Here's How to Evaluate Investments in the Oil Sector
Contributed Opinion

The world's oil supply took a huge hit in 2020.

The pandemic-led disruption pushed oil prices down to record lows. That collapse sent a wave of bankruptcies through the sector.

The worst is behind us, but oil is still a hated sector. That means we have opportunities to make some money out there.

According to the Energy Intelligence Group, global oil production fell from 100 million barrels per day in November 2018 to 84.9 million barrels per day in June 2020. That's a huge 15% decline and it takes world oil production back to 2010 levels.

That decline mirrors what we see in the U.S.

Here, oil production fell from 12.8 million barrels per day in December 2019 to 10.0 million barrels per day in June 2020. That's a 22% fall in U.S. production. That takes the U.S. back to 2018 levels.

However, even with production collapsing around the world, prices stay low, as you can see in the chart below:

With supply information and the low oil price, we can work out that demand must be low as well. And according to Energy Intelligence Group's data, oil demand fell to 90.2 million barrels per day, its lowest point since 2012.

However, global demand rebounded to 92.8 million barrels per day in July 2020. That's well below the Energy Intelligence Group's production number of 87.4 million barrels per day. That means the world is using up stored oil for now.

That can continue for a while, but it will begin to show up in the price soon.

The U.S. production data only goes through May 2020. I expect to see it continue to fall as the summer data comes in. There is little hope for the U.S. regaining or exceeding that December 2019 peak.

Instead, expect to see it continue to decline.

Over the last five years, the U.S. became the "swing producer" in the oil market. U.S. production could sway market prices. As demand returns, that extra oil production won't be around anymore.

That means prices must come up. Global consumers used to paying low prices for available crude are in for a shock…I expect to see oil back up above $80 per barrel in 2021, as demand returns. And that's where we have an opportunity, but it requires some homework.

I like to begin with service companies. Because when the oil price falls, it demolishes these companies. Giant oil service company Schlumberger (SLB) fell 70% from January 2020 to its low in March 2020.

However, there are better opportunities among the smaller companies.

For example, let's compare these two U.S. drilling companies: Helmerich & Payne Inc. (HP:NYSE) and Patterson-UTI Energy Inc. (PTEN:NASDAQ).

The two companies' financials look quite similar. Both are still generating free cash flows (which is critical). The problems crop up when we dig a little deeper in.

Patterson UTI has over $1.0 billion in debt, but only $247 million in cash. The bulk of Patterson's debt isn't due until 2028. However, the company has $100 million in debt due in 2022. My concern is that its cash reserves need to keep the company afloat and still cover that liability.

That's not a huge red flag, but it is a worry.

In contrast, Helmerich & Payne has more cash than debt and none of that debt comes due until 2025. That makes Helmerich & Payne a more attractive speculation.

That's the way I'm approaching the entire oil sector right now. Take the time to look at cash, debt and due dates. A little bit of pencil work can reduce your risk and possible avoid an expensive mistake down the road.

Matt Badiali

Matt Badiali is a geologist and independent financial analyst. He spent fifteen years researching and writing about great investments inside the natural resources sectors. He can be reached at www.mattbadiali.net.

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