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Tough times for energy stocks, good times for investors

Energy companies operating in Western Canada are being pinched especially hard by the fall in the price of crude. The first wave of budget cuts at oil companies hit Calgary last week.


Crude oil has been trading below $80 (U.S.) a barrel for the past three trading days, looking increasingly comfortable with the low side of the threshold and causing a great deal of pain to Canada's oil patch.

You can see the damage in the S&P/TSX composite index's energy sector: It has fallen 32 per cent from its near term high in March 2011, and it is very close to hitting its lowest level in three years. My colleague Carrie Tait noted in Monday's Globe and Mail that the decline in oil prices is affecting the oil patch's production plans.

As she explains: "The first wave of budget cuts at oil companies hit Calgary last week, with a few firms admitting further exploration and production makes little sense given today's oil prices. The cutbacks underscore how rapidly the economics of the oil patch have changed, and raise concern that more expansion plans may be trimmed in the weeks ahead."

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Analysts are also making adjustments. Kristopher Zack at Raymond James last week cut his recommendation on Pengrowth Energy Corp. to "market outperform" from "outperform," partly because he sees little chance of oil rebounding anytime soon. Indeed, he estimates oil will still be trading about about $80 a barrel through 2013.

In a note, he said he believed that Pengrowth "will be reviewing spending and the monthly dividend in the context of lower commodity prices near-term to help manage debt levels. We also continue to believe that non-core asset dispositions are also an option, but given the macro concerns currently overhanging the market and the significant number of assets for sale, we see a higher level of uncertainty around potential transactions."

Pengrowth is a relatively small company, with a market capitalization of just $3-billion (Canadian). But analysts are starting to rethink their view on the mega-caps too – which, typically are better-able to withstand downturns. While maintaining an "outperform" recommendation on Suncor Energy Inc., Raymond James took a hatchet to its target price, reducing it recently to $36 from $43 – a 16 per cent cut. Similarly, First Energy cut its target price on Suncore to $36 from $42.

No doubt, investors have to be asking themselves if all the doom and gloom in the oil patch has already been baked into share prices. For sure, they seem to be in line with other dips in the price of crude oil. When Canadian energy stocks were last trading at their current levels, in October 2011, oil traded at about $78 (U.S.) a barrel or very close to where it is now.

However, Canadian energy stocks are also close to their level of July 2009, when oil traded considerably lower, at just $67 a barrel – implying that today's energy stocks could be pricing in a deeper decline in the oil.

Things could get worse for energy stocks, of course. (Full disclosure: I own units of an exchange traded fund that tracks the Canadian energy sector.) To get to their deeply depressed levels of February 2009, when the broader Canadian stock market was also in the process of bottoming out after the devastating bear market of the previous year, it would need to fall another 35 per cent.

The dips underline the fact that energy stocks remain highly cyclical – even with Chinese consumption rising and the issue of whether there will be enough oil to meet the world's long-term demands still an open question. But just as cyclicality hurts on the way down, it can be awfully sweet on the way up: Canadian oil stocks rose 100 per cent from February 2009 to March 2011. And they rose 25 per cent from last year's trough in October to their high this year, in February.

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Meanwhile, production cuts among energy producers can merely reinforce the cyclical upturn by creating future production shortages when the economic backdrop improves.

No doubt, the news driving energy stocks is universally bad right now. While that's hard to bear if you've already made a big bet on the sector, it can be very encouraging if you're thinking about wading in.

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About the Author
Investing Reporter

David Berman has been writing about business and investing since 1995. He has written for a number of magazines, including Canadian Business and MoneySense. He worked at the Financial Post as an investing writer and daily columnist before moving to the Globe and Mail in 2008. More


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