I’m not a big fan of buying distressed stocks.
While rewards are typically the highest with this kind of approach, chances of success are low, and prices can drop further.
Meaning, more often than not, crisis investing results in catching a falling knife. Given that I’m a conservative portfolio manager, I prefer to avoid such situations.
Nonetheless, there are still occasions where even I will consider buying into a distressed industry.
If I feel the prices have declined too far and that there is a high probability of recovery, and if I can find stocks with robust balance sheets that can withstand the crisis, then I will invest 10% of my portfolio in such opportunities.
Moreover, I will only do that once the bottom has been established to protect my investment from further decline.
Of course, situations when all these factors converge are rare… but they still occur.
And right now, that’s what’s happening in the oil & gas market.
What’s Behind The Oil Price Shock
If you’ve been following the oil prices over the last three months, then you know how sharply they’ve declined.
At $20 per barrel, the West Texas Intermediate, the most common benchmark for oil prices, is trading roughly 70% below its January 6 highs.
You should understand that severe price declines like these only happen whenever both supply and demand experience a shock.
Take the 1998 oil price crash, for example, which is the last time WTI was trading as low as today.
During that time, the combination of slowing demand caused by the Asian Financial Crisis and an internal conflict within the OPEC which country can produce more, pushed the prices down by about 60%.
Today, the situation is nearly identical.
On the one hand, we are experiencing a global demand shock from the coronavirus, with consumers in lockdown, closed factories, and massively reduced logistics operations.
On the other, the top oil-producing countries are once again bickering over production quota.
The OPEC and Russia, which have been making joint production cuts since 2016 to help the oil prices recover, are now both increasing supply, despite the low demand.
Between the extremely low demand and the growing supply, the situation could hardly be worse… which is precisely why this is the time to start considering buying into this market.
That’s How I Know This Is The Bottom
I’ve said before that with crisis investing, I like to wait for the bottom to form.
I think we’re at that point now.
On the demand side, I don’t think the situation can deteriorate any further.
The economy is already in a complete lockdown. All but the essential factories are closed, the consumers can’t spend anything less, and there is next to no commercial or personal traffic. I don’t see how we can go lower than that.
On the supply side, under pressure from the United States, the oil-producing countries have finally agreed on a solution this week to cut production by 10% unilaterally.
I expect more measures like that this year if the price stays below $35 a barrel, which is roughly the breakeven price for the U.S. oil companies. The United States simply has too much political power over other countries to allow otherwise.
As you can see, chances that the supply and the demand picture could deteriorate from here on out are low, so I’m comfortable investing in the oil industry.
My Favorite Oil Stock In This Market
In the beginning, I’ve also mentioned that my priority in such situations is to look for companies with robust balance sheets that can withstand the crisis.
There are three such oil stocks that meet that criteria—Exxon Mobil (NYSE: XOM), Phillips 66 (NYSE: PSX), and Royal Dutch Shell (NYSE: RDS.B).
As such, all are great investments.
Nonetheless, the one I’m considering buying is the latter. Royal Dutch Shell is just slightly better than the other two.
It’s got more cash and is more effective at managing its liabilities than Exxon Mobil. And, it has a higher credit rating than Phillips 66, something that will come in handy during this crisis.
The bad news is that the oil giant’s stock is up by about 80% since its March 18 lows. This is unfortunate, first, because it lowers the upside potential, and second, if we experience another shock, its price could decline quite a lot before it hits the lows again.
For that reason, I’m staying on the sidelines for now, and I think you should too.
I understand that’s probably not what you wanted to hear. But sometimes, this happens and opportunities slid by you.
I do, however, recommend you watch the price closely. Should RDS.B slide below $31.50, I think it will once again represent an excellent buying opportunity.
Since the worst of the recession headlines are still coming our way, the probability of that happening in the coming weeks is high.