Beneficiaries of Weak Oil

08/05/2015 10:00 am EST

Focus: STOCKS

Roger Conrad

Founder and Chief Editor, Capitalist Times

For those looking to hedge a long energy portfolio or speculative on declining oil prices, Roger Conrad of Energy & Income Advisor discusses a trio of ideas that are positioned to perform strongly in a weak energy environment; here, he looks at an airline stock, a leading cruise line, and an ETF that rises when oil prices fall.

Steven Halpern:  Joining us today is Roger Conrad with Energy & Income Advisor. How are you doing today, Roger?

Roger Conrad:  Great, Steve.  

Steven Halpern:  Energy markets are highly cyclical, and as a result, you suggest that a review of history will help provide a working roadmap to understand what potentially could be ahead.  Could you extend on that?

Roger Conrad:  Well, you know, speaking just in terms of just of energy, which we spend a lot of time covering in our Energy & Income Advisor at Conrad’s Utility Investor and Capitalist Times, energy’s a cyclical industry in that prices tend to surge for a period of years and then fall off for a period of years.  It follows supply and demand.  

What we try to do at our publications is keep that in mind, look for companies to hold long-term positions in that will finish every cycle in stronger shape, but also try to take a look at where we are in the cycle, try to forecast a little bit here and adjust our portfolio accordingly.  

Not every energy company responds negatively to falling energy prices. Some companies, in fact, benefit when the price of a raw commodity drops. Those are the positions that we’ve been emphasizing, actually, over the past year.  

We began to get a little bit bearish on where energy prices were going to go—particularly oil—at the beginning of 2014.  We’ve adjusted our portfolios accordingly, and it’s, you know, pretty much a lot of investors just sell everything to do with energy but we are seeing a number of positions that we’ve had over the past year or so do pretty well in an environment of low energy prices.

Steven Halpern:  Now, in terms of that cycle, do you see the potential for continued weakness in oil prices at least over the short- to intermediate-term?

Roger Conrad:  We do.  We haven’t quite seen the kind of supply response that you would expect to see in a downturn.  A lot of people—particularly in the industry, not just investors—have viewed the declines that began last summer as a repeat of what we saw in 2008, 2009 when we saw a tremendous drop off in demand and expectations for demand as the credit crunch set in.

But we got out of it pretty quickly, because as the Fed started pumping up the money supply and expectations for demand started coming back, prices rebounded very quickly.  

This is a little bit of a different decline in that it’s caused more by heavy supply coming on the market. The US is really been a phenomenal growth story, but you look at other places around the world—particularly in Saudi Arabia where they’re worried about losing market shares—you’ve had something of a war between producers and the Saudis haven’t cut back production. The US hasn’t yet.  

While we do see what you might call the mother of all buying opportunities at some point here, our view is that oil’s going to come down a little bit more and we’re going to see a little bit more of or perhaps considerably more of an adjustment in the industry.  

Some companies simply aren’t going to make it.  Some companies will emerge in better shape than ever. Some companies will profit from the low price environment.  

Again, like I said, those are the situations we want to be in as prices stabilize. We’re looking for prices to come down probably a little bit more in the near term, but more importantly to remain at a fairly low level over an extended period of time the next couple of years.

We’re not really buying into those $10 to $20 dollar per barrel forecasts that we’re starting to see some places or the thesis that no recovery is possible for another ten years. Keep in mind that the consensus was for $100 oil to last forever about a year ago. That’s more of an emotional response, I think, those types of forecasts.  

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Again, we are looking forward to seeing a little bit more weakness and we’re looking forward to seeing a better buying opportunity in the more cyclical names. In the meantime, again, we want to look at the companies that are well positioned for, at least, a couple of years more of a weak pricing environment.

Steven Halpern: Now, I’d like to touch on a fascinating article you had in the recent Energy & Income Advisor where you recommended a trio of hedges that are a way to hedge the downside risk you see in oil overcoming months that, I guess, in a way, would allow people to maintain their longer-term energy positions.  One of those is the ProShares UltraShort Oil and Gas ETF (DUG).  What’s the benefit of this position?

Roger Conrad:  Well, ProShares—we generally recommend people own for their long-term positions individual stocks—but these ProShares exchange-traded funds are very innovative in that they give you actual leverage on various positions so you can go long in a leveraged way, and with the UltraShort Oil position, you’re basically in a trade where you can buy this.  

It’s not like you’re actually taking out leverage or be in a position as you were with an option where you have a finite time period for something to work out. You’re basically just in something that trades like a stock but it goes up two percentage points for every one percentage point oil prices come down.  

I think you can see how effective this can be as an additional position for you.  If you have a large position of good oil companies, or say even good midstream pipeline owning master limited partnerships, you’re worried about oil prices coming down and taking the value of your positions down.  

You can take a little position here, and when oil prices come down, the value of your portfolio is probably going to come down, but this particular ETF is going to go up again in a leveraged way two percentage points for every one percentage point decline in oil.  There are a couple of other vehicles out there too.  

ProShares also has a long fund, a long ETF, ProShares Ultra Oil & Gas (DIG). The short ETF, DUG, again, is set up to rise two percentage points for every one percentage point decline in the Dow Jones Energy Index.  

Again, it gives you a nice way to protect your overall portfolio value at a time when prices are volatile and we’re probably going to see some more downside, even in those really good names that we don’t want to sell.  

One advantage when we do get to that buying opportunity, this thing is going to probably be on much higher ground and selling it will make a ready source of cash for picking up positions in what will be lower price energy stocks, best-in-class companies selling it at good prices.  

A lot of people say, "Well, I already own so many energy stocks, it’s going to be hard to buy more at the bottom." If you take up position in one of these short funds, you can protect the overall value of your portfolio, and again, save yourself a lot of cash to come in with and make some good trades at the bottom that are really going to help you as we get into the next cycle.  

Steven Halpern:  Now another hedge you recommended since early last year is buying the shares of American Airlines (AAL).  Could you explain how this stock acts as a hedge for energy investors?

Roger Conrad:  Well, you know, airlines consume a lot of energy, a lot of fuel, jet fuel primarily. The price of jet fuel does follow the price of oil so when oil prices are surging, airlines tend to suffer.  They can only pass so much of that fuel cost along to passengers in terms of ticket prices and so forth given the competition that we now have. Those tend to be bad times.  

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Conversely, when oil prices come down, the price of jet fuel comes down.  It’s a big shot in the arm for airlines.  Their costs suddenly drop and these earnings tend to do extremely well in those periods, so the stocks tend to do pretty well in those periods.  

American Airlines, which, of course, has been taken over by US Airways and now it’s basically what you see there, the stock is US Airways—although they changed the name—it’s done fairly well for us if you look at a chart, particularly when oil prices have been coming down.  Of course, we had a recovery of sorts in early part of this year in oil coming up from the low $40s to around $60 where it hung in for a while.  

American Airlines, other airlines came down on that news. Now that we’re seeing oil prices coming down again, these stocks have benefitted.  Airlines are one good way to do that.  

We like fuel distributors too.  Not quite as aggressively positioned against energy prices, but fuel distributors benefit when there’s more demand for fuel.  They tend to pass along the cost of the wholesale price of gasoline or other fuels that they sell.  

When those prices come down people use more energy, they use more gasoline. This has been actually a pretty good driving season.  Businesses that work on volume—like these distributors—tend to do pretty well in those environments.  Again, those are the types of stocks that we’ve been talking about I guess for about the past year.  We think that those are still pretty good places to be.

Steven Halpern:  Is there a name in that area that you would suggest for listeners?

Roger Conrad:  Well, there are a very large number of companies that are in this business.  One that we like because of its association with the Energy Transfer (ETP) family is a company Sonoco LP (SON).  Energy Transfer Partners, for those that are unfamiliar, are a very aggressive acquirer of other MLPs.  

We’re looking for them to make another major acquisition at some point here. They had made a bid for Williams Company (WMB).  Most recently, they acquired some fuel distributors and they packaged them together in Sonoco LP.  This one yields about 6.5%.  

Again, they’re adding assets.  Their May dividend was $0.645.  That was up from $0.60, which was the February dividend.  They’re growing their distribution at a pretty fast pace, actually, 21% over the past 12 months.

Really nice package there again in a business that is going to benefit the longer energy prices stay down.

Steven Halpern:  Now, finally, I’d like to touch on Royal Caribbean Cruises (RCL), which you’re also recommending as a hedge.  I guess the theory there is similar to American Airlines in terms of the cruise industry being a heavy user of energy.  

Roger Conrad:  Yeah, that’s definitely part of it.  The other part of it is that when energy prices come down, gasoline prices come down.  It puts money in consumer’s pockets so we’ve also taken a good look at industries that benefit from more money being available for the consumer.  

The telephone business is actually one with wireless areas, but also the leisure business, and this is, again, you’ve got kind of a double leverage to low energy prices.  

People maybe feel a little more flush here as the economy picks up a little bit with these lower fuel prices.  Maybe not if you’re living in an area where the economy depends on energy production.  

Certainly, most of the country is benefitting from lower gas prices and where are they going to spend that money? Probably on vacations as well as other items that are maybe a little more fundamental like data usage and movie downloads for cell phone companies.  

Steven Halpern:  Well, it’s always fascinating to hear your thoughts.  Thank you so much for taking the time today.  

Roger Conrad:  Hey, thank you for calling.

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