There will be blood....
The repeated turmoil in the energy space for the last few months climaxed during Thanksgiving week with the decision by OPEC to abdicate its role as the swing producer and price setter for oil. In the last meeting, OPEC, or better Saudi Arabia, decided against cutting production to ease a supply glut in the crude market. The decision, while not entirely surprising given previous public comments, still shook the thinly traded holiday market which corrected precipitously.
OPEC’s decision was interpreted as a way to fight for market share and inflict pain on a number of commercial and political competitors such as U.S. shale producers, Iran and Russia.
Oversupply in the market is estimated at approximately one million barrels a day which may increase to 1.5 million in the first quarter of 2015 if there is no production response. The glut should start easing afterwards. In light of supply and demand data, the response of the market seemed extreme; it should be noted that 1 to 2 million barrels a day of excess supply is equivalent to only 1% to 2% of daily consumption and depletion alone eliminates about 4% of total production each year (Morningstar).
For now, demand is still growing, albeit at a slower pace, but it could re-accelerate quickly as global economic growth (especially in the U.S.) has a very good chance to improve. Conversely, if demand were to falter, then lower prices could be justified.
In light of such a bloodshed, what is an investor to do? Chances are that the price of crude, while remaining volatile for some time, is probably bottoming and it is in search of a new range for 2015. On the equity side, energy stocks will probably lower their earnings estimates in aggregate but pockets of opportunities have definitely been opened. A report by Standard & Poor’s Capital IQ, shows how energy stocks reacted 12 and 24 months forward after periods of underperformance relative to the S&P 500 index. S&P reports that the rolling 12 month relative strength for the S&P 500 Energy Index is 80.70, meaning the sector’s price change is 20% below the main equity benchmark. Since 1990, its lowest 12 month relative value was 73.65 (January 1999). The current level is below one standard deviation from the mean of 88.11 and it is approaching the minus 2 standard deviations level of 74.39. In layman terms, the sector is historically and statistically oversold.
Since 1990, there have been six times when the sector traded at or below its current relative strength value. S&P reports that in five times out of six , the sector posted positive 12 month forward price return (and the only decline was marginal at 0.1%); it outpaced the S&P500 three times out of six and it recorded an average gain of 13.45%. Over a 24 month timeframe, the energy sector was positive six times out of six and it outpaced the S&P 500 by an average 16.2 percentage points.
The probabilities of future outperformance seem to be stacked in favor of the sector and we think there are also specific opportunities within the space. For example, midstream stocks were sold off in sympathy with the market but they carry modest exposure to the price of the commodity; large midstream companies with good balance sheets provide value. Some examples are: OKS, WPZ, EPD, WMB and ENB.
Major integrated companies also provide value given their diversified operations (upstream, midstream and downstream). Once again companies which are diversified and have strong balance sheets would seem attractive:
- XOM
- Superior capital allocator which has historically delivered higher ROC relative to peers
- Best value creator out of upstream and downstream chain
- Strong balance sheet
- CVX
- Strong balance sheet to protect dividend
Other possible selected value plays are:
- OXY
- Morningstar fair value at $99 estimating crude at $67 for 2015.
- Permian position provides decade’s worth of low cost unconventional drilling inventory.
- It has already streamlined its operations
- $4 billion stake in PAA GP.
- PSX
- Refiners benefits from lower crude prices
- Morningstar fair value is $89
- Entered 2 joint ventures to build pipelines from the Bakken to the Gulf Coast
- EOG
- Best operator in the business (cost control)
- Diversified portfolio
- Morningstar fair price is $100 in light of new crude correction
As the Baron Rothschild famously once said: “Buy when there is blood in the street…even if the blood is your own….”