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Oil crash: Are these three cheap oil shares a buy?

The Organisation of Petroleum Exporting Countries (OPEC) held its semi-annual meeting in Vienna last Friday. The fallout from its decision to increase production sparked a vicious fall in oil-related shares on Monday, with Oil Search Limited (ASX: OSH), Santos Ltd (ASX: STO) and Woodside Petroleum Limited (ASX: WPL) selling off indiscriminately.

Here is why I think all three are a compelling buy today.

OPEC

OPEC is a treaty signed between 12 oil rich nations comprising Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela. OPEC countries account for approximately 40% of global oil production. For years, OPEC countries have acted as a cartel, coming together to set daily oil production limits to maintain oil prices.

In 2011, OPEC countries agreed that its constituents will not collectively produce more than 30 million barrels of oil a day. This ceiling has been breached for the last 18 months, with Bloomberg data showing OPEC countries currently produce 31.5 million barrels a day. Given OPEC’s contribution to global supply, any excess production by OPEC countries has an impact on daily crude oil prices.

At the present time, U.S. and Russian shale producers are increasing production volumes, causing an oversupply to the market. This is met by OPEC’s increased oil production, which is not being absorbed by excess demand, causing downward pressure on oil prices. Accordingly, OPEC has played a large part in the 60% fall of crude oil since July last year.

The OPEC meeting

At OPEC’s meeting last Friday, it signalled no end to excess production. In fact, the cartel stated its intention is to continue production at current levels to win back market share from U.S. and Russian producers. This effectively gives OPEC countries carte blanche to increase production, placing further pressure on the oil prices.

The fallout from the OPEC meeting has left many wondering how low oil will go. Analysts at Goldman Sachs cite a lack of demand from China and the persistent oversupply as reasons for why oil could fall to as low as US$20 per barrel (from its current price of US$37 per barrel).

Whilst I think Goldman Sachs’ dire prediction won’t eventuate, given global demand remains resilient and U.S. growth is positive, investors seeking exposure to oil need to ensure a company can withstand the low oil price environment. Oil Search, Santos and Woodside are three stocks which I believe can.

Oil Search Limited

Oil Search is arguably the golden-child of oil-related stocks at the moment. The Papua New Guinea (PNG) based producer has been at the centre of takeover talks from Woodside, given its 29% interest in PNG LNG – the world’s largest liquefied natural gas (LNG) plant.

Importantly, Oil Search has a strong balance sheet with the ability to generate free cash flow at current prices. As at 30 September 2015, Oil Search’s cost of production sat between US$9-$11 per barrel of oil equivalent (boe). As such, Oil Search should be able to comfortably withstand depressed oil prices.

Santos Ltd

Santos recently completed its entitlement offer, raising a total $2.5 billion from its retail and institutional components. It also sold individual assets and provided a $500 million placement to private equity firm Hony Capital, to reduce total debt by $3.5 billion.

These initiatives should provide Santos with breathing room as oil prices fall, with growth coming from Santos’ exposure to LNG through its stakes in GLNG and PNG LNG.

Woodside Petroleum Limited

As alluded to above, Woodside recently lobbed a scrip-for-scrip takeover bid for Oil Search at an implied value of $7.75 (on the date of the bid). The deal subsequently fell through, with Oil Search rebuffing the $11.7 billion offer stating that it undervalued the company.

Despite the failed attempt, Woodside remains in an enviable position with cash of US$3.3 billion and debt sitting at US$2.6 billion. This provides it with a very strong balance sheet which it can leverage to acquire distressed companies or quality assets if the oil price continues to fall.

With Woodside also generating free cash at current prices from its existing projects, investors are likely to be rewarded with dividends during the downturn, making it a compelling investment proposition.

Foolish takeaway

Although it is unknown if OPEC will reinstate its production limits to curb oil’s free fall, long term investing is not about speculating on price movements. Instead, investors should focus on buying companies that have strong balance sheets with the ability to outlast any lingering downturn in crude oil prices.

On the face of it, Oil Search, Santos and Woodside Petroleum all offer sound investment theses, making these three stocks ripe for the picking in the current environment.

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Motley Fool contributor Rachit Dudhwala owns shares of Santos Limited. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. 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.

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