Gearing up for first quarter earnings in the energy patch
The first quarter of 2015 officially ended on Tuesday, marking the first full quarter of depressed energy prices since the crash of 2009. Despite cuts in capital spending and sporadic layoffs across the sector, larger energy companies have so far been spared any significant pain. Energy stocks have shown incredible resilience, indicating significant optimism among traders that crude oil prices will soon recover.
The spring of 2009 turned out to be a very profitable entry point for astute investors. Crude oil prices and energy stocks rebounded sharply through the summer of 2009, gaining almost 50% by the end of the year.
So will this spring be a repeat of 2009? Not surprisingly, analysts are expecting this quarter's earnings in the energy patch to be bleak at best. But all traders know that current oil prices are irrelevant. What matters most for oil companies and investors is the prognosis going forward.
Will crude oil prices show a meaningful recovery this year? Here's a look at some of the factors that will be front and centre this earnings season.
It's no secret that rising oil production, a strengthening US dollar and weak global demand growth is to blame for the current softness crude oil prices. Are any of these factors going to change any time soon?
There's no mistaking it - the average oil price for the first quarter of 2015 will be 35% lower than the previous quarter and almost 50% below prices from the same time last year. For the non-integrated companies that produce upgraded light oil producers, that translates to a sizeable drop in revenue.
West Texas Intermediate
West Texas Intermediate climbed as high as $54 in February and hit a low of $42.50 in mid-March. Prices have been trending sideways and have yet to rebound meaningfully. So far, there are no signs of an upturn in oil prices.
Western Canadian Select
Western Canadian Select (WCS) heavy oil prices have not been spared in the decline. Spot prices for the heavy crude stream are down over 40% from the last quarter and more than 50% from the same period last year. WCS prices hit a low of $29 per barrel in mid-March and have been stuck in the $30-$40 trading range since the beginning of the year. The largest producers of Western Canadian Select are Canadian Natural Resources and Cenovus.
US Dollar Strength
Since crude oil (and all other global commodities) are priced in US dollars, the dollar has an inverse relationship to the price of oil. The US dollar strength has been a huge drag on oil prices, which began its decline just as the Greenback began strengthening in late summer 2014.
The US dollar has taken a pause during the past few weeks after hitting a 12-year high in early March. Despite a significant appreciation in US currency since January, the price of oil has been surprisingly steady, trading sideways from the upper-40s to the low-50s range.
Apart from the obvious impact on oil prices, a strong US dollar (and conversely a weak Canadian dollar) can act as an additional drag on Canadian energy producers. For example, companies which issue US-denominated debt will see debt servicing costs rise as the value of the Canadian dollar falls. A weak currency also makes it expensive to buy equipment, piping and parts from outside of Canada.
Rising Canadian Crude Oil Production
Canadian crude oil production also continues to climb steadily, reaching an estimated 3.7 million barrels per day in the first quarter of 2015 (excluding condensates). Canadian crude oil production is expected to reach close to 4 million barrels per day in the next few years when several large oil sands projects are due to begin first oil production.
Rising US Crude Oil Production
US production also continues to climb at an aggressive pace, reaching a 43-year record high of 9.4 million barrels per day by the end of the first quarter. This represents a gain of 1 million barrels per day in only one year. The US Energy Information Agency expects production growth to slow in the coming months, but this has yet to materialize.
North American oil production in the past 5 years has grown from 8 million to just over 13 million barrels per day, an increase of 60%. This is displacing oil imported from other countries, most notably Venezuela, Mexico and the Middle East. Canadian oil imports into the US have increased exponentially, reaching over 3.4 million barrels per day, thanks mostly to improvement in pipeline infrastructure near Cushing, OK. Although crude-by-rail gets a lot of publicity, only 130,000 barrels per day of crude oil was shipped to the US by rail last January, representing only 4% of Canadian oil exports to the US.
North America's growing oil production certainly is creating supply challenges for the industry. Some of this oil is going into storage as producers are opting to stockpile their oil in the short term and hoping for better prices down the road. US and Canadian exports to overseas is growing, but not nearly fast enough. Canada continue to import more expensive Brent crude on the East Coast due to west-to-east transportation bottlenecks. This is all translating to significant price discounts between Brent, West Texas Intermediate and Western Canadian Select, which is not expected to be resolved any time soon.
Although the data looks bleak, commodity prices can turn very quickly, as was the case in 2009. Here's a look at some of the positives for Canadian oil producers.
North American Oil Rig Count
The abrupt drop in North American rig counts has been unprecedented. US oil rigs in service fell off a cliff at the end of 2014, declining by almost 50%.
Canadian drilling data is also very interesting. Active rig counts in Canada is down a stunning 80%, indicating an almost complete halt of drilling activity in Western Canada.
The sharp drop in active rigs is raising hopes that North American oil production will begin to slow as we go into the end of the year, or at least not grow as fast as the past few years. US production will likely be more affected than Canadian oil growth, since shale oil has a high depletion rate and requires drilling rigs to be constantly moved into new areas. Since most of the growth in Canada will come from the oil sands (not conventional oil), the drop in Canadian active rigs is unlikely to significantly impact Canadian oil production in the short term.
Low Natural Gas Prices
Much like the US shale oil boom, the step-change made with fracking technology has significantly increased North American natural gas supply, keeping domestic gas prices stubbornly low.
But low natural gas prices can be a double-edged sword for Canadian energy companies. Natural gas is one of the highest input costs for many oil producers, particularly for in-situ oil sands operators. Expect companies such as Suncor, Canadian Oil Sands, Husky and Cenovus to benefit from the low gas prices. However, many oil producers are also significant natural gas producers, so chronically depressed gas prices will adversely affect earnings for such companies, which include Canadian Natural Resources and Imperial Oil.
Good Refining Margins
Despite low oil prices, refining margins are still holding up relatively well. Refiners are presently able to buy crude oil at low prices and produce value-added products such as gasoline, diesel and jet fuel. This differential is know as the "crack spread" and translates to good revenues for integrated oil companies and independent refiners. Large refiners such as ExxonMobil, Chevron and Shell are therefore not as badly affected by falling oil prices. Canada's largest integrated majors such as Suncor Energy, Imperial Oil and Husky are therefore expected to outperform non-integrated players.
ENERGY SECTOR PERFORMANCE SO FAR
Despite the lack of recovery in crude oil prices, Canadian energy stocks have held up remarkably well. Most stocks hit a low in mid-December and have since rebounded nicely. Share prices have been buoyed by promises of spending cuts and in anticipation of a recovery in oil prices by year end. Not surprisingly, larger energy companies with cash in the bank and strong production have held up much better than smaller operations with high debt loads.
IS 2015 THE NEW 2009?
First quarter of 2009 was an excellent entry point back into energy stocks. The 2008 collapse in oil prices was abrupt and oil prices hit an exaggerated low of $33 in February 2009. However, prices recovered just as quickly and rebounded back above $50 per barrel by the time earnings season came around in the spring of 2009. Most energy stocks gained 50% by year end, making for one of the steepest climbs in history.
So can 2015 be a repeat of 2009? Unlikely, but not impossible. Here are a two things to consider:
- After peaking in March of 2009, the US dollar began a long decline, precipitated by a lowering of interest rates in the US and the launch of Quantitative Easing (QE). At present, the opposite forces are in effect. While central banks around the world are lowering interest rates, US interest rates are set to rise, which will further boost the value of the US dollar. While a rising dollar may not necessarily drag oil prices lower, at best it will act as a headwind and prevent oil prices from recovering meaningfully.
- World oil production was more than 5 million barrels per day lower in 2009 than in 2015. Demand from emerging markets has stagnated since the collapse of 2008 and demand is presently outstripping supply by an estimated 2 million barrels per day. This imbalance is unlikely to be resolved any time soon.
WHAT TO EXPECT THIS EARNINGS SEASON
Consensus for year-end oil prices have been revised from $85 to $60 a barrel for West Texas Intermediate, with weak prices expected to persist until next year. Analysts are already anticipating dismal earnings this quarter, so that won't be much of a surprise. Companies will be looking for ways to improve earnings per share (EPS) in light of weak energy prices. Here are some examples of what to expect this earnings season:
- If cash flow has gone negative and is not forecasted to improve, expect more cost cutting and potentially more announcements of job cuts.
- Dividend cuts are also on the table, particularly if pay-outs exceed free cash flow. Since many investors now shun stocks that don’t pay a good dividend, reducing dividends is generally a last resort for many energy companies since this can seriously damage share prices.
- Asset sales are a very good way to generate cash and goose quarterly earnings. Companies such as Chevron have recently been on a fire-sale, desperately divesting of anything that doesn’t generate positive cash flow.
- For small start-ups, expect them to put the entire company up for sale. Companies such as Sunshine, Laricina, and Connacher will struggle to become cash-flow positive unless prices significantly recover from this point. These companies will need to raise more debt or refinance existing debt loads and risk getting taken over by creditors.
Of course, the alternative would be to stay the course and hope for a speedy recovery in energy prices. As most traders know, stock prices reflect forward earnings. So it doesn’t matter so much where you are, it matters where you're headed.
First quarter results for 2015 begin rolling out in mid-April.