Oil Search Limited (ASX: OSH) has slumped by 6% in 2016. This is in line with the performance of oil and gas sector peers Woodside Petroleum Limited (ASX: WPL) and Santos Ltd (ASX: STO). They have fallen by 7% and 4% respectively year to date. Looking ahead, I feel that Oil Search’s future is uncertain because of external and internal challenges.

LNG Prices

Liquefied natural gas (LNG) prices have fallen by 19% since the start of the year. I believe that further price falls lie ahead, since increased supply is forecast to reach the market over the next few years. Nine liquefaction trains are forecast to start up in 2016. They are due to add around 35 million tonnes of LNG to what is already an oversupplied market.

By 2020, global LNG production is forecast to increase by 50% to 370 million tonnes a year as new plants in the US and Australia come onstream. However, demand for LNG is not growing at anything like the same pace. Between January and August 2016, 186.6 million tonnes of LNG were shipped. This was 7.7% higher than for the same period of 2015 and 10.7% greater than for the corresponding period of 2014.

Therefore, in my view the imbalance between supply and demand will increase and LNG prices have yet to reach their bottom.

Risks

A falling LNG price is bad news for Oil Search because of its lack of diversity. The Papua New Guinea (PNG) LNG project dominates the company’s earnings profile. Oil Search’s operations elsewhere in the world are minor in comparison. It is a price taker and its financial performance is closely tied to the price of LNG.

Further, Oil Search’s financial standing is not strong. Its balance sheet is highly leveraged and contained US$3.4 billion of net debt as at the end of financial year 2015. This equates to a net debt/adjusted EBITDA ratio of 3.1, while Oil Search’s net debt to equity ratio was 72%.

Its interest coverage ratio of 1.6 is likely to fall over the medium term. That’s because of a forecast decline in LNG prices, but also because of the likely construction of a third PNG LNG train from 2020. This would be likely to require additional debt which would stretch Oil Search’s balance sheet and cash flow even further.

Outlook

Oil Search faces internal and external challenges. The price of LNG looks set to fall due to a worsening of the current supply/demand imbalance. As a price taker this will hurt Oil Search’s profitability. Its financial standing increases its risk profile and this situation could worsen if operating conditions deteriorate. Therefore, I feel that Oil Search should be avoided and you should focus on these three blue-chips instead.

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Motley Fool contributor Robert Stephens has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.