Here’s Why Cheap Oil & Gas and Commodity Stocks May Be a Big Money Trap

A fierce decline in the prices of many commodities – such as coal, steel, and oil – in recent years have led to severe business difficulties and share plunges in share prices for many companies involved in these sectors.

The big falls in the shares of these companies have also left many of them trading at what seems to be bargain prices. As an example, of the 55 oil & gas-related stocks in Singapore’s stock market that are around today, 38 of them are priced below their book values.

Some, like Swiber Holdings Limited (SGX: AK3), EMAS Offshore Ltd (SGX: UQ4), and Otto Marine Ltd (SGX: G4F), are even carrying significant discounts to their book values as you can see below. For context, the SPDR STI ETF  (SGX: ES3) – an exchange-traded fund tracking Singapore’s market barometer, the Straits Times Index  (SGX: ^STI) – is trading at 1.2 times its book value at the moment.

Share Price-to-book ratio (2 August 2015)
Swiber 0.176
EMAS Offshore 0.183
Otto Marine 0.332

Source: S&P Capital IQ

Firms with a price-to-book (PB) ratio of less than 1 can be deemed to be bargains since the owners of such a company can theoretically earn a profit simply by liquidating all the firm’s assets and settling all its obligations. But anyone who wants to go bargain hunting on this basis may want to tread with caution – the assets of such companies may very well carry inflated values.

This danger’s highlighted in a recent Bloomberg article with the headline “Three Years Ago This Coal Mine Was Worth $624 Million. Now It Sold for $1.”

The article had described the sale of an Australian coking coal mine for US$1 last week after Japan’s Sumitomo Corp. had bought a 50% stake in said mine for around US$320 million merely three years ago in 2012. Coking coal’s painful attrition in its price over the past few years – a three-quarter decline today from a 2011 peak – was what had predominantly led to the fire-sale of the Australian mine.

While oil and coking coal are quite obviously different beasts, lessons from the latter can still be applied for the former.

For instance, the collapse in oil prices (the price of oil is now less than half of where it was at its peak in 2014) will lead to lower profits for oil & gas explorers and ultimately result in lower demand for all kinds of assets that are related to the industry.

This in turn can then lead to lower asset prices. With these, it’s not difficult to see how companies in the oil & gas industry may have assets that carry significantly lower market prices in the future than what’s recorded on their balance sheets.

Elsewhere, the sale of the Australian coking coal mine for the pitiful price of US$1 is also a noticeable event for investors in commodities trader Noble Group Limited  (SGX: N21).

Noble is currently worth only 0.5 times its trailing book value at its current price of S$0.485. But, Noble’s total assets of US$19.1 billion (as of 31 March 2015) include investments in associates of US$1.96 billion (these associates include many coal explorers and miners) as well as US$6.70 billion in fair value gains on commodity contracts and derivative financial instruments.

So while Noble may look like a fetching bargain with its low price-to-book (PB) ratio, investors may want to carefully consider how accurately Noble’s reported book value actually corresponds to current and future market conditions for coal, as well as other commodities.

To be clear, none of the above is meant to be taken to be a statement that oil & gas stocks – and Noble for the matter – are involved in impropriety when it comes to the reporting of their financials.

Rather, it’s meant to be a call for investors to be aware of situations where even a proper adherence to accounting rules and guidelines on the part of a company can result in significant future deviations between said firm’s accounting value and real economic value.

A Fool’s take

Companies carrying significant discounts to their book values can be a good starting point for investors looking for bargains. But, it’d still pay for investors to dig into the balance sheet and figure out if the real economic value of a company’s assets is in line with what’s reported.

If you'd like to discuss more about bargain hunting and book values, you can come meet David Kuo and the rest of the Fool Singapore team on August 15! 

Please join us at Invest FAIR Singapore on 15 August. (Suntec Centre, Booth B-16). Come chat with us at our booth, and see our MAS-licensed Director, David Kuo, give his official SGX investor presentation.

You won't want to miss this! Add Invest FAIR Singapore to your calendar today.

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 companies mentioned.