Investing in any Canadian oil company right now might feel like a long shot for most investors given the way this bear market in commodities has hurt valuations in this sector.
For those seeking long-term value opportunities and are seeking the methodologies to pick oil companies right now, I’ve got two key strategies that can help weed out a majority of companies, leaving only the best long-term play for investors to choose from.
Buy companies with low leverage to the price of oil
When I say “Buy companies with low leverage to the price of oil,” I mean focus on investing in companies with the ability to make a profit at a low oil price.
Far too many Canadian companies only earn a profit when West Texas Intermediate (WTI) is $60 or $70. This means at current levels around $50 WTI, these companies provide no profit and little or negative cash flow.
It’s important to read the financial statements of the companies you’re considering investing in, and modeling out what their breakeven price of oil is to determine how risky of an investment you’re making. The higher the breakeven price, the higher the company’s stock price is levered to the price of oil.
By example, Cenovus Energy (TSX:CVE) has a breakeven profit price around $45 WTI. If this is a wide enough margin of comfort for you to make an investment, go for it, but really what this comes down to is risk tolerance and risk management.
Also, it’s important to note that most companies in the oil and gas sector have been investing in various cost reduction and efficiency initiatives with the goal of decreasing the leverage to the price of oil through cost improvements, so updating your models over time is important.
Focus on companies that are reducing debt
The reality is that this most recent bear market in commodities prices caught many producers with their pants down. Producers borrowed heavily to acquire other companies or expand production capacity. Commodity prices seemed to be an afterthought (mostly because prices remained elevated).
With credit downgrades increasing the cost of debt, companies have been forced to deleverage, though the rate at which this deleveraging is taking place varies.
Again, using Cenovus as an example, the company has committed to chipping away at its $6 billion debt load through asset sales as well as increasing its free cash flow over time.
The company notes it is on track to complete its target of $5 billion in asset sales by late 2020 or early 2021, which is a good sign for investors banking on this.
For investors looking to take advantage of some bargains in the oil and gas sector, focusing on how companies manage their cost structure and debt loads is the best way to go.
Betting on a rise in the price of oil is foolish. Instead, focus on companies that execute well on what they have jurisdiction over.
Stay Foolish, my friends.
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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Chris MacDonald does not have ownership in any stocks mentioned in this article.