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The price of oil took yet another hit following the recent OPEC meeting where member nations decided to maintain current production levels, which reportedly are at record highs.  In the immediate aftermath of the meeting investors have been peppered with predictions about the future direction of the price.

As with any investment, you will find those who expect the price to fall and those who expect the price to rise, either sometime in 2016 or 2017.  Here is what you will not find: no one is predicting the price of oil will go to zero.

For most, it appears a virtual certainty the price will rise; “when” is the question.  Right now the top four ASX listed Oil & Gas Producers are trading at multi-year lows and the following table shows the grim picture. The “Match” Price/Date Is the last time each stock was trading at or near its current price.

Oil Search Limited (OSH) is the only O & G Producer with a positive growth forecast over the next two years. It has the lowest dividend yield and the lowest projection for reducing dividend payments.  The remaining four have growth forecasts that could best be described as bleak.

While it is true these stocks are trading at prices not seen for years, those prices could go much lower should the price of oil continue to fall.  Why would anyone in their right mind even consider buying stock in any of these companies?

We can offer four reasons, two of which stem from economic theory and the remaining two from market trading patterns and company valuation.

First, Stein’s Law states that ‘If something cannot go on forever, it will stop.” This economic tenet gets little play among market participants but it offers a simple explanation for both the rise and fall of the price of oil. Despite predictions of $200 per barrel oil from the likes of US based investment bank Goldman Sachs, price rises could not go on forever.  So they didn’t.  Now the reverse is true.  As long as people still need oil, the falling price cannot go on forever. (The simple ‘law’ was formulated by Herbert Stein, the chairman of the US council of economic advisors under US Presidents Nixon and Ford.)

Second, the basic economic laws of supply and semand tell us when demand outstrips supply, prices will rise; and when supply exceeds demand, prices will fall.  With the price of oil well over $100 per barrel and rising, producers the world over began pumping to capacity and exploring far and wide for new oil fields. With the price collapse producers are shutting down rigs and putting capital expenditures on hold.  Demand may not be as explosive as in the past, but experts tell us it is rising.  When the imbalance between supply and demand is restored, prices will rise.  As you know this will take time as OPEC continues to pump away to protect market share.  Reportedly, only Russian and US shale oil producers are scaling back on production. 

Third, once the Sector begins to recover, expect a short squeeze that could approach historic proportions. As you may know, stock markets are one of the few places on earth where you can “win” by betting on a loser. If you think Company A is headed for trouble, you “short” the stock by borrowing shares at the current price. If the stock falls substantially, you can buy and replace the borrowed shares at the lower price and keep the difference.  The danger in shorting stocks is the potential of enormous losses if the stock climbs higher than the shorted price.  As a result, nervous shorts can be squeezed to cover their positions quickly.  

The following price chart for the price of Brent shows what appears to have been a “mini” squeeze.  The price went up shortly before the announcement of the OPEC decision.  An analyst at New York based Tradition Energy stated there was some short covering before the announcement in case there was a production cut. When we found out that wasn’t the case, we gave up the gains, shifting the market back to fears of oversupply.’  You can see the brief spike and the quick reversal in the following price movement chart.

Finally, perhaps the best reason to consider buying is the Enterprise Value of each of the producers.  When companies and private equity firms are on the prowl for acquisitions, one of their favorite measures of valuation is the Enterprise Value.  Market capitalization is simply a measure of what market participants think a stock is worth.  Enterprise Value (EV) is considered a better measure of a company’s worth in that it goes beyond market cap and factors in a company’s total debt, cash, and cash equivalents such as liquid inventory and accounts receivables.  Every stock in the table has an EV higher than its market cap, with the EV at BHP, ORG, and STO doubling the market cap.

BHP Billiton (BHP) has the highest dividend yield, but like all these stocks it is expected to go down.  The company is in the unenviable position of facing strong headwinds from four sides.  The prices of oil, coal, copper, and most notably, iron ore are crushing BHP’s bottom line.  Add to that the recent mining disaster at its Brazilian joint venture with Vale, and BHP management is already hinting at dividend cuts.  BHP investors would need rising prices in both iron ore and oil to see a major trend reversal in share price.  

Woodside Petroleum (WPL) is already the country’s largest oil and gas producer, with hopes of getting bigger through the acquisition of smaller rival Oil Search Limited (OSH).  The initial offer was deemed too low and Woodside now states it has abandoned plans to acquire OSH.  

Although the company remained profitable in FY 2014, the Half Year 2015 results showed a 39% profit decline.  The expectations for the full year are gloomy as well.  

Woodside has rewarded its investors with healthy dividend payments in the past, with the revenue generated from its successful Pluto LNG operation. The company is the majority partner (30.6%) in a joint venture partnership with Shell, BP, Japan Australia, and PetroChina to develop a Floating Liquefied Natural Gas (FLNG) operation called Browse.  Woodside also has a healthy balance sheet with which it can acquire assets from other stressed producers.

Santos Limited (STO) has interests in LNG operations at the Gladstone (GLNG) project, which shipped its first product in October.  The Woodside share price has weathered the storm better than the Santos price, perhaps because of the success at the Pluto LNG operation.  Here is a two year price chart comparing the two.

Santos is the majority partner (30%) in the GLNG along with Petronas, Total, and Kogas.  The company hemorrhaged money on the GLNG project and recently completed a capital raise to strengthen its balance sheet.  In a sign of just how reluctant retail investors are to take a chance on Santos, news reports indicate the retail portion of the capital raise did not meet company expectations. 

However, Scepter Partners, an investment bank for Middle East and Asian sovereign wealth and high net worth families, sees enough value in Santos to have made a $7.1 billion dollar takeover offer, which Santo rejected.  Santos also has extensive assets in natural gas production.  With the GLNG operation now shipping, Santos could follow the success of Woodside at Pluto.  Santos also holds a 13.5% interest in the PNG LNG (Papua New Guinea Liquefied Natural Gas) operation, along with Oil Search Limited (OSH) with a 29% interest, second only to project operator Exxon Mobil at 33.2%.

Oil Search reported a surprising 69% increase in revenue and a 49% rise in profit for its Half Year 2015 results.  The share price shot up and climbed close to its 52 week high before investors learned the potential takeover by Woodside was dead.  A one year price movement chart for OSH shows investor reaction.

Origin Energy (ORG) is an integrated energy company, offering investors a little more safety in its diversified energy assets.  The company is involved in gas and oil exploration and production, LNG operation, power generation, and energy retailing. Origin is also a majority holder in New Zealand’s Contract Energy, a provider of natural gas, electricity, LPG and other energy related products and services. Origin has six generating stations using natural gas and only one using coal. The company also generates from a wind farm, a hydro plant, and two solar powered generating stations.

Origin is an equal partner (37.5%) with Conoco Philips on the Australia Pacific LNG (APLNG) project, with a third partner, Sinopec, holding 25%.  The project is now operational having produced its first LNG, scheduled for shipping by the end of this year. 

While each of these stocks could go lower, eventually they are likely to come back.  No one knows exactly when and the track record of Oil & Gas Sector forecasts borders on the laughable.  Remember the Goldman Sachs prediction of $200 oil?  Analysts there are now stating the price could fall to $20.  Remember: if something cannot go on forever, it will stop.

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The publication of this information does not in any way constitute a recommendation on the part of TheBull.com.au. You should seek professional advice before making any investment decisions.