Despite the possibility of a political crisis in the Middle East that could cut oil shipments and send crude oil prices shooting skyward, things aren’t looking so good for energy stocks

A year ago, it was a different story. A renewed bull market seemed to be underway. Since then, however, energy stocks had dropped, had rallied for a while and have been dropping again since February. (See top chart.)

This downward trend would not seem serious except for two negative factors: trading volume in energy stocks is dropping, and energy companies’ share prices have been dropping relative to the broader market since 2008.

In addition, Statistics Canada reports that energy-sector profitability has been dropping for about a half-dozen years. In 2011, the sector’s return on equity dropped to 5.9%. In 2006, in contrast, ROE had reached a high of 20.8%; in 2001, ROE was 20%.

Sure, the price of crude oil has climbed again recently. But the price of natural gas is close to 10-year lows. The reason for that is that the exploitation of shale gas has made natural gas more than plentiful in North America.

The long-term price trend for oil is negative because of descending highs. February’s high of US$109.77 a barrel for West Texas intermediate crude, the U.S. benchmark, was below the 2011 high, which, in turn, was well below the 2008 peak. In Europe, the price of Brent crude had reached a high of US$128 a barrel in March and has been on a plateau since.

Price momentum has turned downward. And, unless there is an early, upward reversal in crude prices, the latest rally has ended.

Canadian oil producers have another problem. Prices they receive for crude are always below U.S. benchmark prices – notably, the delivered price of WTI crude. The price gap has widened again, so Canadian producers had benefited less when prices climbed in the last half of 2011.

Consumer complaints focus on gasoline prices. Their surge reflects both the recent crude price rise and tight wholesale gasoline supplies, the latter of which is a result of the fact that North American refineries have no surplus capacity and are vulnerable to production glitches and plant shutdowns for maintenance.

The one thing that is growing in the energy sector is capital investment, which indicates that the sector is continuing to invest for the future. Capital spending had reached $48.5 billion in 2011, according to StatsCan data, compared with $13.5 billion in 2008.

So, what could reverse the outlook for the energy sector? A crisis in the Middle East is the most likely possibility. Sustained world economic growth is not in the picture – at least, not this year.

The crude price differential for Canadian producers has worsened. At the start of 2009, WTI had traded at less than US$20 a barrel above Canadian grades such as Edmonton light and Cromer medium. Now, the differential is more than US$40 in favour of WTI. (See bottom chart.)

Look at it this way: from the August 2011 low, the monthly average price of WTI had risen by 24% to March, while Edmonton light had increased by 18%.

“Oil and gas extraction and support activities” – StatsCan’s name for the energy sector – had $494 billion in assets at yearend 2011, with capital assets of $290 billion. The year’s operating revenue, at $182 billion, was 24% higher than in 2010, but net income at $15 billion was 10% lower.

The latest earnings for the S&P/TSX capped energy index are $16.4 billion, with an expected 12-month dividend payout of $7.9 billion. Converted into index terms, earnings are $14.90, up from $8.02 in mid-2011 and down from $35 at yearend 2009.

These significant dropping trends show up in profitability ratios, such as the energy sector’s pretax profit margin.

The change in cash flow is significant. It had reached a high of $53 billion in 2008, had dropped to a low of $27.6 billion in 2009 and had recovered to $42.5 billion in 2011. But, despite this drop, capital spending has risen. IE

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