Why You Should Proceed With Caution with the Cheapest Oil Stocks

It was just last June when the price of oil hit a 2014-peak of around US$115 per barrel. But in the space of six months or so, the precious commodity has seen its price fall by more than half to less than US$50 today – in fact, Brent crude, a key price gauge for crude oil, is now at a six-year low, according to the BBC.

This fall in the price of oil has caused pain for many shareholders in oil-related stocks in Singapore. According to stock exchange operator Singapore Exchange, there are 54 oil & gas stocks listed here. Since the start of June 2014, these 54 shares have lost some 25% on average; in comparison, the SPDR STI ETF (SGX: ES3), an exchange-traded fund which tracks the market barometer the Straits Times Index (SGX: ^STI), has gained 1.8%.

Sharp declines in the shares of oil companies have led to many of them now sporting statistically cheap-looking valuations. In fact, of the group of 54, some 28 of them are currently carrying price-to-book ratios of less than 1; for some perspective, the SPDR STI ETF actually carries a PB ratio of 1.3 at the moment.

Here’s a list of the oil stocks with the lowest PB ratios: JES International Holdings Limited (SGX: EG0), Swiber Holdings Limited (SGX: AK3), Hoe Leong Corporation Ltd (SGX: H20), EMAS Offshore  (SGX: UQ4) and Ezra Holdings Limited (SGX: 5DN).

Company Price-to-book ratio (as of 12 Jan 2015)
JES 0.18
Swiber 0.18
Hoe Leong 0.21
EMAS Offshore 0.34
Ezra 0.37

Source: S&P Capital IQ

I trust it’s obvious to see that the quintet are currently carrying really low multiples to their book value at the moment. For investors interested in picking up statistical bargains, this group might be of interest. But here’s something important to note: Even if these shares may look really cheap, there are also reasons why investors may want to proceed with caution.

Let’s use Swiber as an example. At first glance, the firm seems to be in a healthy financial position given that it has some US$2.24 billion in total assets and only US$1.58 billion in total liabilities, according to its last reported financials. This gives the firm a comfortable book value of US$664 million.

With the firm being in a financially solvent position – meaning to say it has more assets than liabilities – and carrying such a low share price, surely it’s a bargain? Not so fast.

As my colleague John Maxfield had previously pointed out in his article titled “Playing With Fire: A Framework for Predicting Failure,” even companies which are solvent can become bankrupt. Although John’s article dealt mainly with retail firms, the broad strokes are still very much applicable for oil stocks too.

Some examples of solvent companies going bankrupt are given in John’s table below:

Bankruptcy table

The problem with companies like Circuit City and Linens ‘n Things, as John highlighted in his article, was mainly liquidity. According to him:

“When a company is in its final throes, the most acute problem it faces is the inability to convert assets into cash, which can then be used to buy inventory and satisfy expenses like rent and wages. This happens when creditors lose faith in a company and stop accepting its assets as collateral for lines of credit. It’s this, in turn, which triggers the actual demise.”

One of the main hallmarks of a company threatened by liquidity problems is an inability to generate cash – and that is an issue which plagues some of the cheapest oil stocks. As you can see in the table below, four out of the five cheapest oil stocks have generated negative operating cash flow over the past 12 months.

Company Operating cash flow (last 12 months)
JES -S$6.3 million
Swiber -S$301 million
Hoe Leong -S$7.6 million
EMAS Offshore -S$30.1 million
Ezra S$50.5 million

Source: S&P Capital IQ

The situation is worse for both JES and Swiber as they have been unable to generate cash from their businesses even in 2012 and 2013.

With the price of oil having fallen rapidly and its future movements unknowable, there’s a possibility that oil companies without the ability to generate cash might be squeezed harder by their creditors when it comes to credit issues. This thus has the potential to lead to a liquidity problem. The situation would be exacerbated if these oil companies are highly leveraged, as is the case with most of the quintet (the table below plots their net-debt to equity ratios).

Company Net-debt to equity ratio
JES 44%
Swiber 131%
Hoe Leong 120%
EMAS Offshore 100%
Ezra 85%

Source: S&P Capital IQ

Liquidity issues can result in pain for shareholders in many different ways, such as dilution of existing shareholders’ stakes through the sale of shares to raise capital, or in the worst-case scenario, bankruptcy.

A Fool’s take

None of the above is meant to say that the aforementioned quintet of the cheapest oil stocks would necessarily make for a poor investment. After all, a cheap share in itself is a catalyst for good returns. But that said, cheap shares can still become bad mistakes.

And with the current situation that many cheap oil companies find themselves in, bargain hunters ought to step in with their eyes wide open and be fully aware of the risks involved.

For more investing analyses and important updates about the stock market, sign up to The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.