Oil companies are in big trouble next year.
As longtime readers know, there are massive risks facing the oil industry in 2016. I’ve talked about these risks several times in these pages.
The breakeven price to produce oil in America is roughly $55 a barrel. Oil prices are trading below $45 a barrel today. However, some oil companies can continue to make money producing due to hedges.
Next year, hedges will fall from 30% of production (in 2015) to just 11%. That means most companies won’t be able to produce oil for a profit.
Plus, oil companies are sitting on $500 billion of debt. Most of this debt is due over the next five years.
To put this in perspective, 85% of operating cash flow generated by U.S. oil producers is being used to service their debt right now. This compares to less than 45% in 2014.
The bullish argument on oil stems from the huge decline in rig counts (down 60% this year). Also, oil companies have cut spending (capex) by roughly 20% in 2015. This is supposed to result in a massive decline in production …
Yet, the latest statistics (released Nov. 28) paint a much-different picture …
According to the government, U.S. oil companies are producing 9.1 million barrels of oil per day. This is down only 5% from a record 9.6 million barrels of oil per day set earlier this year.
To put this in perspective, oil prices plunged by more than 60% (yellow line below) from May 2014. Yet, oil production in the U.S. is up nearly 10% (blue line) over the same time frame!
What you need to understand as an investor …
Oil is not expected to come off the market anytime soon. This excessive supply will result in depressed oil prices at least over the next few years.
And lower oil prices will lead to much-lower profits for oil companies.
Outside of the oil industry, many industries benefit from lower prices. This includes retailers with large fleets (Wal-Mart / Target) and chemical companies (DuPont / Dow Chemical) where oil is a huge input cost. Yet, the biggest beneficiaries of lower oil prices are airlines.
Airlines have had a remarkable run over the past three years. They outperformed the S&P 500 Index by a 2.5-to-1 margin.
However, airlines have underperformed the market over the past year. The sector is down 5% over the past 12 months. This compares to a 1% gain for the S&P 500.
This underperformance is surprising given the huge decline in oil prices. For example, investment firm Moody’s projects global airlines will spend $70 billion less on fuel in 2015 compared to 2014.
To put this in perspective, the three major U.S. airlines (Delta, American, United) generated a combined $9 billion in net income in 2014. With oil prices projected to stay low for the foreseeable future (below $65 a barrel based on analysts’ forecasts), airlines should easily outperform the markets.
My call to buy airlines is not just based on lower oil prices …
The industry has gone through a massive transformation over the past few years. The major airlines are dirt-cheap — and generating billions in free cash flow. They are buying back stock, raising dividends and aggressively paying down debt.
These positive trends are expected to continue for many years. And now airlines are saving billions of dollars in fuel costs, which should directly result in more spending on growth, larger buybacks and further dividend increases.
The easiest way to invest in the industry is through the NYSE Arca Airline Index (XAL). The index is trading at just nine times earnings and tracks the largest U.S. and global airline companies including United Continental (UAL), Delta (DAL), Southwest (LUV), American (AAL) and JetBlue (JBLU).
Our massive supply in oil will likely keep oil prices depressed (under $65 a barrel) for the longer term. Instead of trying to catch a falling knife in the oil patch, a better alternative is to buy airline stocks.