We’ve been cautious on the oil and gas markets (XLE, AMLP) for some time, and that includes our October move closer to market neutral on the sector, but we’re still underweight the group. We’ve been saying that crude oil prices are more likely to hit the $20 per barrel level than move significantly higher, and we maintain our view that they may never again return to the $100 per barrel, a level many have grown accustomed to. After all, why should they?
Unfortunately, the fallout continues to punish traditional “buy and hold” investors who have been trained to ignore most “news” and may still be holding on the belief of the fallacy of mean reversion, something that we believe cannot be guaranteed, especially when structural shifts in markets occur. For example, the distinct change in strategy from previous energy cycles by OPEC member nations to produce to gain market share expansion rather than price stability is one. That commercial inventories in the US remain near levels not seen for this time of year in at least the last 80 years is another (Source: Summary of Weekly Petroleum Data for the Week Ending November 27, 2015).
In the spirit of helping investors, we’ve announced several high-profile moves in the Valuentum newsletter portfolios, the Best Ideas Newsletter and the Dividend Growth Newsletter, in anticipation of the rout in energy markets. No one can predict commodity prices with absolute certainty, nor do they have to in order to be a successful investor, but given our concerns about the potential lethal combination of looming contractionary monetary policy, significant capital intensity, refinancing risks, and collapsing product prices for both oil and gas, the writing on the wall was clear, at least to us. Barron’s highlighted Valuentum as a “Survival Guide for Oil Investors” in January of 2015, and we’ve done our best to live up to that coveted designation.
After avoiding much of the collapse in the energy markets but sticking with some of the strongest entities during most of 2014, in March of 2015, Valuentum removed Chevron (CVX) from the Dividend Growth Newsletter portfolio (shares have collapsed from $102 to ~$86); in June, we removal of Kinder Morgan (KMI) from the Dividend Growth Newsletter portfolio (shares have collapsed from $40 to ~$15), one of the most controversial yet most timely calls yet seen. Please be sure to view Mr. Nelson’s “5 Reasons Why We Expect Kinder Morgan’s Shares Will Collapse,” and then his “5 More Reasons Why We Expect Kinder Morgan’s Shares Will Collapse.”
Here’s a short snippet from his worries in mid-June, for example:
“…the credit rating agencies have a lot to think about. Kinder Morgan’s investment-grade credit rating is in part supported by the firm’s ability to access the equity markets to sell its own stock. But its share price is artificially propped up by the incorrect application of dividend discount models that are using financially-engineered dividends, which themselves are in part supported by the debt raised from an investment-grade credit rating, which is then used to keep raising debt and growing the dividend…and so on.”
Growing even more cautious on the master limited partnership arena, Valuentum then removed Energy Transfer Partners (ETP) from the Dividend Growth Newsletter portfolio in August, with shares dropping from nearly $50 each to the low-$30s since that time. Please be sure to read our rebuttal, “The Long-term MLP “Value Trap,” to “MLPs for the Long Run”, which itself was a response to a previous article we had written. Out of the major pipeline plays, we think Plains All American (PAA) is next in line to cut its distribution (see here). We’ve only recently inched closer to market neutral on the energy sector with the addition of the Energy Select Sector SPDR ETF (XLE); the ETF now makes up ~5% of each newsletter portfolio, but we continue to be underweight the sector as a whole, which had been ~9% of the S&P 500 at the start of the year.
Why did we choose a diversified ETF? For one, we’re not comfortable taking on the risk that comes with being exposed to the operations of any one upstream, or even a midstream energy company. Share prices have collapsed so quickly in the energy markets that even the most responsive and forward-looking executive teams may not have fully embraced the notion of permanently lower energy resource pricing. Just recently, for example, West Texas Intermediate crude was trading below $37 per barrel, the lowest point since the Great Recession, yet most companies created 2015 budgets assuming crude oil would be trading around $70 per barrel. The pressure simply won’t let up.
After OPEC’s December 4 meeting, no output ceiling was agreed upon, indicating that the cartel would continue its current level of production at least until its next meeting in the summer of 2016. The pressure from OPEC is mostly coming from two of its top dogs, Iran and Saudi Arabia. Our belief is that Saudi Arabia intends to continue to pump excess crude oil into the global market to drive higher-cost US shale producing oil companies out of business, and the lifting of sanctions against Iran from the Western world will further open the supply floodgates in the Middle East, even if only marginally (as some believe). Iran has indicated that it would not consider curbing production until it restores output levels that had been scaled back for years under the Western sanctions.
Many still believe a reversion to the mean with respect to energy resource pricing is a “fact of the markets” or the most likely path (meaning that we’ll be back to $100 per barrel oil in no time), but we encourage investors to leave open the very real scenario that a trip to $20 per barrel is equally, if not more likely, from here in light of supply growth. Though most of the energy sector continues to roll out extensive cost cutting programs that extend into 2017 and 2018, we doubt many have fully prepared for what many are calling a “doomsday” scenario of $20 per barrel oil. We’re not sure that $20 per barrel is completely out of the question.
Why? For one, investors are forgetting that even at $20 per barrel oil, that level would be twice the average price in 1998, for example, less than a couple decades ago. Could this this be the “true” reversion to the mean investors should be betting on? And if so, could energy markets then overshoot those depressed levels to the downside, much like they have overshot to the upside in recent years? After all, with commercial supplies at 80+ year highs in the US, OPEC supplying vigorously, shale oil independents requiring a production trajectory for survival and emerging economic growth questionable at best, the bear case for energy resource prices is considerable as it is evident. If the past is any guide, crude oil prices ranged between $10-$35 per barrel in real terms for most of economic history (1870-1970) – that’s 100 years! That would mean that we’re at the high end of the range today.
To put it bluntly, even the strongest of energy giants may see their dividends come into question during this phase of the energy cycle, especially if the pain is prolonged, even mom-and-pop favorites such as Chevron and ConocoPhillips (COP), for example. Only ExxonMobil (XOM) stands out to us a secure idea, but even its debt load has also ballooned as energy resource prices have collapsed. In the event that energy resource prices do revert back to real averages (~$20 per barrel of oil equivalent), it’s probable the dividends for most in the upstream arena will become an afterthought, and many in the midstream space that require these same customers to be healthy, will face inevitable pain.
That a company or partnership will be around over the long haul does not mean that it won’t have to significantly dilute shareholders or unitholders to stay afloat along the way. Or in the worst of cases, equity holders or unitholders can be completely wiped out under Chapter 11 bankruptcy proceedings, when creditors take possession. We doubt many debtholders will let troubled equities keep paying out massive distributions now, leaving them holding the bag when things really get bad. The long term means little if companies cannot survive the near term with their existing equity structure intact.
Don’t forget to read the rebuttal, “The Long-term MLP Value Trap.”
Energy Equipment & Services (Large): BHI, CAM, FTI, HAL, NBR, NOV, SLB, TS, WFT
Energy Equipment & Services: CLB, DRQ, FI, HLX, HP, OII, OIS, PDS, PTEN, SPN, TDW
Energy Equipment & Services – Offshore Drilling: ATW, DO, ESV, NE, RDC, RIG, SDRL
Oil & Gas – Major: BP, COP, CVX, PTR, RDS, TOT, XOM
Pipelines – Oil & Gas: BPL, BWP, DPM, ENB, EPD, ETP, EVEP, HEP, KMI, MMP, NS, PAA, SE, SEP, WES