Are Oil Prices All Set to Burn Investors?

Madhuchhanda is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A couple of weeks ago, when crude oil prices were skyrocketing, many analysts came up with different explanations as to why crude oil would reach $140 and some said it would go to $180. With the recent steep drop in prices, however, that doesn’t seem possible to me anymore.

Crude oil prices fell sharply and suddenly, with oil at $90 a barrel for the first time in almost eight weeks. The Energy Department said total US Fuel use decreased 1.1 percent in the four weeks endedSeptember 21st. It is very likely that the price of crude oil will continue to decline because for the first time in a decade, supply is exceeding demand.

Why this happened
The sudden drop in oil prices somewhat shocked the global market. But if you think about it, this really isn’t that much of a surprise. Since March­­ — for the first time since 2006 — oil production has been above consumption level. With Gas Energy satisfying most of our demands, the market for fuel is gradually dwindling. As I had mentioned in my previous article, the recent boom in the Shale Gas industry has led to diminished demand for oil supply. 

According to the energy intelligence group, global oil consumption has been declining since the end of 2011, falling to 88.5 million barrels per day at the end of April, from 90.4 million barrels per day in late December 2011. For the first time, we are producing more than we need! The price drop was, hence, inevitable

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(Source: Businessweek Website)

The market view
Brent oil for November settlement dropped 41 cents, or 0.4 percent, to $110.04 a barrel on the London-based ICE Futures Europe exchange. The European benchmark grade’s premium to West Texas Intermediate in New York widened to $20.06, the largest gap based on settlement prices since Aug. 16.

Energy stocks too are broadly lower with the NYSE energy sector index falling 1.1% and the S&P energy index sliding about 0.7. 

Since two-thirds of the price of gasoline is determined by the price of oil, that should continue to lower prices at the pump. Gasoline inventories slid for a ninth week, down 481,000 barrels to 195.8 million, and distillate fuels, which include diesel and heating oil, decreased 482,000 to 127.7 million. At the end of May, the average price of a gallon of gasoline in the U.S. was $3.66, 12¢ lower than it was a year ago, providing a welcome relief to vehicle owners.

Ramifications of Oil Drop
Oil’s price move has had a major effect across oil and gas ETFs and stocks. But the main question remains: what effect would softer oil prices have on earnings in the future of E&P companies? Let us have a look at some of the major players in this field. 

Bonanza Creek's (NYSE: BCEI) primary asset is about 63,000 acres in the Niobrara and its oil/natural gas sales split is 75%-25%. Currently analysts are estimating sales of $233 million for 2012 and $361 million for 2013, generating EPS of $1.64 and $2.68. Just a $10 drop in oil prices would reduce the EPS to $1.33 for 2012 and to $2.18 for 2013. At the current $18.20 stock price that would translate into a next year P/E of 8.4. The stock is clearly cheap, and we can probably expect it to fall some more.

Carrizo Oil and Gas Inc. (NASDAQ: CRZO) has 41,000 oil acres in Eagle Ford, 58,000 acres in Niobrara, some natural gas properties, a smallholding in the Utica and a share in a North Sea oilfield that it plans to sell in 2012. Excluding the North Sea asset, its oil / natural gas sales mix is 75%-25%. Analysts are forecasting sales of $428 million for 2012 and $636 million in 2013, with EPS of $2.46 and $4.57. A further $10 drop in oil prices would cut EPS to $1.97 in 2012 and $3.76 in 2013. Currently the stock is $24.68 and, with that lower oil price, it is estimated to drop further.

Northern Oil and Gas Inc. (NYSEMKT: NOG) stock analysis shows similar results. Northern has approx 170,000 acres in the Bakken and produces a very high oil/gas mix of 95%-25%. NOG's earnings have also been softening recently. Analysts are forecasting sales of $310 million in 2012 and $435 million in 2013 with EPS of $1.20 and $1.78. Oil $10 lower would translate to EPS of $0.88 in 2012 and $1.36 in 2013. With the stock trading at $17.20 these low-ball EPS figures equate to a next year p/e of 12.6. Comparatively, this looks not so bad, but again, I would not advise investors to invest in it just yet.

Remember, a $10 difference in a barrel of oil is a move of $10,000 per contract. Based on that, it is easily discernible that future earnings for the crude oil producers are not looking up. Companies like United States Oil and Plains Exploration and Production Company are reporting similar low revenues.

With the current low demand, it is unlikely prices are about to rise anytime soon. Energy Sectors dealing purely in oil and oil products are now on a precarious edge. With further drop in oil prices, revenues might be sufficiently down to cause company officials significant worry. 

In such an event, I would advise investors to stay away from such companies. If you were planning to invest in oil stocks, this would be the perfect time to re-think that decision.

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