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Last week, the Bank of Canada increased interest rates by an incredible 100 basis points. It wasn’t the first rate hike of the year, but it was by far the largest. In response to the move, banks’ lending rates immediately moved up. The TSX Energy Index measures oil stocks and shows a 5.5% drop for the week.
A supply crunch has caused oil prices to rise this year. Saudi Arabia has exhausted its reserves and Russian oil is under sanctions. There is now less oil available than last year. Due to rising oil prices, oil stocks outperformed last year’s market. Oil stocks are now falling as interest rates rise. So the question is: Should you sell your oil stocks now or wait for future gains?
What are 100 basis points?
One 100th of one percent is a basis point, or 0.01%. A 100 basis point Rate hike refers to a 1% rate increase. The Bank of Canada’s rate hike took us from a 1.5% to a 2.5% overnight lending rate. It was a significant jump. If 1% doesn’t seem big to you, remember that we’re talking about a 1% increase on the amount borrowed. When you increase interest expenses from 1.5% up to 2.5%, the percentage change is 66%.
This is an example. Imagine borrowing $10,000 to purchase a car. The interest rate starts at 1.5%, which means you will pay $150 each year. The car dealership later informs you that they have made a mistake on your financing agreement and you now have to pay 2.5%. Your $150 per year interest payment suddenly becomes $250. A $100 increase. If that doesn’t seem like a big deal to you, imagine the loan was for $100,000. Your interest expense would rise by $1,000 in that scenario.
Are oil stocks still of good value?
High interest rates can help to reduce oil prices and decrease demand. Two forces influence the price of oil: supply and desire. If demand is high and supply is low, prices tend to go up. This year, supply is low, and that’s putting upward pressure on oil prices. The Bank of Canada has no control over this. It can, however, influence demand. If you routinely borrow money to gas up your car, you’ll probably drive less when interest rates rise. That could help bring down oil prices if enough people do it.
This could lead to oil stocks becoming like Cenovus Energie (TSX.CVE) less valued. Cenovus has made a lot from gasoline sales this year. Husky Energy is a chain of gas stations in Canada that it operates. CVE generates more revenue from these gas stations if more people drive. However, rising interest rates could make it more difficult for people to drive. They wouldn’t stop driving altogether, but they might cut back, leading to lower sales volume and lower prices for CVE. That could eventually show up in the company’s revenue and profit, taking the stock lower.
However, overall, however, the fundamentals could keep the oil stocks up in this year. Factors like the war in Ukraine and OPEC’s lack of spare capacity keep prices high regardless of demand, and oil stocks have cheap valuations. I can’t say for sure that oil stocks are going to resume their raging first-half bull market, but they are cheap compared to their earnings and cash flows. It is worth looking at them.