Stocks have suffered lately, with year-to-date returns for U.S. equities once again negative. The most recent driver of the sell-off, and accompanying volatility, hasn’t been fears of a Federal Reserve (Fed) rate hike, but rather collapsing oil prices and the implications for energy-related debt.
Paying less at the pump might seem like a good thing for consumers, but the recent drop in crude prices has reinforced fears over slow economic growth and deflation, placing pressure on a range of asset classes related to energy.
According to Bloomberg data, amid concerns over energy issuers in the high yield market, high-yield spreads continued to widen last week. The fall in oil is also putting more pressure on already battered emerging market oil-exporting currencies, including those of Mexico, Russia and Columbia. Finally, and not surprisingly, any company in the energy space is feeling pressure. This includes not only oil production and service stocks, but also Master Limited Partnerships (MLPs).
However, while market sentiment has certainly turned more negative lately, many investors are wondering if it’s time to start bottom fishing, especially with regards to beaten-up energy assets.
Considerations for Energy Sector Stocks
My take: Though I would remain cautious toward the commodity and believe energy-related names are likely to come under more short-term pressure, I do see longer-term opportunities for those with little or no exposure to energy stocks.
The near-term risk for investors is that, regardless of the particulars of the business model, any stock even tangentially related to oil or energy is being thrashed. This is likely to continue to the extent oil prices have more downside. In fact, given the abundance of supply and bulging inventories, I’d be hesitant to call a bottom in oil prices.
While I believe that oil supply and demand will start to balance toward the middle of next year, absent a supply disruption from the Middle East or a much sharper deceleration in U.S. production, the simple truth is that there’s still too much oil supply relative to demand.
The outlook for Middle East supply remains undimmed, despite growing geopolitical risks. The Organization of the Petroleum Exporting Countries (OPEC) is unable to even set a production target, and Saudi Arabia and Iraq are producing record amounts of oil. Even a country like Libya, with no functioning national government, has dramatically increased production in recent months.
Making matters worse, non-OPEC oil production has remained resilient. In an attempt to generate much needed revenue, Russia is pumping a record amount of oil. In the U.S., while production has pulled back from the spring peak, production cuts have been modest thanks to improving efficiency. The number of U.S. rigs is down more than 60 percent from its 2014 peak, but U.S. domestic production is off by less than 5 percent, according to data accessible via Bloomberg.
Nor is a surge in demand likely to quickly rescue oil markets. For 2016, global demand growth is estimated to fall to 1.2 million barrels per day (bpd) from 1.8 million bpd this year, as data via Bloomberg show. It will take time to balance out oil markets, assuming we don’t see a more meaningful disruption in supply or a spike in demand, which is unlikely given the sluggish pace of global growth.
However, while an imminent V-shaped recovery in physical oil looks unlikely, some of the stocks in this sector may still represent a good long-term opportunity, especially considering that energy-sector valuations are now the cheapest we’ve seen in decades, according to data accessible via Bloomberg. There are two places in particular investors underweight the energy sector may want to start looking to add positions: U.S. drillers levered to low cost production sites and midstream MLPs.
1. U.S. drillers levered to low cost production sites
The cratering in oil prices is hurting any and all energy companies, but I believe those with lower production costs, such as Exploration & Production companies focused in the Permian Basin in west Texas, are better positioned to ride out a period of depressed oil prices.
2. Midstream MLPs
While MLPs aren’t immune to the energy market, as evidenced by the recent 75 percent dividend cut by Kinder Morgan, many MLP businesses are focused on natural gas storage and pipelines. These midstream businesses are less exposed to the daily fluctuation in oil prices.
The bottom line: While the energy sector comes with considerable near-term downside, the key for the long term is selectivity and a focus on those names best positioned to survive, or even thrive, in what may be a prolonged period of low energy prices.