Should You Buy Oil Stocks Right Now?

In the midst of the coronavirus market crash of 2020, oil stocks have cratered. Crude oil prices have fallen almost 70% since early January. At recent prices, both Brent and West Texas futures haven't been this low in 20 years. Simply put, the 2020 oil crash is unprecedented in both its swiftness and severity. 

But oil is still the black blood that flows in the veins of the global economy. Even as renewable energy supplants gasoline, diesel, and other refined hydrocarbons, they will remain important fuels to power transportation and generate electricity for many years to come.

So, with oil prices at record lows, and essentially every stock in the oil and gas sector now trading at massive discounts to their prices only a couple of months ago, should investors be buying? This is the very moment when we should heed Warren Buffett's advice to be greedy when others are fearful, right? After all, some of the most diversified and best-known oil companies have seen their stocks get crushed over the past couple of months. Shares of Royal Dutch Shell (NYSE: RDS.A)(NYSE: RDS.B)ExxonMobil (NYSE: XOM), and Phillips 66 (NYSE: PSX) have lost between 40% and 56% of their value. 

Man reaching for cash in a rat trap.

Many oil stocks are full of risk right now. Image source: Getty Images.

There will undoubtedly be some oil stocks that turn out to be massive winners from recent prices, and companies like these three should have the balance-sheet strength to ride out even the worst of it. Eventually, oil prices will rise, and the best-capitalized, best-run companies will reward investors who buy during this terrible downturn. 

But there will also be a lot of oil companies that don't make it, and tens of billions of dollars in investor wealth will evaporate. As much as oil will remain relevant for years to come, there are factors at play right now that the average investor may overlook. And this could result in permanent losses that you could avoid. 

A double-edged sword 

Oil prices aren't just falling on global coronavirus fears and the risk of recession. Those would ordinarily be enough reason for oil prices to fall, as global oil demand is set to decline sharply in the weeks and months ahead. But the situation is far, far worse in the global oil market than just a coming massive recession that's set to send oil demand down by some of the biggest declines in history. 

Over the past several weeks, Saudi Arabia has gone from a market-stabilizing force, having cut oil output multiple times over the past several years, to launching an all-out effort to upend the global oil market. Since the early March announcement that it would crank up oil output as soon as the current OPEC+ production deal expires on April 1, Saudi Arabia has been joined by the United Arab Emirates (UAE) in boosting output. And it added more fuel to the fire with plans to use more natural gas to further free up oil to export. 

Stacks of oil barrels.

Image source: Getty Images.

Add it all up, and Saudi Arabia says it will export more than 10 million barrels per day in April, a 43% increase from January and February. And it plans to pour another 600,000 barrels on top of that in May. 

So we are headed toward a record collapse in oil demand that adds up to all of Russia's and Saudi Arabia's average production combined. And instead of reducing production to stabilize the market, Saudi Arabia, the UAE, and Russia are increasing their ultra-cheap oil production to drown American shale out of the market. 

The biggest immediate problem isn't price

One of the biggest problems oil producers are already starting to face is a lack of demand coupled with a lack of storage. As much as you'd think buyers would be moving quickly to purchase as much crude as possible for $20 per barrel, demand has already fallen so sharply that pipeline and storage facility operators are running out of places to put what they are getting

As my Motley Fool colleague Matt DiLallo pointed out in the article linked above, Plains All American Pipeline and Enterprise Products Partners have started asking oil producers that have contracts with them to provide proof that the oil they are sending into their pipelines has a buyer already lined up. 

Crude oil tanker ship.

Tanker rates are skyrocketing as oil buyers contract them for temporary storage. Image source: Getty Images.

As a result, oil producers could be facing an even bigger problem. Crashing demand and overflowing storage facilities could force some producers to reduce the output of existing wells, further cutting off cash flows from wells they have already sunk cash into. 

In other words, we could see many of the most cash-strapped oil producers face a worst-case scenario of cratering oil prices and collapsing demand (paired with record recent production) that's keeping them from selling oil they've already spent much of their cash to bring on line. 

The first shoe just dropped

Before I could even finish writing this article, the first casualty emerged. Whiting Petroleum (NYSE: WLL) filed for Chapter 11 bankruptcy on Wednesday, having reached a deal with key holders of much of its senior and convertible debt. This deal, if approved by bankruptcy courts, would result in common shareholders retaining only 3% of the company, with the remaining equity being exchanged for approximately $2.2 billion of the company's debt. In other words, common investors will lose 97% of their investment, while Whiting will be able to emerge from bankruptcy with substantially less debt. 

Chesapeake Energy (NYSE: CHK) is another producer that may already have one foot in the grave. The company hired lawyers from a firm with expertise in bankruptcy and restructuring in mid-March. Oil prices have fallen 21% since. 

It won't be the last

Hands reaching up for a dollar bill.

Image source: Getty Images.

It's almost a certainty that Whiting will prove to be only one of many independent oil producers to go bankrupt in the next few months. Some will be able to follow its model and reach agreements to remain a going business, while others will simply have to cease operations and have their assets liquidated. 

In either case, rest assured that shareholders will be lucky to get anything more than the 3% of their original stake that Whiting's common investors could end up with. 

It's also not a stretch to expect we will see some of the typically "safer" oil investments (pipelines) be at risk as well. After all, these companies face a painful realty of falling demand on one end of their pipelines, and insolvent producers on the other end. If you make a living moving oil, a worst-case environment of pipelines full of oil you can't get rid of, and producers who can't pay you to ship it, could upend even this typically safe subsector of the oil industry. 

Some of the financially weakest midstreamers have already cut dividends, and another half-dozen seem destined to follow. A spate of bankruptcies in the producer space could put significant pressure on any one of these, particularly if they have large exposure to one or just a few of the weakest oil producers. 

What's an investor to do? Step lightly or just shop in another aisle for now

The oil and gas industry is in a painfully dangerous place right now. Saudi Arabia and some of its cohorts have some of the planet's cheapest oil to produce, and it seems like that country is firmly committed to drowning out a large portion of U.S. shale production. It's really an unsurprising turn of events, considering that Saudi Arabia, along with Russia, has taken the brunt of global production cuts in recent years to prop up prices while the U.S. has issued forth a growing gusher of new oil:

Saudi Arabia Crude Oil Production Chart

Saudi Arabia crude-oil production data by YCharts. Figures are barrels per day.

Even if Saudi Arabia were to reverse course from its plan to reestablish the world order in crude oil, the horse is already out of the barn. Oil markets are oversaturated, and that's not going to change overnight. This downturn is going to be painful and prolonged, barring massive cuts by all of the world's major oil producers. And the cards read like the only cuts we will see anytime soon will be from U.S. producers that don't have any choice. 

For that reason, investors would do well to step very carefully in the oil patch. The pure plays are the most at-risk, particularly oil producers in the short term, but also the companies they contract to do the drilling or other fieldwork, or the ones that sell materials like frack sand, drilling pipes, and other components. 

How many dominoes we see fall depends on a lot of factors, but right now, the best tack is probably one of observation. After all, as much as oil stocks have cratered, there are plenty of other bargains to be had, and most with far less risk than the oil stocks.

If you're dead-set on investing in the oil patch right now, look to the diversified giants of the industry, including Shell and Phillips 66, with their strong balance sheets and diverse operations that should continue generating cash flows during the downturn. You just have to be willing to accept that it could get really ugly before it gets better, and even these best-of-breed oil stocks could face very tough times ahead. 

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Jason Hall has no position in any of the stocks mentioned. The Motley Fool recommends Enterprise Products Partners. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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