Oil Prices Are in a Bear Market (Again)

Last week was another rough one in the oil market. Oil fell as much as 5% at one point, which when added to May's 16% slump, pushed crude more than 20% below its high in late April. That 20% decline from the top means crude oil had entered into another bear market, its second in less than a year.

The renewed selling pressure in the oil market is another reminder to investors that they should avoid oil stocks that need higher oil prices to fuel their operations.

The oil price roller coaster

Oil prices have been all over the place in the past year. Crude crested at more than $75 a barrel last October, fueled by concerns about a potential global supply shortage as the Trump administration imposed new sanctions on Iran. Those sanctions, however, weren't as powerful as promised, causing crude prices to cash more than 40% at the end of last year.

That forced OPEC to come to the oil market's rescue by reducing its production once again. The move helped ignite another rally in the oil market in 2019, with crude rebounding nearly 50% from its bottom in December to more than $66 a barrel by late April. However, growing concerns about the strength of the global economy due to the escalating trade war between the U.S. and China have weighed on crude prices over the past six weeks, pushing it down about 20% from that high to less than $55 a barrel. Crude could continue falling if the data starts confirming market fears that oil demand is beginning to weaken.

The haves and the have-nots

Changes in oil prices will directly impact the cash flows of nearly every oil producer. However, some are less equipped to handle this volatility than others.

Denbury Resources (NYSE: DNR) is one of those that desperately need higher oil prices. The oil producer is in such a tight spot financially that it cut its spending by about 25% from last year's level so that it could generate some excess cash to help chip away at the more than $2.5 billion of debt that's weighing it down. As a result of its reduced investment level, Denbury's production is on track to decline by about 4% this year.

The company noted during the first quarter that thanks to the rebound of oil prices in early 2019, it was on track to produce more than $150 million in excess cash this year. However, every $5 change in oil prices impacts its cash flow by $100 million. Thus, with oil crashing into the $50s, it's likely to produce less than $100 million in free cash flow this year, which would barely make a dent in its debt load.

Financially stronger oil producers, on the other hand, are in a much better position to navigate crude oil's recent slump. Marathon Oil (NYSE: MRO) and Devon Energy (NYSE: DVN), for example, can thrive at lower oil prices. Both need oil to average only around $45 a barrel to support their growth plans, which would see them increase their oil output at a double-digit rate this year. Because of that, each can generate significant free cash flow above that level.

In Marathon Oil's case, it can produce more than $750 million in cumulative cash flow through 2020 at $50 a barrel and upward of $2.2 billion if crude is around $60. Devon Energy, meanwhile, can produce $800 million in free cash by 2021 with oil at $50, increasing to more than $2.3 billion if oil averages $60 over that time frame. Since both companies already have healthy balance sheets and strong growth profiles, they don't have any need for this money. Because of that, each will likely return it all to investors through share repurchases and dividends.

Stick with the low-cost cash flow machines

While oil companies like Denbury Resources have tremendous upside potential at higher oil prices, they have such a large financial hole to dig out of that they're not ideal investments, given all the volatility in oil prices. Instead, investors should focus on oil producers that have low oil price break-even levels. That's because they're positioned not only to thrive at lower prices, but also cash in on the next upward wave in crude oil.

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Matthew DiLallo owns shares of Denbury Resources. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.