Oil prices were disrupted in the fourth quarter of 2014 for a number of reasons. Slowing growth in the global economy put pressure on prices from the demand side while a glut of oil from shale production in the U.S. and inflexible members of OPEC flooded the market with supply. However, falling oil prices aren’t enough to justify the magnitude of the decline in many oil stocks.
Many of the smaller firms in the oil business declined because lower oil prices reduced margins to the point that debt capitalization becomes a bigger issue. Particularly in the U.S., shale producers may not be able to support their capital structure with prices as low as they are, which would force them to sell assets. So-called “forced selling” is usually a precursor to a crash within the sector.
For example, Goodrich Petroleum Corp (GDP) fell from $30 to $5 per share since the decline in oil prices began in 2014. While GDP is an extreme case, the problems it faces are representative of many other firms in the industry. Too much debt, overvalued assets, lower oil prices, and inefficient management combined to drive many firms like GDP to new lows.
Many of these companies might not survive the next few years. The market’s process of natural selection is inescapable (unless you’re a bank).
In light of the problems in the oil sector, it may seem counterintuitive to look within it for an investment in 2015. However, sometimes it makes sense to buy when everyone else is selling. It’s a little contrarian, but the decline has damaged the good companies alongside the bad one. Some perfectly good stocks are trading at extremely low valuations thanks to aggressive, industry-wide selling.
Because so many firms were in a precarious capital position this year, some production assets have already been pulled offline. However, oil prices are volatile, and this isn’t the last time it we will experience unusual volatility. We feel that the selling has been overdone in the short term, and expected economic growth in 2015 will drive prices higher over the next few quarters. Bringing those assets back online is expensive, and companies that are struggling now will want to move quickly to ramp up production.
Noble Corp Will Lead the Oil Sector Higher
We feel that this is likely to be very good for services firms in the sector like Noble Corporation (NE), that have been, somewhat unjustifiably, beaten down like the rest of the group in 2014. Unlike many of the shale companies in the U.S. that operated as highly leveraged partnerships or regular C-corps, this contract-driller still has an attractive capital position.
Noble Corp missed out on some of the speculative windfall over the last few years, but it can now afford to swoop in and ramp up production when energy prices start to recover.
We don’t think we are the only analysts to make the same observation. Already, selling pressure has begun to ease. From a technical perspective, NE stock has formed a large bullish divergence over the last 3 months that was confirmed just recently. Generally, the mid-point of a big divergence like this is a good initial estimate for upside potential, which would put prices near $22 in the short term. However, we think the stock is more likely to reach its prior highs ($26-29) in 2015.
Buying on an early bounce in a sector that is in a clear downtrend is risky. It seems unlikely that investors would add this kind of position as a core-holding. However, in our opinion, the upside is attractive enough to consider an entry as momentum begins to build. Unlike other firms in the industry, Noble Corp has the capital available to take advantage of future demand from producers and end-consumers.
We expect another ‘rush’ into the energy sector to favor the companies that won’t have to deal with the distractions of asset impairments and debt issues, making NE stock our pick for the Best Stocks for 2015.