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Analysts in the energy sector have yet to reduce earnings forecasts for their stocks. This raises the distinct possibility of a nasty New Years' surprise for investors in the sector.

The chart below compares the West Texas Intermediate crude oil price, the North American benchmark, to the total estimated earnings for the S&P/TSX Energy index. The consensus analyst guess at earnings for the next 12 months has been reduced by a scant five per cent since the July high, while the crude price has plummeted 25 per cent.

SOURCE: Scott Barlow/Bloomberg

Domestic companies will adjust to the new environment, so there's no reason to expect a 25 per cent drop in the commodity price to result in an exact 25 per cent fall in profits. Still, the earnings forecast looks remarkably optimistic in light of the oil price weakness.

The chart also shows huge surges in earnings expectations posted in December 2013 and December 2014. Analysts clearly waited for year end to make major changes in expectations.

The ongoing unpleasantness in the commodity market suggests that the big change in earnings forecasts next month will be in the downward direction. The energy index currently trades at 17.4 times forward earnings. A ten per cent decline in forward earnings expectations (as an example) would raise the forward price to earnings estimates to a far less attractive 19.4 times.

These numbers are averages for all 69 members of the index and there are doubtless companies that will remain attractive after analysts change their forecasts. But investors should verify valuation levels now and guard against what could be a very difficult start to the year in energy stocks.

Follow Scott Barlow on Twitter @SBarlow_ROB.

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