This week I attempt to estimate the cuts in forward earnings estimates in the domestic energy sector. Brace yourselves, it's not pretty.
Consensus earnings per share expectations for S&P/TSX energy index in the next 12 months stands at $167, which makes no sense. In December, 2013, when the crude price was $25 higher in Canadian dollar terms, profit expectations were actually 18-per-cent lower at $142 per index unit. The odds of higher earnings next year with energy prices far lower are not good. Estimates will undoubtedly be cut in the weeks ahead to reflect the new oil price environment.
The accompanying chart compares the West Texas Intermediate (WTI) crude price, converted to Canadian dollars, against forward analyst earnings projections for the S&P/TSX energy benchmark since 2009. As we'd expect, higher oil prices have translated into higher profit expectations for the sector.
SOURCE: Scott Barlow/Bloomberg
It is important to disclose that I changed the starting point on both y-axes on the chart to find the best "fit" and this process was somewhat random. I tried to be as fair and non-alarmist as the data permitted.
It is also important to note that energy companies will do everything in their power – cutting costs and investments, suspending unprofitable operations – to mitigate the effects of lower oil prices on earnings. The relationship between energy prices and profits will (one hopes) become looser as this process takes place – profits will not fall as far as the commodity price.
So, the conclusions from the chart should be regarded as a worst case scenario. Which is good, because the numbers imply that forward earnings estimates will be cut by 40 per cent from $167 to about $100 a share.
A 40-per-cent reduction in profit estimates would do all kinds of terrible things to valuation levels. At $167 in earnings, the current forward price-earnings level for the energy index is 15.8 times profits. This is an attractive level compared with the five year average of 18.8 times earnings.
But, if analysts cut profit projections to $100 as our worst case suggests, the forward P/E ratio leaps to a highly unattractive, prohibitively expensive 26.5 times earnings.
One of the key takeaways for investors is that the commonly used trailing P/E ratio – using the past 12 months of earnings to value stocks – are not going to be much help at this point. Crude prices are 30-per-cent lower and last year's results for trailing P/E (not shown on chart) will prove an ineffective guide to earnings going forward in most cases.
There are certainly risks associated with trusting analyst estimates. But the commodity price playing field has changed so dramatically in the past three months that consensus expectations will likely provide better guidance than 2014 results.
Until the crude price stabilizes, investors in the energy sector who don't want to get blindsided by earnings revisions should verify that their holdings are reasonably valued relative to 2015 forecasts. And get ready for volatility.
Follow Scott Barlow on Twitter @SBarlow_ROB.