has had flat production for the year despite reports of higher production due to techniques like double-counting of fields). Iraq simply can’t afford sub-$40 oil, and the country certainly wouldn’t have the capex to grow production at anywhere near these levels.
This is good news for Baytex shareholders. While news of no agreement could lead to a big short-term plunge in oil, investors can be confident prices will slowly rise in 2017 back to the mid-$40s, even in a bearish scenario.
Motley Fool Canada's market-beating team has just released a brand-new FREE report revealing 5 "dirt cheap" stocks that you can buy today for under $49 a share.
Our team thinks these 5 stocks are critically undervalued, but more importantly, could potentially make Canadian investors who act quickly a fortune.
Don't miss out! Simply click the link below to grab your free copy and discover all 5 of these stocks now.
Fool contributor Adam Mancini has no position in any stocks mentioned.