Last week proved itself very lucrative for bottom-feeder oil investors.
What I mean is that many of the oil industry’s biggest losers, like Seadrill Ltd (SDRL), Marathon Oil Corporation (MRO), Chesapeake Energy Corporation (CHK), Bonanza Creek Energy Inc (BCEI) and Denbury Resources Inc. (DNR) were the biggest winners last week.
After such big stock gains in these securities, investors might think they have missed the boat. However, each of these stocks could still be purchased for unprecedented gains.
The only catch is that you must be willing to lose everything.
|Ticker||5-day gains||12-month losses|
Clearly, each of these stocks had a good week, but all remain well off their 52-week highs, and are down even bigger on a two-year chart. However, these stocks did not all rally last week, and fall significantly prior to last week, for no reason. Instead, the price action in these securities can be explained rather easily.
The activity in each of these five stocks is a direct reaction to the volatility in oil prices. The gains last week followed a price hike in crude oil over the same span, and the reason that each of these five stocks are still beaten so badly long-term is because oil prices remain pressured from the $90 prices they once hovered around.
CHK, SDRL, MRO, BCEI and DNR need oil prices of at least $60 to generate profits, and in some cases $80. These are generally companies with high debt loads which are unable to meet their debt obligations in this current environment. As a result, equity prices have crashed, reflecting the uncertainty that surrounds the future for oil prices, and assuming a worst-case scenario for each of the five companies.
Fact is, if oil prices were to stay below $40 permanently, not one of these five companies would survive, and that explains why these five stocks have been punished so significantly.
How to Play These Oil Stocks
There are three scenarios for oil prices:
- First, oil prices go lower, and the stock companies noted here get wiped out in a matter of two years.
- Second, oil prices stay put, and these five companies survive a little longer, but most likely do not survive long-term.
- And finally, oil prices recover, go back over $70, and in that event, the gains in these five stocks could be unprecedented.
The problem is that each of the three scenarios are equally likely, but the upside for stocks like SDRL, CHK, BCEI, DNR and MRO is too much to ignore. As a result, it is wise to own one or several as a speculative investment for higher oil prices.
Here’s the catch: You must be willing to lose that entire investment if oil prices do not recover. If you buy any of these stocks, it needs to be an amount of money you can afford to lose entirely if oil prices fall further. And while that amount will be small, it will be large enough to create a substantial amount of money in the event that oil prices turn higher.
How Big of Gains?
Let’s say oil prices move back to $60, which would still be 40% from crude’s two-year high, and assume that equity prices for each of these five stocks were to return to levels that were supported with $60 oil. If so, returns for these five stocks would look like this:
What’s really fascinating about the implied gains is that even if each stock were to reach these levels, it would still represent a loss from five-year stock highs. In other words, there is a boatload of upside in each of these five stocks if oil prices can recover, even partially.
In my opinion, this makes these beaten-down stocks very appealing, especially a stock like BCEI.
Prior to the decline in crude oil prices, BCEI’s production was roughly doubling every year, and its operating margin was around 35%. But in this low-crude-price environment, operating margins have sunk to -280%, and its debt-to-asset ratio has skyrocketed from 40% to near 70%.
The good news is that BCEI can once more become that highly efficient, highly profitable company in the right environment. Given the enormous upside that’s possible, even a small — say $2,000 — investment can be very lucrative.
At the end of the day, the same logic applies to each of these companies to some degree. That’s why investors are wise to consider owning one or several, so long as they are prepared to lose that money.
So long as it is a small investment, there’s not much downside, just tons of potential upside.
As of this writing, Brian Nichols owned shares of BCEI, MRO and CHK stock.