Warning: Sell Oil’s Next Victim Now
The roughly 70% drop in oil prices in less than two years has claimed many victims.
The economies of entire countries such as Nigeria and Venezuela have been devastated. Shale oil boom towns like Fargo, N.D., have gone bust.
Shares of many energy companies have been decimated — some even to the point where it is probably too late to short them. For instance, stocks like Chesapeake Energy (NYSE: CHK) and Whiting Petroleum (NYSE: WLL) have lost more than 90% of their value since oil’s peak and now trade in the low single digits.
However, one group has only recently begun to feel the heat from the plunge in crude: Canadian banks, which have significant exposure to oil and gas.
Of the six major banks in Canada, the one that looks the most vulnerable is The Bank of Nova Scotia (NYSE: BNS).
Commonly known as Scotiabank, it is the third largest bank in Canada, with assets of C$856 billion ($639 billion USD) at the end of fiscal 2015 (Oct. 31). The bank provides financial services to 23 million customers in more than 50 countries. Last year, Canadian banking accounted for 50% of earnings, while international banking contributed 27% and corporate and investment banking contributed 23%.
According to Moody’s, Scotiabank will be one of Canada’s hardest hit lenders if the already prolonged energy downturn continues.
One reason is that the Bank of Nova Scotia has a 21% share of the consumer loan market in Canada’s oil-producing provinces. Declining oil prices have forced energy companies to lay off a significant number of workers, who in turn may have trouble meeting their loan commitments.
Scotiabank also has one of the most vulnerable loan portfolios of the Canadian banks. In a prolonged oil price decline, like the one taking place now, the bank is likely to face both loan defaults and a loss of investment revenue from such sources as underwriting.
In a “moderate” case, Moody’s projects Scotiabank could see regulatory capital losses of 41 basis points, while a “severe case” could lead to a 100-basis-point drop, or C$3.52 billion.
If the worst comes to pass, the bank could be forced to preserve capital and dilute its share base by raising equity and cutting dividends. In this sense, Scotiabank is almost as vulnerable to continued low oil prices as energy companies.
Warning signs can already be seen in the bank’s fiscal fourth-quarter and full-year (ended in October) earnings report.
Impaired loans to the oil and gas industry rose to C$165 million in Q4, up from C$96 million in the third quarter and C$44 million a year earlier. Provisions for credit losses in the oil and gas sector were C$24 million compared with none a year earlier. Plus, Scotiabank’s global banking and markets division recorded a 14% decline in net income.
Revenue and earnings growth is also slowing. Revenues for fiscal 2015 rose less than 2%, down from nearly 11% growth in fiscal 2014. Earnings were just 0.2% higher in FY 2015 versus 10.8% growth in the previous year.
And while Scotiabank increased its dividend 6.3% in 2015, the hike did not keep pace with slowing earnings growth. As a result, the payout ratio climbed 3 percentage points to 48%.
First-quarter earnings are due out March 1 and could bring more bad news. Analysts estimate the company will earn C$1.03 per share, down 6.4% from a year ago. Just three months ago, analysts were expecting a slight expansion in earnings.
Turning to the chart, the picture for BNS only grows darker.
After bottoming in the fall of 2011, the stock made a series of higher highs and high lows before peaking in the summer of 2014, along with oil prices.
The uptrend officially ended in late 2014, as shares broke down through the major trendline, and a sharp retreat ensued.
The major downtrend line drawn from the 2014 peak currently intersects the chart just above $42.50. We’ll set our stop-loss slightly above that at $43.05.
With very little support on the chart other than the $35 spike low, BNS could easily fall to the low $30s.
Recommended Trade Setup:
— Sell BNS short at the market price
— Set stop-loss at $43.05
— Set price target at $33.05 for a potential 15% gain by Q3 2016
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