What's Next for Energy?

12/21/2015 10:00 am EST

Focus: ETFs

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

Energy guru Elliott Gue has been spot on in his forecasts for oil, previously calling the long-term upcycle and then accurately forecasting the current, ongoing decline. We talk with the editor of Energy & Income Advisor to get his road map for the year ahead and a look at some favorites on his watch lists.

Steven Halpern: Our guest today is Elliott Gue, energy sector expert and editor of the Energy & Income Advisor. How are you doing today, Elliott?

Elliott Gue: Great. Thanks for interviewing me today.  

Steven Halpern: Now, you’ve shared your thoughts on the energy sector with our listeners over the past few years and consistently kept them on the right side of this trade. In fact, you were bullish during the long uptrend and then predicted the major decline over the past year. With prices now in the 30s, have we seen all the downside risk?

Elliott Gue: I don’t think we have. In fact, I’ve been saying for some time I thought oil prices would get down to about $30 a barrel at some point towards the end of this year or early in 2016. I now think we are actually going to go a little bit lower than that in the short-term. I think we are going to get all the way down to $20 to $25 a barrel.  

The main reason has to do with oil inventories here in the US.  We are looking at inventories of about 120 million barrels above the seasonal average for this time of year, and in fact, some of the key oil trading hubs in the US such as Cushing, Oklahoma are nearing their full capacity, are nearing maximum capacity.  

What really has to happen is oil prices need to drop down low enough in the short-term that it actually causes producers to shut in their existing wells. Remember that oil prices around $40 or lower are low enough that most producers can’t make money drilling new wells.

So we’ve seen the US oil-directed rig count—the number of rigs drilling for oil—absolutely plummet over the last 18 months or so, but even at $40, $45, a lot of producers can still make money on existing wells because the cost of drilling those wells is already a sunk cost, it’s already factored out of their profit from existing wells.  

We need to get that oil price down to a level which is below their variable costs so that they actually can’t even make money producing oil from existing wells.  I think that’s the only way that we are going to be able to slow down the flow of oil into US oil inventories which are already getting near capacity.  

|pagebreak|

I think that cash cost level is somewhere around that $20 to $25 a barrel range.  I think we’ve got a lot more downside here in the first part of 2016, fortunately, I think things get better thereafter.  

Steven Halpern: Now, despite the drop we’ve seen so far, there have been few headlines about oil firms going out of business. If, in fact, we go down into the 20s, as you foresee, would you expect some of those headlines to change?

Elliott Gue: I think we are going to see more bankruptcies though. We saw, just the other day, Magnum Hunter Resources announced they are going bankrupt.  No big surprise there.  I think we are going to see more among the heavily leveraged firms.  In fact, I think that’s really a necessity before we get to a low.  

What happened was, a lot of these producers took on tremendous amounts of debt to try to fund drilling activity in the shale fields, like the Bakken Shale of North Dakota, you know, the Eagle Ford Shale in Southern Texas, the Permian Basin of West Texas, and that made a ton of sense when oil prices were at $90, $100, even $80 a barrel, but it makes pretty much zero sense at current prices and they are going to struggle unless we get a very rapid recovery in oil prices to continue servicing that debt.  

I think this is what typically happens in oil down markets.  If you go back to the late 1980s early 1990s, which was kind of the last time we saw a supply lead down cycle in crude oil, you saw a lot of bankruptcies and those assets, that acreage that these companies owned or leased, all their assets passed from those weak hands, those over-indebted hands to the strong players.  

Companies that have not a lot of debt or a lot of cash on the balance sheet, companies that did not borrow aggressively to fund expansion during the boom years, they are really in the cat bird seat here, because they are going to be able to go out and buy up these distressed companies, these companies they are going to buy up out of bankruptcy, assets they are going to buy up out of bankruptcy at fire sale prices.  

They will be able—without all that debt—to actually make money on those assets even if, as I expect, oil prices are going to remain lower for longer.  There really are companies that benefit from this just like there were back in the 80s and 90s.

Steven Halpern: Now, while over the past year while energy has been falling, your subscribers have benefited from a number of trades, in fact, trades that you have shared with our audience in the past, such as cruise lines and airlines and sectors that have done well in a declining energy cost environment. But I understand you’ve recently sold those hedges. Could you explain why?

|pagebreak|

Elliott Gue: Sure, absolutely. Those companies definitely do well in a declining oil price environment, airlines, cruise lines. They benefit both from lower cost, lower cost of buying fuel, and also higher demand, because as consumers spend less money on energy, they have more money in their pocket to spend on other things like going on a cruise in the Caribbean or flying around the country and traveling and going on holiday.  We certainly saw that over the last year.  

Here’s my problem. I see a lot of these companies getting a little expensive. That was an out-of-consensus view a year ago that those companies would do well.  A lot of people thought consumer discretionary was a bad place to be a year ago but now it’s kind of the consensus view.  It’s a very crowded trade and so the evaluations are much higher than they were a year ago or 18 months ago.  

The second thing is I’m very concerned about the broader stock market and economy going into 2016.  We’ve see on the rallies—that we’ve seen over the last six months or so since the market hit its highs in May—we’ve seen fewer, and fewer, and fewer stocks participating in those moves.  Most recently, as the market was strong in November, we saw really less than 40% of New York stock exchange stocks are actually trading above their 200-day moving average.
We’ve seen that decline in breadth.  

I also have a lot of concerns about the economy.  I think there is a very cozy consensus out there, kind of a groupthink that the US economy is going to grow about 2.5% again in 2016 just like it did in 2015 and I just think there is a lot of downside risk to that.  

If you look at the data on manufacturing activity in the US, we’re already in a recession on the manufacturing side of the economy and we are getting some early signs that the services side or non-manufacturing side of the economy is following suite and also weakening.  

I think there is a lot of downside risk to those economic growth forecasts for 2016 and I think we will probably see a bear market in the S&P500 at some point in the first half of 2016 that could take us down 20% to 30% on the S&P500, and you know, no stocks are really going to be able to completely withstand that selling pressure for the broader market.  

Now I’m recommending that—rather than buy names like the airlines and the cruise lines—if you want to hedge your exposure to energy stocks, I like some of these inverse ETFs, like the ProShares Oil & Gas Ultra Short (DUG).

It’s an ETF that tracks the inverse performance of the Dow Jones oil & gas index.  When the Dow Jones oil & gas index goes down by 1%, that ETF goes up by 2% in value. I think that’s a great way to hedge your exposure through the first half of 2016.

Steven Halpern: Now, I know from what you are explaining that it’s too early to really talk about what oil stocks people should be buying, but I was wondering if you could highlight a few of the names that you would keep high on your watch list. The ones that you would expect to buy when the next upturn in the energy cycle does unfold.  

|pagebreak|

Elliott Gue: Yes. Well, I would look at some of the names that don’t have a lot of debt. Companies that don’t have an awful lot of debt, that have cash on their balance sheet. That still have access to credit if they need it. These companies in the energy industry are really going to be in the cat bird seat as we head into this very weak period for oil prices.  

They are going to be the ones that are going to be able to go out there and buy up these high quality assets that are owned currently by very distressed owners, these companies that have too much debt.  

Basically, these really high quality assets are going to pass from the weak hands to stronger hands, and historically, and again, go back to the 80s and early 90s and you will see exactly what I am taking about.  

The buyers, the companies that are really financially strong—that could take advantage of the declines in asset values, take advantage of these fire sale prices—they did very, very, very well. They actually beat the broader market over this time period even though oil prices remained very low and kind of in a trading range.  

A couple names I would be looking at, one is EOG Resources (EOG), an outstanding US-based producer. They have exposure to several different big shale fields including the Bakken Shale of North Dakota, the Permian Basin of West Texas, the Eagle Ford Shale of Southern Texas, and even some exposure to the Marcellus Shale gas field in Appalachia.  

They don’t have a lot of debt.  They have a net cash position. They have a very high credit rating if they wanted to borrow more and they’ve also done an amazing job bringing down their cost structure.  

A few years ago they were making…in 2012 they needed $95 a barrel or $90 to $95 a barrel oil to make the same returns on wells in the Bakken Shale that they can now make the same returns with $50 oil.  That’s an amazing increase in efficiency.  I would look to buy that stock on any dips to the low 60s or the $60 to $65 level, that’s kind of my dream price on that name.  

Another name on the midstream side I like a lot is Enterprise Products Partners (EPD). The master limited partnerships like Enterprise have really been hit this year, partly due to the energy price collapse and partly due to turmoil we are seeing in the junk bond market, which has spilled over to the MLPs.  

This particular MLP though is very well-positioned.  In particular, I like their exposure to the energy export market.  In particular, on the Gulf Coast they own a lot of dock space that can be used for exporting natural gas liquids like propane and ethane.  

Also, with Congress now likely to repeal the crude oil export ban, I think they are going to be a major beneficiary of that. I wouldn’t look to buy it right here, but under $20 a unit I think Enterprise Products Partners is a screaming buy.  

Steven Halpern: Again our guest is Elliott Gue of the Energy & Income Advisor.  Thank you so much for your insights today.

Elliott Gue: Thank you for having me.  

Subscribe to Energy & Income Advisor Here…

Related Articles on ETFs

Keyword Image
The Omen
12/07/2017 10:50 am EST

The probability of an equity market correction over the next few months is slim to none, so there co...