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Bumpy Road Ahead for These Energy Stocks

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The harsh realities of the current down-cycle continue to plague the energy industry now for the third successive year. Although the OPEC-induced rally has helped commodity prices recover somewhat in 2016, they remain significantly below 2014 levels. Stuck in a long-term bear market, money managers do not rule out chances of more pain ahead for energy stocks.

In fact, as long as there is big oil and natural gas surplus, the arduous market environment will continue -- suggesting that the odds are firmly stacked against a sustained rally and point toward ‘lower for longer’ commodity price expectation.

With no guarantees that things will improve in the near-to-medium term, investors would be better off ignoring the following set of stocks.

Anemic Margins, Exorbitant Compliance Costs Hit Refiners

Until recently, U.S. downstream (refining and marketing) stocks were seen notching up healthy gains and earnings beats. This is because the companies use oil as an input from which they derive refined petroleum products like gasoline, the prime transportation fuel in the U.S. Hence, lower the oil price, higher will be their profits.

However, this also led to overproduction and stock build-up that now threatens to bite the refiners. Refiners have been struggling this year with the existing stocks of refined product inventories – gasoline and distillate – remaining at their maximum seasonal levels in at least 20 years despite healthy demand. Consequently, margins have narrowed forcing some of the operators to announce production cuts, postpone capital spending and retrench employees.

In fact, as per industry data from British oil major BP plc (BP - Free Report) , refining margin – the income from converting crude into gasoline and diesel – dropped 42% year over year to $11.60 per barrel in the third quarter of 2016.

Last but not least, the U.S. refiners are feeling the pinch of higher Renewable Fuel Standard (‘RFS’) costs to comply with new cleaner gasoline production rules.

As a result of these bearish factors, the tendency for a downward estimate revision has been more obvious in recent times. In addition to Zacks Rank #5 (Strong Sell) World Fuel Services Corp. (INT - Free Report) , companies like Murphy USA Inc. (MUSA - Free Report) and Phillips 66 (PSX - Free Report) look to be in most trouble. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Tough Market for Oilfield Equipment Suppliers

Despite early signs of recovery in North America, the current oilfield environment remains one of the most difficult. With new competitors entering the market and drilling contractors too rattled to make new investment decisions, oilfield machineries and equipment suppliers have seen their pricing fall drastically.

While firms catering to North American land drillers have been the worst affected, lack of new deepwater drilling orders are starting to haunt the subsea part of the industry. This comes after commodity price rout has already made a number of deepwater drilling projects uneconomical.

As such, with several quarters of reduced activity and diminishing contract backlog, most of the players are facing continued pressure on revenues, earnings and cash flows.

As it is, fourth quarter activity is likely to be weak due to holiday and seasonal weather-associated disruptions. Moreover, pricing pressure is expected to continue over the near-term with international business set to be flat sequentially.

In particular, we suggest avoiding exposure to Oceaneering International Inc. (OII - Free Report) , Gulfmark Offshore Inc. GLF and Flotek Industries Inc. (FTK - Free Report) .

Offshore Drillers: The Wreckage Continues

In 2015 and 2016, offshore drillers struggled to get by, and more of the same is expected in 2017.

With majors like Transocean Ltd. (RIG - Free Report) and Diamond Offshore Drilling Inc. (DO - Free Report) suspending dividend and companies including Vantage Drilling Co. and Paragon Offshore plc delisting from major exchanges, there is enough evidence that offshore drillers are not out of the woods yet and are still facing a bleak industry outlook.

As crude prices hover at less than half their mid-2014 levels, the top energy companies have cut spending (particularly on the costly drilling projects) on the back of lower profit margins. This, in turn, has meant less work for the beleaguered drillers as offshore exploration for new oil and gas projects has almost come to a standstill.

Secondly, with large, multinational energy firms looking to rein in their skyrocketing capital expenses, the offshore drilling space is witnessing intense competition, as multiple firms chase a single contract. This excess capacity, in turn, has led to significantly lower utilization/dayrates.

Companies like Seadrill Partners LLC and Independence Contract Drilling Inc. (ICD - Free Report) look to be in most trouble. Eating through backlogs without replacing them with new business, cash flow for these operators are likely to dry up further.

Check out our latest Oil & Gas Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy.


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