Oil prices have staged a remarkable comeback over the past few months. After tumbling into the low-$40s earlier this summer, crude quietly came storming back. Fueling that rebound has been accelerating demand and tame supply growth, which have combined to drain some of the market's glut. That improvement recently pushed prices to a two-year high of $63 for the global benchmark (Brent) and $57 for the U.S. oil benchmark (WTI).
However, prices might be close to topping out. Driving that view is the International Energy Agency's (IEA) latest market report, which painted a less rosy picture of the oil market. If that forecast comes to fruition, it could weigh on oil prices over the next few months, which would hit financially weaker oil stocks the hardest.
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A dimmer view
The IEA puts out a report each month detailing what it sees in the oil market. One of the themes this year is that global oil demand has been healthy. In fact, demand was remarkably strong in the second quarter, increasing by 2.2 million barrels per day (BPD) versus the year-ago period. Because of that, the IEA estimated that demand would increase by 1.6 million BPD this year, or about 1.6% higher than last year.
However, it tapped the brakes on that forecast this month, cutting its view on demand growth for both 2017 and 2018:
While the organization still expects demand to increase -- 1.6% this year and 1.3% in 2018 -- the downward revision is not exactly bullish for oil prices. Several factors are driving this decline, including warmer winter weather and the more than 20% recovery in crude, which will push gasoline prices higher and curb some demand.
That said, even more concerning was its outlook for the difference between supply and demand. The IEA noted that expected supply growth would largely cancel out rising demand. Because of that, it estimates that even if OPEC maintains its production cuts through the end of next year, the market will remain oversupplied through the first half, with supplies exceeding demand by 600,000 BPD in the first quarter and another 200,000 BPD during the second. That estimated excess is why it doesn't think that current oil prices in the $50 to $60 a barrel range represent the "new normal" for the oil market.
The haves and the have-nots
The implication here is that crude prices might decline unless there is an unexpected supply outage. That scenario could lead to a sell-off in financially weaker oil stocks that need higher oil prices to help them get back on their feet. Companies like Denbury Resources (NYSE: DNR), California Resources (NYSE: CRC), and Baytex Energy (NYSE: BTE) could be among those most deeply impacted because all three still have a mountain of debt to address. In Denbury's case, the company noted that it had borrowed $495 million of the $1.05 billion available to it under its current credit facility, which is a $194 million increase since the start of the year. Denbury needs oil well above the current price to pay that back with excess cash flow; the company recently indicated that a low-to-mid $50 oil price would give it enough extra money over the last few months of the year to pay borrowings down to a range of $450 million to $475 million.
Canadian driller Baytex Energy is also in a tight spot. Last quarter, for example, the company noted that it reduced net debt by 70.6 million Canadian dollars ($55.4 million) through a combination of excess cash flow, a non-core asset sale, and the stronger Canadian dollar. However, that barely put a dent in its outstanding borrowings since Baytex still has 1.75 billion Canadian dollars ($1.4 billion) in debt outstanding. Meanwhile, California Resources is one of the most indebted oil companies in the industry. Despite paying off more than $1.6 billion in debt since mid-2015, it has an unsightly leverage ratio of more than 112% of its total capitalization, when most oil companies like to keep that number below 30%.
Those tight financial situations are a reminder that investors should steer clear of oil stocks that can barely hang on should oil fall back toward $50 a barrel. Instead, they should consider investing in those that can excel in that environment. One that stands out is ConocoPhillips (NYSE: COP). The U.S. oil giant has repositioned its operations so it can maintain its current production rate and pay its dividend even if oil falls into the mid-$40s. Meanwhile, at $50 oil, ConocoPhillips can generate enough cash flow to send more money back to investors while also delivering meaningful production growth. Because of that, its stock should hold up -- if not increase in value -- even if crude dips.
Stick with the best
While the oil market is on the mend, it's not in the clear just yet. That's because the balance between supply and demand remains fragile, which could cause oil prices to teeter back and forth. This delicate state is why energy investors are better off sticking with top-tier oil stocks instead of gambling on the potential rebound of a weaker oil company.
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