In last week’s Energy Letter (A Slippery Slope for Crude) I noted that some stocks are more sensitive than others to depressed crude oil prices. Primarily these are companies that are highly leveraged, and/or those that have less of their crude production hedged. Today I will look at some of the companies in these categories, as well as others more protected against the current weakness in crude.

I will focus on domestic upstream producers that are primarily focused on oil. Midstream companies and master limited partnerships (MLPs) are more protected against oil price fluctuations, and refiners (downstream) aren’t necessarily negatively affected by falling oil prices.

On July 31, the price of West Texas Intermediate dropped below $100/bbl and has been below that level ever since. After averaging $105.79 in June and $103.59 in July, the average daily closing price in August fell to $96.54. For the first three weeks of September, the average daily close is down to $93.16.

The 12% decline in the price of WTI directly hits the bottom line of crude oil producers. ConocoPhillips (NYSE: COP) — the largest independent oil and gas producer in the world — has estimated that each $1/bbl drop in the price of WTI cuts its annualized net income by $35 million to $40 million. (Declining Brent and Canadian crudes negatively impact COP’s income in addition to this).

When oil prices are rising, highly leveraged oil companies can provide extraordinary returns, in a way that is similar to investing on margin. This is by nature a riskier strategy, because when the markets inevitably turn against you, you may get the dreaded margin call and have to sell at the worst possible time.

Over the long haul, smart leveraging can be a very effective for growing a company quickly. But too much leverage in a down market can overwhelm a company’s ability to pay back the loans. So let’s consider a few examples of companies at various levels of leveraging.  

At the upper end of the leverage scale are companies like Halcon Resources (NYSE: HK), Kodiak Oil & Gas (NYSE: KOG) and Aggressive Portfolio holding Oasis Petroleum (NYSE: OAS). Each of these companies has a debt-to-equity ratio for the past 12 months of at least 175%. Since July 31, these companies have seen their share price decline by 33%, 12%, and 26% respectively. (Kodiak isn’t a completely typical situation, because it’s being acquired.)

The middle tier of leveraged companies — those with debt-to-equity ratios between 75% and 125% — includes Continental Resources (NYSE: CLR), Carrizo Oil & Gas (NASDAQ: CRZO), Laredo Petroleum (NYSE: LPI) and Sanchez Energy (NYSE: SN). Since July 31, these stocks have declined respectively by 12.6%, 16.9%, 23.8% and 15.8%.

Companies with a debt-to-equity ratio below 75% include Whiting Petroleum (NYSE: WLL), Denbury Resources (NYSE: DNR), Anadarko Petroleum (NYSE: APC) and Diamondback Energy (NASDAQ: FANG). Since July 31, these stocks are down 11.7%, 12.8%, 5.2% and 15.4%, respectively.

Also impacting a company’s performance is the commodity production mix. In recent years, it has been more profitable to drill for crude than for natural gas. It is possible for the prices of these two commodities to trade out of sync, in which case falling crude prices might have a much larger effect on Halcon Resources — with 84% of its reserves classified as oil — than on Chesapeake Energy (NYSE: CHK), whose reserves and production are predominantly natural gas.

The extent of commodity price hedging can also influence a stock’s performance as oil prices change. Some companies will hedge a significant portion of expected output to guard against a protracted decline in oil prices. Carrizo, for example, has more than 75% of its expected production for the second half of 2014 hedged above $90/bbl. This provides protection against plunging oil prices, but it also limits the upside potential should prices rise. Conservative hedging strategies are essentially an insurance policy that helps stabilize cash flows during volatile market conditions. As such, hedging is very popular among upstream MLPs seeking stable distributions. Just keep in mind that insurance isn’t free.  

Bearing in mind that leverage is only one factor that impacts a company’s volatility, the following table summarizes the performance of a number of oil stocks at different levels of leverage during this period of falling oil prices. Each stock’s performance for 2013 — when the daily closing price of WTI averaged $97.98 — is included for comparison. Note that because I am focusing on US producers I haven’t included companies with significant overseas production like ConocoPhillips, Occidental Petroleum (NYSE: OXY), Marathon Oil (NYSE: MRO) or Apache (NYSE: APA).

I included the Debt/EBITDA ratio, which indicates how many years of EBITDA at last year’s level would be necessary in order to pay back all the debt. The median across mid-cap oil companies is 2.9. For EV/EBITDA, which divides the sum of market capitalization and net debt by EBITDA, the median across the industry is 9.3.

Five stocks in the table have a lower EV/EBITDA multiple than the industry median: Oasis Petroleum, Continental Resources, Whiting Petroleum, EOG Resources (NYSE: EOG) and Sanchez Energy. All but Sanchez are in one of the Energy Strategist portfolios. In the Aggressive Portfolio, Oasis and Continental Resources both returned more than 50% in 2013, but Oasis is more highly leveraged and suffered a greater pullback recently after WTI fell below $100.

The Growth Portfolio is home of EOG Resources, which returned more than 40% in 2013 and recently pulled back by 10%. EOG is the largest company in the table, and also the least leveraged. Whiting is also in the Growth Portfolio, and should soon reclaim the distinction as the top crude producer in North Dakota’s Bakken after recently announcing a $6 billion all-stock acquisition of Kodiak.   

Overall, when we look at the financial measures of the domestic oil producers we still like the companies in the portfolio. However, the entire sector will be hurt by a sustained decline in crude prices. Since 2010 there have been a few dips below $90/bbl, but none lasted very long. The current dip might temporarily go a bit lower but, as I argued in last week’s Energy Letter, there is little risk in oil trading at $80/bbl for long if it reaches that low point. At that price marginal production would start to be shut in, and OPEC would likely take strong action to ensure that oil prices don’t remain depressed for long.

Thus, I would argue that the downside from here is limited. Further, “Black Swans” that impact the oil markets inevitably tend to drive oil prices higher — sometimes very quickly. If you have the risk tolerance, Oasis remains a Best Buy, but keep in mind that Aggressive Portfolio holdings can suffer frequent corrections of more than 20%. For more risk-averse investors, EOG Resources remains a top pick, and one that has held up well during the current correction.  

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