Jeff Reeves's Strength in Numbers: This gusher in oil stocks will not end well

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    Investors in oil and energy stocks are breathing easier nowadays.

    In 2015, as crude oil prices CLV6, +2.00%  cratered, energy-sector mega-caps took a dive as well. For example, shares of Exxon Mobil Corp. XOM, -0.37%  crashed by more than 20%. Small-caps lost even more; for instance, shares of Range Resources Corp. RRC, +0.55%   were cut in half. But this year the oil stocks have fought back and are currently sitting on some nice year-to-date returns.

    Indeed, after recent talk of an oil freeze, many investors are convinced the worst is over in the oil patch. But that line of thinking could be dangerous for your portfolio. Because what’s likely coming next for oil and energy stocks won’t be pretty.

    To be sure, the energy sector writ large has outperformed in 2016 so far. The broad-based Energy Select Sector SPDR ETF XLE, +0.57%  is up 17% vs. 7% for the S&P 500 SPX, -0.01% while the specialized SPDR S&P Oil & Gas Exploration & Production ETF XOP, +0.66%   is up about 26%.

    That said, a recovery for some stocks belies structural problems for the energy sector that cannot be easily fixed. There simply isn’t much margin for error here, and a closer look reveals several big challenges ahead.

    Debt problems persist

    As energy stocks went on a tear, the bond market told a different story about these companies. Fitch calculated that for the first half of this year, energy-sector bond defaults hit $28.8 billion, with a default rate of 15%. For the subset of exploration and production stocks in the space, the default rate climbed to a massive 29%.

    This was amid a seemingly nonstop march higher for crude oil from January lows under $30 a barrel to more than $50 in June. So just imagine what will happen if crude softens up and debt service becomes even harder to manage.

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    Separately, Haynes and Boone’s latest Bankruptcy Monitor estimated that 90 oil and gas firms have declared Chapter 11 since the beginning of 2015, defaulting on $66.5 billion in total debts. If that wasn’t bad enough, in a recent interview, a partner at Haynes and Boone posited that the industry was only “one-third of the way through the bankruptcy cycle.”

    That would peg total damage at around $200 billion, with some 270 firms going belly-up.

    Think about those numbers carefully before you invest in oil stocks, or if you currently hold companies in the sector and believe the worst is over.

    Supply glut may worsen

    Part of the reason energy prices crashed is simple supply and demand. Speaking broadly, demand for energy has been weak lately due to sluggish global growth, particularly in China, as well as a supply glut as the world’s oil producers continue to pump freely.

    That trend will persist, and perhaps get worse. Consider that despite a year and a half of severe pain for the oil sector, giant Royal Dutch Shell RDS.A, +0.68%  admitted that oversupply won’t reach equilibrium with demand until the second half of 2017 at the earliest.

    That’s because there continues to be “all talk, no action” from major oil producers, including Russia and Saudi Arabia, which rely heavily on the energy sector to fuel their economies. Instead of talking about how and when they will curtail production, we have hilarious moments such as Saudi Arabia’s minister of energy promising not to flood the market with 12.5 million barrels a day of oil.  

    It’s impossible to resolve this prisoner’s dilemma where all major oil producers need to simultaneously sacrifice the revenue made from pumping extra oil to stabilize pricing and supply over the long-term.

    Sure, there has been theoretical progress on the topic. But that’s what we were told earlier this year, before Iran refused lower production goals and OPEC’s meeting in Doha came to nothing. Moreover, the U.S. continues to be a major factor in production. The Energy Information Administration just revised 2016 production higher in its latest forecast, and is now estimating a significant boost in domestic production next year. EIA estimates currently peg U.S. oil output at 8.51 million barrels a day in 2017, up from 8.31 million barrels projected previously.

    So if OPEC does defy critics and put a plan in place to cut its output, what’s to stop U.S. oil and gas companies from ramping up production to offset those measures? Long story short: It’s much easier said than done to simply curtail production and normalize prices.

    Oil stocks have nowhere to go

    If the risky debt levels and the threat of persistent supply gluts weren’t enough to deter you from the oil patch, consider the energy sector in context of the broader market. For instance, energy equipment and services firm Schlumberger Ltd. SLB, -0.22%   has a forward P/E of about 40, while its peer Halliburton Co. HAL, -0.37%   sports a forward P/E of almost 50. The P/E of smaller, independent energy companies such as EOG Resources Inc EOG, -0.54%   are well into triple digits.

    Sure, the valuation of mega-cap stocks such as Exxon and Chevron Corp. CVX, +0.44%   aren’t quite as high. So maybe you’re thinking you’ll cherry-pick, avoiding the smaller players and focusing on the top of the food chain. After all, Exxon shares yield close to 3.5% while Chevron offers 4.2% in dividends.

    But with the potential of a hike in U.S. interest rates either late this year or early next, you might want to think twice about overpaying for dividend-rich oil stocks, given that higher rates may strengthen the dollar and weigh on crude prices. A lot needs to go right to support existing valuations, let alone drive share prices higher — and a lot can go wrong.

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