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Issues

E&P Playbook

In the short term, oil prices appear to near the top of their range, having rallied too far, too fast off their February low. At these levels, US shale producers will start to ramp up drilling and completion activity and hedge their expected output for 2017, though decline rates could accelerate in the back half of the year.

Despite the sharp drop in oil prices last year and the recent recovery, rebalancing the market will take time; years will pass before oil prices top $60 per barrel for an extended period. As a result of over-exuberant investors piling into the sector in recent weeks, many energy stocks have rallied to valuations that have outstripped reasonable expectations for fundamentals, setting the stage for a pullback.

We remain bullish on exploration and production companies with franchise assets, low production costs, strong balance sheets and high-quality management teams; these names stand to take market share in an environment where energy prices struggle to break out of their trading range.

Thanks to efficiency gains and price concessions on basic services, America’s best independent exploration and production companies can generate a solid return on investment in their core acreage even if oil prices range between $40 and $60 per barrel in coming years.

To identify the best-positioned producers, we considered a handful of basic criteria. First, we focused on companies that can reduce their capital expenditures and live within (or close to) their annual cash flow without suffering a major decline in production.

Companies that fit this bill won’t need to borrow significant sums or issue a ton of equity to fund their planned expenditures for 2016 and can continue to grow their output. These names will benefit disproportionately when oil prices rally to the high end of our range and hold up better and take market share when the commodity slips to the lower end of our forecast.

 

Focusing on the Bigger Picture

In the short term, oil prices appear to near the top of their range, having rallied too far, too fast off their February low. At these levels, US shale producers will start to ramp up drilling and completion activity and hedge their expected output for 2017.

Despite the sharp drop in oil prices last year and the recent recovery, rebalancing the market will take time; years will pass before oil prices top $60 per barrel for an extended period.

As a result of over-exuberant investors piling into the sector in recent weeks, many energy stocks have rallied to valuations that have outstripped reasonable expectations for fundamentals, setting the stage for a pullback.

Nevertheless, energy stocks appear to have bottomed; investors should focus on upstream and midstream names with the best prospects to grow their production and throughput volumes in an environment where oil prices remain lower for longer.

Instead of aiming to time the cycle’s nadir, investors should remember that buying energy stocks near the bottom historically has produced impressive gains over a two- to three-year holding period.

The easy money has already been made during the wave of indiscriminate selling that occurred late last year and in early 2016 and the indiscriminate buying (and short covering) that took place in recent months. Going forward, stock selection will become more important to outperforming in the energy sector.

MLP Musings: Earnings Takeaways and Conference Prep

Master limited partnerships (MLP) and exploration and production companies have been among the biggest winners in the sharp rally that has occurred since oil prices bottomed on Feb. 12, with the Alerian MLP Index gaining 35 percent and the Bloomberg North American Exploration & Production Index surging almost 55 percent.

The Bloomberg North American Independent Refining & Marketing Index has also underperformed significantly this year, validating our lack of exposure to this corner of the energy market.

In the MLP universe, the most downtrodden midstream names have outperformed; since oil prices bottomed on Feb. 12, the Yorkville High-Income Infrastructure Index has returned almost 60 percent, while the Alerian MLP Index has gained about 44 percent.

This sharp snapback has narrowed our losses on some of the names in our MLP Portfolio’s aggressive sleeve, though hindsight reminds us that we should have been more proactive about adding positions when valuations reached ludicrously low levels.

Nevertheless, investors who bought our favorite MLPs at dream prices should sit on solid gains. After the recent rally in midstream equities and bonds, investors should continue to focus on high-quality MLPs with superior costs of capital and exposure to low-cost basins that should take market share over the long haul.

Investors who fear that they’ve missed out on the opportunity to buy these MLPs should keep their eyes peeled for the inevitable dips to add to their positions.

 

Facing the Fear of Missing Out

The recent rally in the energy sector has lifted all boats, including the worm-ridden ones; investors should take advantage of this opportunity to exit any of the Sell-rated names in our coverage universe.

In fact, many of the weakest energy stocks have posted the biggest gains, suckering in momentum-seeking investors with a fear of missing out. These companies, many of which were raised on $100 per barrel oil, lack the balance sheet and franchise assets to survive in an environment where West Texas Intermediate ranges between $40 and $60 per barrel.

Investors must also stay disciplined. Most of our Portfolio holdings trade above our dream prices, and some have rallied beyond our value-based buy targets.

As such, investors should consider taking a partial profit off the table in any of their big winners and reserve this cash for future pullbacks.

Look Before You Step

Last year, we called for the price of West Texas Intermediate crude oil to tumble to between $20 and $25 per barrel in the first half of 2016, citing the rapid growth in US oil inventories and limited storage capacity.

Unfortunately, the probability that oil prices will retrench to our target range has diminished significantly as the withdrawal season approaches. With the oil market entering a period of seasonal strength, hedge funds appear reluctant to push their luck on the short side until after the April 17 OPEC meeting.

Although investors shouldn’t expect this meeting to produce any earth-shattering agreements, you can count on oil ministers to try to jawbone oil prices higher or lower after the event, putting a floor of about $30 per barrel under WTI.

Any upside also appears to be capped, as a sustained rally into the low $40s per barrel would prompt shale producers to hedge their 2017 output, stemming the decline in US onshore production—the primary driver of a recovery in oil prices.

Moreover, even as global oil supply and demand rebalance in the second half of 2016, draining the excess inventories accumulated since mid-2014 will take at least a year, short-circuiting the V-shaped recovery in oil prices that some pundits continue to predict.

Bottom Line: We expect oil prices to trade between $30 and $43 per barrel for the balance of 2016, followed by a recovery to our lower-for-longer trading range of $40 to $60 per barrel in early 2017.

Despite this tight range, volatility and economic uncertainty will create excellent trading opportunities in energy stocks and master limited partnerships over the next three to six months. We’ll look to go long during the inevitable selloff in anticipation of a snap-back rally in late 2016, when incoming data points start to demonstrate that the global supply-demand balance has improved.

But in many cases, the recent oversold bounce in oil prices and energy stocks appears to be overdone, giving investors an ideal opportunity to exit any of the riskier, sell-rated names that they may still hold in their portfolios.

With many readers afraid of missing the boat on energy stocks, we explain why we remain bearish on refining stocks–a pocket or relative safety over the past year–and oil-field services and capital equipment names.

Energy Bonds: Patience and Selectivity Are Critical

Although bonds lack the liquidity of equities and require more up-front capital to purchase, income-seeking investors shouldn’t overlook the opportunities in this corner of the energy market. Because bonds have a higher position in the capital structure than stock, a company usually privileges its interest payments over dividends or distributions to investors who own common shares or units.Bondholders also tend to benefit when companies raise capital by issuing equity; shareholders don’t necessarily benefit from this dilutive action.

More in the Tank

The Bloomberg Global Tankers Index has given up almost 20 percent of its value since mid-October 2015 after a strong run earlier in the year. Despite this recent bout of weakness, shares of tanker companies have outperformed their peers in dry-bulk and container shipping over a similar time frame.

Although legitimate concerns have emerged about projected growth in the global tanker fleet over the next two years, much of the recent downside likely reflects profit-taking in a weak market and sympathy selling with oil prices and other shipping industries that face major headwinds.

Trading at 0.65 times book value, tanker stocks haven’t been this cheap since early 2013—even though industry fundamentals have improved significantly from three years ago. In our view, this disparity creates a good opportunity for investors to build positions in tanker companies.

The Most Wonderful (and Frenzied) Time of the Year

Fourth-quarter earnings season is in full swing, inundating investors with a deluge of news, numbers and management commentary—useful intelligence on how various industries and individual companies have coped with the macro developments that have dominated the tape for the past 18 months.

In our recent Live Chats (the next one is scheduled for Feb. 23), the preponderance of the questions focused on master limited partnerships (MLP), likely because of the extreme volatility the group has endured over the past year.

In this issue, we analyze fourth-quarter results from our MLP Portfolio holdings that have reported thus far.

Risk On, Risk Off

The most recent issue of Energy & Income Advisor, Dusting off the Crystal Ball, laid out our outlook for the stock market, the US economy and the prices of oil, natural gas and natural gas liquids (NGL) over the coming year. These views shape our strategy for investing in master limited partnerships (MLP) in the near term and for the long haul.

Any improvement in oil prices hinges on a decline in overall production, a chunk of which will come from shale plays in the US onshore market. We revisit our MLP Portfolio holdings with exposure to this risk and highlight name on our watch list as we look to high-grade the Portfolio.

Meanwhile, some of our favorite MLPs stand to benefit from low-cost basins winning market share and increasing visibility on long-term demand growth.

Dusting Off the Crystal Ball

At the beginning of each year, we update our outlook for the US economy, stock market and commodity prices in the year ahead.

Although we routinely adjust our forecasts to reflect incoming economic data and corporate earnings, the 24-hour news cycle constantly bombards investors with sensationalist headlines.

In this environment, having a road map can help to prevent disorientation amid this welter of information and infotainment. And with the massive upheaval in global energy markets, investors can easily get bogged down in minutiae.

We review what we got right and what we got wrong last year and highlight our outlook for the US economy, equity markets and energy prices–and the best ways to profit from these trends.

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  • Live Chat with

    Elliott and Roger on Jun. 30, 2016

  • 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