West Texas Intermediate crude oil (Dec’14) fell under $75 per barrel today, now almost $30 lower than its 52-week high, reaching the lowest level since September 2010. Brent crude also fell to a four-year low. We view the move in crude as a net-negative for the economy and S&P 500 earnings, even though many from transportation to retail will benefit from lower energy costs. The energy sector accounts for roughly 10% of the S&P 500 (SPY), and ExxonMobil (XOM) and Chevron (CVX) top the index’s top 10 holdings.
We think falling crude oil prices are more a reflection of expectations for declining global economic activity, which in itself, signals that trouble is on the horizon. North American shale production continues to climb, and concerns regarding growth in emerging markets and China have created a perfect storm in the oil markets. All of this has offset ongoing geopolitical uncertainty as the Russia/Ukraine drama continues, perhaps indicating that the true price of crude oil (excluding any geopolitical premium) is much, much lower. Our comprehensive outlook for oil and gas prices, released June 2013, eerily predicted the slide in crude, though we’ve been a little light on the magnitude to the downside. Present crude oil prices reside between the base and downside case at the moment.
Image Source: Valuentum’s Comprehensive Outlook for Crude Oil and Natural Gas Prices
Refiners may benefit from lower feedstock costs (crude is an input), but slowing demand for refined products—one of the reasons for the declining crude oil prices in the first place—could mitigate aggregate earnings expansion for the group, despite an improved refining margin. Equity prices for a large portion of the refining industry have already surged thanks in part to the proliferation of advantaged crude (heavy crude oil from Canada and Latin America, lighter Canadian grades, and WTI), which sells at a discount to crude oils tied to the global benchmark, North Sea Brent.
The Dividend Growth portfolio benefited significantly from CononoPhillips’ spin-off of Phillips 66 (PSX). Though Phillips 66 estimates that “a savings of $1 per barrel across (its) refining system is worth about $450 million of net income,” we’re not anxiously running out to add the company’s shares back to the portfolio. Given that mid-cycle refining margins can be incredibly difficult to predict, a large margin of safety for the group is par for the course. Said differently, the range of probable fair value outcomes is large.
In an environment with falling crude oil prices, constituents in the energy sector will look to combine operations to save on redundant costs and overhead. Almost without delay, news hit the wires that Halliburton (HAL) is looking to buy Baker Hughes (BHI) in a deal that could mark one of the largest in recent years. Terms of the deal haven’t been disclosed, however, and finalization remains uncertain, but there’s plenty of room for negotiation. We value Baker Hughes closer to $70 per share, materially above its ~$59 per share closing price.
The oilfield services firms may not be the only ones looking to tie the knot, however. We continue to believe that two of the fastest-growing independent exploration and production plays Continental Resources (CLR) and EOG Resources (EOG) may be a part of another larger entity’s operations in coming years. These two firms have access to enviable positions in the Bakken and Texas Eagle Ford Shale (respectively) that larger entities would love to get their hands on, in our view. Though perhaps less likely (given the size of such a transaction), there’s even talk of struggling BP (BP) being ripe for a takeover itself. BP has been dealing with lingering troubles and poor PR from the 2010 Gulf spill, and new ownership could alleviate some of the pain. ExxonMobil, Royal Dutch Shell (RDS.A, RDS.B), Total (TOT), and Chevron could all be considered potential suitors.
As for the newsletter portfolios, we’ve successfully steered clear of the crude oil price drop and its ramifications on equities across the energy sector. We removed the lone refiner idea Phillips 66 from the Dividend Growth portfolio a number of weeks ago, and we currently do not have any energy exposure in the Best Ideas portfolio, absent the Utilities Select SPDR (XLU). It’s not that we don’t necessarily like the other majors, but Chevron is our favorite dividend growth idea in the sector, given its best-in-class balance sheet, as measured by its manageable and negligible net debt position relative to its peers. A resilient balance sheet is a necessity for dividend payers in commodity-producing industries. Chevron yields ~3.6% at last print.