These Stocks Will Struggle Should Oil & Gas Prices Not Pick Up

While we cheer strong inventory draws in the U.S., there are still a host of bearish factors that might induce oil’s fall into the mid-$30s and spell doom for investors. With the number of drilling rigs in the oil patch climbing week after week, shale drilling remains resilient. Moreover, restored output from exempted African producers Libya and Nigeria have added to the glut and further slows the rebalancing of the market.

Therefore, although OPEC-led production cut efforts have helped commodity prices recover and stabilize somewhat since late 2016, they remain significantly below 2014 levels.

In fact, as long as there is big oil surplus, the arduous market environment will continue, suggesting that the odds are firmly stacked against a sustained rally. With U.S. crude stockpiles soaring on the back of robust shale production, money managers do not rule out chances of more pain ahead for energy stocks.

As there are no guarantees that things will improve in the near-to-medium term, investors would be better off ignoring the following set of stocks.

Integrated Majors No Longer Safe

Despite the integrated majors’ scale advantage and consistency in delivering shareholder returns throughout the energy cycles, the pessimism comes in the wake of oil’s horror show that has seen black gold’s price come down from some $110 per barrel in mid-2014 to less than $50 now. The commodity’s collapse has threatened the industry’s creditworthiness by hurting cash flows, drying up liquidity and narrowing profit margins.

Moreover, weak realizations limit the companies' internally-generated cash flow amid high capital spending and dividend payments. Worse, refining margins – that have saved the blushes for the supermajors over the last few quarters – have shrunk considerably and will further hamper profits.

Finally, ‘Big Oil’ is suffering from marginal or falling returns, reflecting their struggle to replace reserves, as access to new energy resources becomes more difficult. Given their large base, achieving growth in oil and natural gas production is anyways a challenge for these companies over the last many years.

In addition to Zacks Rank #5 (Strong Sell) European giant Royal Dutch Shell (LON:RDSa) plc (RDS.A), another bottom-ranker PetroChina Co. Ltd. (PTR) – Asia's largest producer of oil and gas – is a risky bet that is best avoided at the moment. U.S. supermajors like ExxonMobil Corp. (XOM) and Chevron Corp. (CVX) are also struggling with the ripple effects from crude’s fall into the mid-$40s. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Refiners Burdened by Rising Compliance Costs

The oil refining business is as tough as it has ever been. Cutthroat competition, stiff regulation and high operating expenses translates into some of the narrowest profit margins in the energy sector.

Over the last few years, refiners have been struggling with a glut of product inventories, namely gasoline and distillate. The amount of refined fuels held in storage in the U.S. remains stubbornly high, resulting in narrow spreads. With supply levels remaining elevated despite fairly strong demand, fuel prices are unable to climb thereby leading to low profitability for the operators.

Of late, the game has become even tougher with refiners having to incur soaring Renewable Fuel Standard (‘RFS’) costs to comply with new cleaner gasoline production rules. Already reeling under an environment of depressed profit margins – reflected by the Oil and Gas - Refining and Marketing industry’s rank of 225 (bottom 12%) – the additional cost of complying with the federal program has put most refiners under pressure.

In fact, as a percentage, the expenses to comply with the renewable fuel mandate now account for more than a fifth of some refiners’ operating income – a substantially high amount. With the companies having to shell out millions of dollars just to stay in business, most of them have seen their profits and share prices slump.

In particular, we suggest avoiding exposure to Phillips 66 (NYSE:PSX) (PSX), HollyFrontier Corp. (HFC) and PBF Energy Inc. (PBF).

Poor Climate to Continue for Oilfield Equipment Suppliers

Despite early signs of recovery in North America, the current oilfield environment remains one of the most difficult. With new competitors entering the market and drilling contractors too rattled to make new investment decisions, oilfield machineries and equipment suppliers have seen their pricing fall drastically.

While firms catering to North American land drillers have been the worst affected, lack of new deepwater drilling orders are starting to haunt the subsea part of the industry. This comes after commodity price rout has already made a number of deepwater drilling projects uneconomical.

As such, with several quarters of reduced activity and diminishing contract backlog, most of the players are facing continued pressure on revenues, earnings and cash flows. With no signs of immediate improvement in market sentiment, 2017 is likely to rank as the third consecutive year of declining oilfield services spending. Even if commodity prices improve, the structural oversupply and pricing pressure will weigh on the sector components’ operating margins.

Companies like Core Laboratories N.V. (CLB), Unit Corp. (UNT) and NOW Inc. (DNOW) look to be in most trouble. Eating through backlogs without replacing them with new business, cash flow for these operators are likely to dry up further. Even biggies like Schlumberger Ltd. (SLB) and Halliburton Co. (HAL) have not been immune to oil’s protracted stagnation and the resultant compression in the energy explorers’ capital expenditure outlook.

Check out our latest Oil & Gas Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy.

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