The oil price has been falling like a stone since the summer of last year. But during January it seemed to have found a bottom, and has since then bounced slightly higher.
There is likely to be some volatility in oil markets over the next few months, but it seems unlikely that oil prices will rise to the levels of a year ago. Most oil producers have now accepted that oil prices will be a lot lower over the next few years than they have been in recent years.
Gulf Keystone Petroleum looks cheap
I have already written about how this will affect the oil majors such as BP and Royal Dutch Shell. But what about small caps such as Gulf Keystone Petroleum (LSE: GKP) and Soco International? The share prices of these companies have already fallen a lot could they now be contrarian buys?
Well, on the face of it, Gulf Keystone Petroleum looks like a buy. After all, the share price peaked at 430p in 2012. The shares are now priced at under 50p. Surely if you buy now, any recovery in the oil price will push the share price higher?
Check the earningsper share progression of this business and you will understand why this is unlikely:
Theres no need to even mention the P/E numbers, as the broad picture is that this is a loss-making company. Even when the oil price was at record highs, it made no money. So what will happen when oil prices are low?
.but it could get a lot cheaper
Investing in small caps has always been much riskier than investing in blue chips. But thegreater growth potential of small caps meant that the returns could be a lot higher.
The difficulty with oil and mining small caps is that you are adding the volatility ofsmall capsto the cyclicality of resources companies. The result is that these firms are cyclical in the extreme: so ifcommodity pricesare high they will rocket, but ifcommodity prices arelow they will plummet.
This is the reason why I tend to givethese companiesa wide berth. It is no coincidence that almost all of thesefirms were created duringthe era of high prices of the past decade. When the oil price was reaching record highs, investors were rushing to buy every oil stock under the sun, and share prices kept rising. When the oil price is falling, the share prices of these type of businesseswill fall a lot faster than the oil majors.
Thats why Gulf Keystone Petroleum, and other resources small caps,are not contrarian buys.
Sometimes, knowing which shares to avoid is just as crucial as knowing which shares to buy if you want to make your fortune in the market.
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