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Issues

Paddling Upstream, Part 2

The first issue in our two-part series on US independent oil and gas producers examined the opportunity set for these names in an environment where oil prices remain lower for longer, likely settling at a level that incentivizes rational development but not growth for growth’s sake. We also looked at some of the larger, diversified exploration and production companies.

This time, we shift our focus to the leading lights of the shale oil and gas revolution, the names that have captured investors’ capital and their imaginations. The best of these companies boast savvy management teams, high-quality resource bases, strong balance sheets and a number of levers they can pull to unlock value.

Over time, these names should be able to grow their production and win market share from higher-cost producers. Unfortunately, the best of the best still trade at elevated valuations that don’t reflect the challenges on the ground. Simply put, a good value is hard to find in the upstream space, if you focus on quality. Investors should maintain their discipline and patience.

Paddling Upstream

During our February and March Live Chats, we fielded a number of questions about specific US exploration and production companies, including Continental Resources (NYSE: CLR), a top producer in North Dakota’s Bakken Shale and leading proponent of the emerging South-Central Oklahoma Oil Province (SCOOP).

Readers’ interest in Continental Resources didn’t come as a surprise; as one of the preeminent players in the Bakken Shale, the name features prominently in many energy-focused investment portfolios.

Outspoken CEO Harold Hamm also appears regularly on financial television to tout Continental Resources’ story, argue for repealing the US ban on crude-oil exports and share his bullish outlook for a snapback in energy prices.

However, questions about SandRidge Energy (NYSE: SD) and Magnum Hunter Resources Corp (NYSE: MHR)—marginal producers with high leverage and dubious business models that struggled even with oil at $100 per barrel—took us aback.

This shift in sentiment in part reflects value-seeking tourists looking for bargains in a late-stage bull market. After all, the Bloomberg North American Independent E&P Index gave up almost 50 percent of its value in the back half of 2014—fertile hunting grounds for non-specialists who remember the snapback that occurred after energy prices collapsed in late 2008 and early 2009.

We prefer to stand aside on most upstream names, as valuations look full, especially when you consider that crude-oil prices will remain lower for longer now that service costs have started to go down, drilling efficiency continues to improve and Saudi Arabia remains committed to building market share by ramping up exports.

Investors interested in wading into the upstream space should consider easing into their positions and focusing on names with strong balance sheets, low production costs, a history of solid execution and franchise assets that can deliver production growth in a challenging environment. Names that can expand their output and win market share should outperform, as cash-strapped peers or those with inferior assets struggle.

With oil prices expected to be lower for longer, better buying opportunities will emerge in the future.

The Renewable-Energy Investment Bible

In the US, renewable-energy developers continue to reap the rewards of favorable policies at the state and federal level. However, concerns about rising electricity costs and general opposition to government subsidies raise questions about whether this support will continue.

Although SolarCity Corp (NSDQ: SCTY) and other outfits with unsustainable business models pose the most risk to investors’ wealth, long-term contracts and the participation of utilities in the space should ensure that renewable energy won’t reprise its disappearing act from the 1980s.

Don’t be surprised if SolarCity tumbles to less than $10 per share when the going gets tough.

At the same time, because many investors view renewable energy as an opportunity for developers to usurp utilities, a good chunk of this industry trades at reasonable valuations relative to their long-run growth prospects.

This issue highlights the best opportunities and names to avoid in the following areas: yieldcos, generation, energy storage, transmission, energy retailing, regulated utilities and components manufacturers.

Risks and Opportunities

Most energy-related equities have taken some serious lumps since the second half of last year, hit by the precipitous decline in the prices of crude oil, natural gas and natural gas liquids (NGL).

With the exception of US independent refiners, most groups in the energy sector have pulled back since the end of last year’s second quarter.

The Alerian MLP Index, which tracks 50 prominent publicly traded partnerships, has pulled back by 17 percent. This resilience reflects the group’s focus on pipelines and other midstream infrastructure that often operates under longer-term, fee-based contracts.

MLPs’ above-average yields also make them popular among buy-and-hold retail investors, while their unique structure helps unitholders to defer taxes—until they exit their positions. This setup makes for a relatively stable investor base.

Although we expect MLPs to continue to outperform relative to other energy groups, investors shouldn’t overlook the headwinds facing these stocks and the potential for further downside.

Rather than viewing the space holistically, investors need to evaluate each MLP’s individual strengths, weaknesses and growth prospects.

In this issue, we review some of the risks in the MLP space, set dream prices for our favorite blue-chip MLPs and highlight a handful of names that offer exposure to growth stories that are independent of commodity prices or driven by drop-down transactions from supportive general partners.

Hunting Big Yields in the Energy Patch — Part 2

Remember when energy prices collapsed in late 2008 and early 2009? Investors who heeded our call to load up on our favorite master limited partnerships (MLP) and other energy stocks during this epic dip made out like bandits.

This time it’s different. Whereas frenzied drilling activity in unconventional oil and gas plays drove huge upside for savvy investors over the subsequent years, the shale revolution has dramatically increased spare production capacity.

Instead of betting on a return to the old normal, investors should position their portfolios for the new normal, a period of overcapacity in the services industry and increasing competition between basins and producers for market share. The winners will boast low production costs and solid balance sheets.

Instead of buying the dip indiscriminately, focus on the names in our conservative portfolio, especially the stocks with a heart next to them–those are our best buys in today’s market.

In this issue, we finish our survey of the highest-yielding MLPs and uncover a gem or two amid the rubble.

Hunting Big Yields in the Energy Patch

With roughly two dozen MLPs (excluding upstream names) offering yields of more than 8 percent, the frequency with which readers asks us about these stocks has increased.

In High-Yield MLPs: The Good, the Bad and the Ugly, we dig into about half these names—we’ll cover the rest in the second February issue—highlighting the ones worth buying and the ones you should sell. Note that a Hold rating means that investors shouldn’t allocate new capital to the name in question. We will continue to monitor Hold-rated names for signs of further deterioration.

We also dig into the tanker market (see Tanker Talk), once a happy hunting ground for investors seeking big yields that eventually turned sour.

The last bull market for oil tankers stretched from the early 2000s to 2007, fueled by insufficient capacity in the global fleet after the phase-out of single-hull vessels and rapidly growing oil demand and China and other emerging markets.

However, overzealous ordering of new capacity, coupled with the onset of the Great Recession, saddled the tanker market with a severe supply overhang that depressed day-rates below the break-even rates for many shipowners.

For the first time in eight years, the supply-demand balance has tightened to the point that this long-neglected space could offer significant near-term upside for aggressive investors.

The Big Picture and Our MLP Investment Strategy

Big changes are afoot in the energy patch. Investors who find comfort in old paradigms and patterns will be disappointed to find that familiar strategies don’t necessarily generate happy returns.

Over the past several years, the stock market has rewarded investors who bought the dips in the energy sector. These fond memories and perceived low valuations have prompted many bargain-seeking investors to allocate capital to upstream names and oil-field services stocks in the hopes of finding a bottom.

There will come a time to buy these names selectively, but smart investors should remain on the sideline for now. Regard any near-term rebounds as a sucker’s rally—another opportunity to exit riskier positions.

Remember that fourth-quarter results won’t reflect the full impact of lower commodity prices; West Texas Intermediate crude oil, for example, averaged $73 per barrel over this three-month period, compared to about $48 so far in 2015. And a mixed barrel of natural gas liquids (NGL) averaged almost $31 in the fourth quarter, about 55 percent higher than in January 2015.

Although some pundits will point to Schlumberger’s (NYSE: SLB) fourth-quarter earnings beating the consensus estimate as a bullish sign, management’s comments during the subsequent conference call gave investors plenty of reasons to remain cautious on oil-field services names, contract drillers and fracking sand providers.

As for what works in this environment, energy analysts are almost universally bullish on midstream master limited partnerships (MLP), citing their fee-based contracts and resilience when commodity prices cratered in late 2008 and early 2009.

But beware complacency when you venture into MLP land. We highlight the emerging risks in the midstream space and review all our MLP Portfolio holdings in light of the recent downdraft in energy prices.

Outlook 2015: Pains and Gains

At the beginning of each year, we update our outlook for the economy and commodity prices for the year ahead. Although our forecast necessarily evolves over the course of the year based on economic data and corporate earnings reports, stepping back to take in the big picture helps to establish a basic roadmap and strategy.

Given the sea changes underway in global energy markets, this exercise is of particular importance as we head into 2015.

The plunge in global oil prices that occurred last fall reflects growing production and spare capacity in North America and slowing demand growth in emerging markets. Although investors shouldn’t rule out the potential for short-term bounces, the down-cycle in the energy patch will take at least six to 12 months to play out.

When the crude-oil market finds a new balance, investors will have a golden opportunity to pick up shares of high-quality energy companies at favorable valuations.

However, this epic buying opportunity has yet to arrive. Until then, investors must remain patient and focus on high-yielding names that pay sustainable dividends and growth stories that don’t hinge on commodity prices.

In this issue, we review our predictions for last year (see Looking into the Crystal Ball), roll out our predictions for 2015 and update our outlook for the stocks in our International Portfolio and International Coverage Universe.

The Demand Side Beckons

The combination of slowing oil demand growth in China and other key markets and surging output from US shale plays—and their implications for global spare productive capacity—has sent crude prices plummeting.

Although crude-oil prices have caught a bit of a bid over the past few days and oil-field services and upstream names have benefited from a bout of short covering, the near-term outlook suggests that crude-oil prices will remain below the elevated levels that became the norm in recent years.

Meanwhile, any moderation in production volumes associated with anticipated reductions to capital expenditures won’t show up for several quarters, especially with operators focusing development activity in their core acreage and pushing for 15 percent to 20 percent price breaks from service providers.

And with US producers able to sink high-probability new wells within a week, this shadow capacity should keep a lid on oil prices in the intermediate term, assuming OPEC maintains its output levels and no major disruptions occur in the usual hot spots.

Against this backdrop, the demand side beckons. Our favorite hedge against lower crude-oil prices–a name that we added to our Model Portfolio in January 2014–has soared by 41.6 percent since the end of the third quarter.

In this issue, we highlight our top picks in several industries that stand to benefit from extended weakness in crude-oil prices and offer exposure to other company- and industry-specific growth trends.

We also highlight an opportunity for investors to lock in high yields on securities that actually stand to benefit from potential dividend cuts in the upstream space.

These picks will work in concert with our top picks in the energy sector to deliver solid returns during a period of heightened volatility.

Game Plan for Lower Oil Prices

Over the past year, we’d taken some steps to reduce the Portfolio’s risk, cashing out of SeaDrill (NYSE: SDRL) last fall and selling fracking sand specialist Hi-Crush Partners LP (NYSE: HCLP) for a roughly 60 percent gain. We also reiterated our Sell call on SeaDrill, a stock we first highlighted in 2007, on several occasions this year.

By design, our Model Portfolios also feature less exposure to oil and gas producers than many energy-focused investment advisories, though we should have lightened up our exposure to riskier, high-yielding names earlier this year.

With only a few exceptions, our Model Portfolio, MLP Portfolio and International Portfolio’s conservative allocations have delivered solid returns and held their value better than most.

This resilience reflects our overweight positions in conservatively run midstream operators—many of which are organized as master limited partnerships (MLP)—that have little direct exposure to fluctuations in oil and other commodity prices.

Our primary hedge against weaker oil prices has delivered a total return of almost 80 percent since we added the stock to the Model Portfolio in January. Equally important, this stock has rallied 44 percent since we highlighted the pick as one of our top demand-side bets in the Oct. 17 issue, Picking the Pockets of Opportunity.

Although we’ve made a lot of right moves, our Portfolios’ aggressive allocations have taken some lumps, making us wish we had booked profits more aggressively at the top.

That being said, it’s not too late to position your portfolios to thrive over what promises to be a challenging six to 18 months.

  • Live Chat with

    Elliott and Roger on May. 28, 2015

  • Portfolios & Ratings

    • Model Portfolios

      Balanced portfolios of energy stocks for aggressive and conservative investors.

    • Coverage Universe

      Our take on more than 50 energy-related equities, from upstream to downstream and everything in between.

    • MLP Ratings

      Our assessment of every energy-related master limited partnership.

    • International Coverage Universe

      Roger Conrad’s coverage of more than 70 dividend-paying energy names.

    Experts

    • Roger S. Conrad

      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor

    • Elliott H. Gue

      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor

    • Peter Staas

      Managing Editor: Capitalist Times and Energy & Income Advisor