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Investing in a Weak Energy Market
10/19/2015 10:00 am EST
A prolonged period of weak commodity prices does not necessarily mean there are no long-term opportunities in the energy sector to consider according to Elliott Gue. Here, the editor of Energy & Income Advisor discusses the outlook for oil, a favorite hedge to protect against another down leg, and two favorite oil firms for long-term investors.
Steven Halpern: Joining us today is energy sector expert, Elliott Gue, editor of Energy & Income Advisor. How are you doing today, Elliott?
Elliott Gue: I’m doing well, thanks for talking to me.
Steven Halpern: Well, thanks for joining us. You’ve been spot on in your energy forecasts, first calling for the sharp decline we saw over the past year and then forecasting the temporary recovery. Here, however, you caution your subscribers that there will likely be another down leg. Could you expand on that?
Elliott Gue: Sure. Well, you know, oil prices fell sharply through most of the summer from late- or mid-June highs around $62 a barrel, all the way down into the 30s. Then, we’ve seen about a 30% recovery from those August lows up to recent highs. I think the majority of that is due to short covering.
What I mean by that is that futures market participants, in particular, hedge funds, had a large short position in oil in August. On August 11, they were short the equivalent of over 160 million barrels of West Texas Intermediate Crude Oil. Most of those positions were taken out between mid-June and the end of July, meaning that those hedge funds were sitting on literally billions of dollars’ worth of profit.
Whenever you have that large a short position out there—and that’s near a record large level—there’s a temptation to cover those shorts and take profits on those trades. When you cover a short, that means buying back oil.
What I think we’ve seen is since August 11, we’ve seen the short position of hedge funds decline to about 108 million barrels, so it’s come down more than, roughly on the order of 50 million barrels and there’s probably a bit more to go.
I think that’s been the main driver of it. Certainly, no change. No positive change in oil market fundamentals. I think that it's really a fake out and I would advise investors not to get sucked in. I think we’re going to see lower lows for oil either late this year or early next year.
Steven Halpern: Now, interestingly, you’ve noted that Select Energy stocks can do well even in a prolonged period of weak commodity prices and you pointed to the period from 1989 to 1995, as an example. Can you explain why you highlight this period?
Elliott Gue: Absolutely. I think the biggest mistake—and a lot of pundits make this mistake—I think the biggest mistake a lot of people have made is to compare the current down cycle in energy to the most recent down cycle in energy, which occurred, of course, in 2008 and 2009, amid the global financial crisis and Great Recession.
It's what psychologists call a recency bias, meaning that humans tend to look for recent patterns and project them into the future. The reality is that the decline in 2008-2009 was primarily driven by demand.
There was a global recession, a global financial crunch, demand collapsed, but then—as the global economy recovered in the back half of 2009 and the front half of 2010—oil demand snapped back and oil prices soared again. It was what we would call a V-shaped cycle. Oil went straight down and went straight back up again. Energy stocks followed suit.
A lot of investors and pundits looking at that cycle have been, basically, continually advising since early 2015 and late 2014, that investors buy the dip in energy in anticipation of the other side of that V, that recovery. The reality, though, is that this is a supply-led cycle.
The basic problem is a surge in supply from non-OPEC countries. In particular, US shale fields, like the Bakken shale and the Eagle Ford shale. Then, Saudi Arabia’s decision late last year, late in 2014, not to accommodate that growth in non-OPEC production. In other words, Saudi Arabia isn’t willing to cut its own production in order to absorb the excess supply coming from countries like the US.
We’re seeing this cycle...the last time we saw a cycle like that, a cycle led by excess supply rather than a temporary dip in demand, was the 1980s. Oil prices topped out in 1980 and then oil prices really accelerated on the downside in 1985, 1986, when Saudi Arabia did exactly the same thing. They stopped accommodating growth in non-OPEC production.
I think that period is actually very, very relevant to look at. You want to look at what happened in the late 1980s and the mid-1990s. What happened was oil prices didn’t do much at all over that period. However, big energy companies that were well capitalized or had solid fundamentals did quite well.
Companies that had the financial ability to weather the downturn, take advantage of low asset prices to make acquisitions, and also to continue to earn decent returns, even at lower commodity prices, did extraordinarily well. In some cases, the stocks handily beat the S&P 500 over that time frame. I think that’s, by far, the most relevant cycle to look at. It’s most similar to what we’re seeing today.
Steven Halpern: So, benefitting from this outlook, you’ve suggested looking at companies, as you mentioned, with strong balance sheets, low production costs, and solid assets, and in particular, you’ve highlighted two large-caps, the first being Chevron (CVX). What’s the story here?
Elliott Gue: Sure. Chevron, of course, is a big integrated US-based big, integrated oil company. What we’re seeing with Chevron—and most of the big oils—is that they’re moving from what we call the investment phase to what we call the exploitation phase. What that means is that when oil prices were rising over the last, generally, over the last ten years or so, these companies really ramped up their capital spending.
Chevron really ramped up its capital spending on new oil field production projects all over the world. Now, with oil prices collapsing, they’re responding by cutting their capital spending.
A lot of those projects that they’ve already invested in are due to come on stream over the next few years. Even though they’re not going to have to invest much, those projects that they’ve already funded are going to see growth; they are going to bring some significant growth and production over the next few years.
If you think about that, that’s really good for cash flows. You have falling capital spending because they’re not spending as much on exploration and development, coupled with rising production from these fields. We’re looking for output to increase at Chevron by about 17% from 2014 to 2017. That’s pretty solid growth.
They have a fairly low cost of production. They also have a very solid position, which I think is often overlooked in the US. Almost a third of their production comes from the US, in particular, places like the Permian Basin of West Texas and New Mexico, which is a really hot area, in terms of shale development with a very low cost of production.
Chevron also has a debt-to-assets ratio of around 10%, giving them the financial ability to go out and acquire acreage from distressed producers in places like the Permian Basin. They can actually take advantage of low energy prices to get bigger and more powerful and set themselves up well for an eventual recovery in commodity prices.
Steven Halpern: Now, you also see a similar situation with the French-based energy firm, Total (TOT). What’s the attraction in that situation?
Elliott Gue: Very similar story for Total. Total is, as you mentioned, is a France-based energy company. They have a little higher debt-to-assets ratio than Chevron, it’s about 24%.
But they’re also going to see an even bigger decline in capital spending over the next few years. Their capital spending was about 30 billion in 2013, fell to 26 billion last year, probably around 23 billion this year, and less than 20 billion by 2017.
So, capital spending is falling by about $10 billion a year over that period. At the same time, they have a lot of projects that they funded during the boom years which are now ready to go into production. They’re going to see significant production growth going forward.
The other thing I like about that name is that because it's based in France, it tends to trade at a discount to a lot of the US energy oil majors. There’s no reason for that because if you think about it, oil is traded in dollars so they earn revenues in dollars, not euros. They’re a global company. They have very little operations, very little operation in Europe at all. It’s primarily outside Europe.
We think that’s a good buy, but with both of these companies—both Chevron and Total—we would say wait for a dip. We think there’s going to be at least one more big downturn in oil prices over the next six to nine months. We would look to buy Chevron under $65 a share and look to buy Total—their American depository receipts—under about $35 a share.
Steven Halpern: Now, in light of your forecast for another dip down in oil, you’ve recommended that a way to hedge an energy portfolio is via an ETF called ProShares UltraShort Oil and Gas (DUG). Could you explain how investors could use this ETF to their advantage?
Elliott Gue: Absolutely. One of the problems is that in extreme sell-offs, where oil is falling very rapidly and energy price—and energy stocks, rather—are following suit, all energy stocks tend to fall. It doesn’t matter whether they’re fundamentally strong or shaky. They all tend to fall. The correlation becomes very high. There’s really no way to protect yourself against that by focusing only on quality companies.
Now, eventually when there’s a recovery, those quality companies will do a lot better, but there’s no way to fully protect yourself from that decline, other than to take on a hedge.
That hedge is the ProShares UltraShort Oil and Gas Fund. It goes up in value by about 2% for every 1% decline in the Dow Jones US Oil and Gas Index. Just, basically, a broad-based index of energy companies.
What we recommend is taking advantage of these rallies in crude oil and crude oil prices this fall, which we’ve seen lately to take...to buy some of this ETF under the symbol DUG.
What’ll happen is if oil prices fall as we expect into early next year, bringing down most energy stocks with them, this ETF should gain in value. Remember, it goes up when oil stocks go down. That’ll offset some of the pain of holding on to a large energy portfolio.
A lot of investors don’t want to sell out of all of their energy stocks. If you’ve owned a company like Chevron or some of the master limited partnerships since, say, the 90s or even the late 80s, you’re probably sitting on huge capital gains, you don’t want those massive capital gains liabilities by selling out of those stocks.
Buying a little bit of DUG to hedge your downside risk over the next six to nine months, I think, is going to be a good bet and will shelter you from that decline.
Steven Halpern: Well, it’s always fascinating to hear your thoughts. Again, our guest is Elliott Gue, of Energy & Income Advisor. Thank you so much for your time today.
Elliott Gue: Thank you very much.
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