Image: Top holdings of the Energy Select Sector SPDR; source: State Street.
Call it luck. Call it good timing. Call it what you will, but we’re calling it tactical prudence within a portfolio management context. The newsletter portfolios have been on the “long side” of energy equities now for the better part of the past few months, after having negligible exposure to the energy-sector bust for most of the past few years. We continue to target achieving the goals of the newsletter portfolios, and we think tactical exposure makes sense at this time.
West Texas Intermediate crude oil prices (USO) have now advanced to ~$40 per barrel from the depths of the mid-$20s just a few months ago, and while most news across the energy sector remains “bad,” we had been anticipating the modest bounce in the price of the black commodity, if only because of a “short-covering” rally and ongoing support from the “rumor” mill. In the Best Ideas Newsletter portfolio, we hold a ~4.4% weighting in the Energy Select Sector SPDR (XLE) and a ~1.4% weighting in recently-added Kinder Morgan (KMI), good for ~6% of the portfolio. In the Dividend Growth Newsletter portfolio, we hold a ~4.1% weighting in the Energy Select Sector SPDR.
There are a few things that we’d like to clarify in this article. Many have asked: if we’re still bearish on energy (and we are), why do we hold energy-oriented equity positions at all? And second, if we like to focus on individual equities with the Valuentum Buying Index methodology, why do we sometimes find it appropriate to add equity exposure via diversified exchange traded funds (ETFs)? These are both great questions — let’s talk about them.
As many readers know, the energy complex has been in flux for the past few years. The credit rating agencies continue to anticipate a surge in upstream defaults that may have profound implications on the health of midstream equities through contract renegotiations, both in and out of the bankruptcy process. Even most of the largest and strongest diversified oil giants have taken some punches. Once-strong entities such as ConocoPhillips (COP) have had to cut their dividends, while other integrated players including Chevron (CVX) and even ExxonMobil (XOM) have had to take on material leverage just to keep pumping. With the strongest facing pressure, we don’t find much comfort speculating in an ultra-leveraged upstream “beta play,” even if its “delta” in the event of a sustained recovery in crude oil prices may be relatively high. Firm-specific risk, outside perhaps ExxonMobil, is incredible in light of energy resource pricing volatility.
That said, part of our short-term thesis has been that there would be some kind of “dead-cat” bounce in energy resource prices (which may have already largely occurred), and we also acknowledge the possibility that such a bounce could be prolonged, before the next leg down across the broader energy complex takes hold. In this context, we haven’t ruled out the possibility that energy shares may be a leading sector in 2016, and as a result, it’s hard for us to not have added some incremental exposure to the newsletter portfolios in advance of the commodity price “pop.” Thus far, our call on the stock-price “bottom” of Kinder Morgan, “Time to Load Up on Kinder Morgan,” appears spot on, and the threat of rising defaults across the upstream complex means, in our view, that diversified exposure through the Energy Select SPDR may be one the best ways to play the rebound. After all, the weakest players Linn Energy (LINE) and Energy XXI (EXXI) are already delaying or missing interest payments, and this downturn could last years.
From a tactical standpoint, the move to increase energy exposure in the newsletter portfolios was tactically prudent, and we think diversified exposure was the best risk-adjusted way to “play” the bounce. In some cases, risk-averse investors may not prefer energy exposure in their portfolios at all, while those of the risk-seeking variety may look for entities with outsize leverage and growing production profiles, entities such as EOG Resources (EOG) and Continental (CLR), which may be most exposed to a rebound in energy resource pricing. The charts of these two equities are now bumping up against the high band of their downtrends, and a breakout may be imminent on market strength. These two ideas are too risky for us at the moment, but we wanted to get them in front of you — should commodity prices continue their move higher. We won’t be adding them to the newsletter portfolios, however.