By Brian Nelson, CFA
The first full week of 2015 was a wild one! Monday and Tuesday brought some hefty losses to the indices, but the middle of the week helped recover most of the ground, only to give some of it back Friday. When all was said and done, however, the S&P 500 still closed comfortably above 2040, a huge leap from just 5-6 years ago. We’re still enjoying the good times, with economic data still coming in relatively sanguine. Like a frog in water, the markets are just waiting for the next shoe to drop, and the Federal Reserve is doing all that it can to assure investors that the Yellen-put is there to prop up the markets should anything adverse happen.
But the next shoe is already here. I have to admit that the drop in WTI (NYMEX) crude oil has been quite frightening, revealing the degree of the fragility of the energy markets, which remain dominated by OPEC decisions. Member nations of OPEC know that they can survive longer than the publicly-traded companies located in the shale-rich regions of North Dakota—firms such as Continental Resources (CLR) and EOG Resources (EOG)—and would much rather engage in a race-to-the-bottom pricing war to drive production declines at US-based rivals than cut production themselves. US oil production is near 30-years highs thanks to shale oil in Dakota and Texas. Why should OPEC cut, member nations argue. OPEC has also learned from past episodes when their production cuts only resulted in their own lost market share, not necessarily the type of price response they had been hoping for. Investors need to accept that there is “no chance of (an) OPEC cut,” and that’s after oil dips below $50. Defending market share is the name of this new game, not supporting prices, and it appears the energy markets aren’t ready to play.
Image Source: Nasdaq
To us at Valuentum, the facts that the oil and gas markets are highly volatile and a range of probable outcomes for crude oil and natural gas prices is simply common sense are not news. To the end user, crude oil is an undifferentiated commodity, whose refined product pricing is driven simply by supply and demand. With OPEC showing no signs of letting up and the US-based shale plays and West Texas Eagle Ford participants enjoying new discoveries of “black gold,” the energy markets will be stuck between a “rock and a hard place” for some time. But supply isn’t the only thing working against the energy markets. Concerns over emerging market demand are real. From our perspective, we haven’t seen anything yet. If the high-$40s mark for a barrel of crude oil is frightening to you, that level only takes us back to 2009 levels. For those that have been in the business as long as I have, I remember there was a time (actually, not too long ago) when we used to think that $50 crude oil was impossible to the upside. Trust me, we can still go lower, and I wouldn’t think anything of it, even if it is a bit scary.
Image Source: Macrotrends
So how are we playing the oil and gas markets these days (as if it is a new question to ask)? Well, the answer is rather simple: the same way that we’ve been doing it since we founded Valuentum. First, we know that crude oil is but an undifferentiated commodity whose price is dictated by an overseas cartel, and as such, we’d only allocate capital commensurate with this particular risk profile. Said differently, we’ve only been and are still only modestly exposed to the energy markets. Much to the dismay of some members, for example, we removed ConocoPhillips (COP) from the Dividend Growth portfolio in the low-$60s in May 2013 and reinvested those proceeds that July 2013 in Apple (AAPL) at a split-adjusted price of about $63 per share. Apple is now over $110 per share, while ConocoPhillips is pretty much at the same price. We removed Phillips 66 (PSX) at $81.43 per share from the Dividend Growth portfolio more recently, and its shares are now trading under $68 each. Too bad the perma-energy bulls never will understand that we have a birds-eye view of the markets and are not limited to investments in energy-linked entities. They’re not reading this anyway.
But to the question: where are we exposed? Only Chevron (CVX), Energy Transfer Partners (ETP) and Kinder Morgan (KMI) are included in the Dividend Growth portfolio, and we have zilch, zero, nada in the Best Ideas portfolio, albeit we do include General Electric (GE), which recently doubled-down on energy with its Alstom purchase. We’ve said this many a time already, but we like Chevron because it has the least amount of net debt among the majors, and we like Kinder Morgan and Energy Transfer Partners the best because their business models are tied more to midstream volumes than oil prices themselves. As for stocks that could experience continued abnormal pain should crude oil prices continue to fall, I’ve compiled the following list of some less-secure energy-related equities, sorted by least-attractive net debt to market capitalization. Those at the top of this list are not for the faint of heart, and many could experience severe price declines if the market factors in a meaningful probability of default as maturities near. Bankruptcy is a real possibility for some. The cost to insure energy bonds has nearly tripled since June.
| Name | Symbol | Div Yield | Market Cap | Net Cash | Net Debt/Mkt Cap | Prob of Bankruptcy |
| Arch Coal | ACI | 0.5% | 443.3 | -3,992.0 | 900.5% | 6.681% |
| Quicksilver | KWK | 0.0% | 228.3 | -1,732.5 | 758.8% | 2.275% |
| Molycorp | MCP | 0.0% | 218.2 | -1,066.0 | 488.6% | 6.681% |
| Alpha Natural | ANR | 0.0% | 521.3 | -2,470.9 | 474.0% | 0.135% |
| Linn Energy | LINE | 12.1% | 2,852.9 | -9,118.1 | 319.6% | Less than 0.1% |
| SeaDrill | SDRL | 0.0% | 7,212.7 | -13,553.0 | 187.9% | Less than 0.1% |
| Peabody Energy | BTU | 2.8% | 3,226.6 | -5,558.4 | 172.3% | Less than 0.1% |
| EXCO | XCO | 4.1% | 1,115.3 | -1,819.7 | 163.2% | 0.621% |
| Noble Corp | NE | 8.3% | 4,561.3 | -5,441.8 | 119.3% | Less than 0.1% |
| Transocean | RIG | 14.3% | 7,563.6 | -7,459.0 | 98.6% | Less than 0.1% |
| Weatherford Intl | WFT | 0.0% | 8,978.4 | -8,292.0 | 92.4% | Less than 0.1% |
| Nabors Industries | NBR | 1.9% | 3,802.3 | -3,476.4 | 91.4% | Less than 0.1% |
| Tidewater | TDW | 3.0% | 1,634.5 | -1,454.5 | 89.0% | Less than 0.1% |
| Kinder Morgan | KMI | 4.4% | 40,259.0 | -35,595.0 | 88.4% | Less than 0.1% |
| Spectra Energy Partners | SEP | 4.5% | 6,985.6 | -5,840.0 | 83.6% | Less than 0.1% |
| Boardwalk Pipeline | BWP | 2.2% | 4,086.9 | -3,406.5 | 83.4% | Less than 0.1% |
| Atwood Oceanics | ATW | 0.0% | 2,088.2 | -1,673.9 | 80.2% | Less than 0.1% |
| Natural Resource Partners | NRP | 10.6% | 1,453.1 | -1,072.7 | 73.8% | Less than 0.1% |
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