Life could be about to get tougher for oil stocks Woodside Petroleum Limited (ASX: WPL), BHP Billiton Limited (ASX: BHP) and Santos Ltd (ASX: STO). The outlook for the oil price has become more uncertain this week. The imbalance between demand and supply could worsen over the medium term and push the price of oil downwards. This would hurt Woodside’s financial performance and could cause its relatively high valuation to come under pressure. Therefore, in my view it is a stock to avoid.
The International Energy Agency (IEA) reiterated its bearish view on oil this week. It stated that the oil market will remain in a state of oversupply until at least halfway through 2017. A key reason for this is sluggish demand for oil. The IEA has reduced its expectations for growth in demand for oil to 1.2 million barrels of oil per day (bopd). This is down from the 1.4 million bopd forecast in August and is also lower than September’s forecast for growth of 1.3 million bopd.
The main reasons for the IEA’s downbeat outlook are slowing demand from China and reduced demand from the developed world. They have contributed to a fall in demand growth to 0.8 million bopd in the third quarter of 2016. This is the lowest rate of growth for four years. In my view, this shows that the IEA’s already bearish forecasts for oil demand growth could fall further.
Despite Opec’s recent agreement to cut production, there is still some way to go before a deal is finalised among its members. A decision on who will cut production and by how much is yet to be confirmed. In September, Opec’s production increased to a record level of 33.6 million bopd. Further increases in production are likely in the short run as supply issues have meant that Nigeria and Libya’s production has been cut. When that production comes back online, Opec’s overall production is likely to hit a new record high.
This makes a cut in production to 32.5-33 million bopd increasingly unlikely in my view. Therefore, the recent rally in the oil price could come to an end.
A falling oil price would hurt Woodside’s financial performance and could cause its valuation to decline. Woodside trades at a premium to the S&P/ASX 200 (Index: ^AXJO) (ASX:XJO). It has a P/E ratio of 26 versus 17 for the index. In my view, such a premium is undeserved given the outlook for the oil industry.
Woodside is likely to survive an oil price fall thanks to its financial strength. For example, Woodside had a gearing ratio of 31% and free cash flow of US$176 million in the first half of financial year 2016. However, in my view its shares should be avoided due to its status as a price taker and the uncertainty of the future oil price.
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