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Issues

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.

MLP IPO Class of 2014, Part 4

In 2014, a record 19 energy-related master limited partnerships (MLP) have completed their initial public offerings (IPO).

And another dozen prospective publicly traded partnerships having filed their S-1 and F-1 registration forms with the Securities and Exchange Commission (SEC), suggesting that the number of newly minted MLPs will easily eclipse 20.

We don’t expect this trend to abate anytime soon. Investors’ appetites for above-average yields and exposure to the shale oil and gas revolution remain robust, providing the energy sector with a ready source of low-cost capital at a time weakening oil prices could crunch balance sheets.

In this environment, upstream operators and private-equity funds will continue to churn out MLPs in an effort to raise capital and monetize earlier investments.

Many of these offerings will offer a visible pathway to distribution growth, usually through structured drop-down transactions; however, the best bets will have a viable long-term game plan to grow cash flow, build franchise value and diversify their asset and customer bases.

However, as the total returns generated by this year’s debutants attests, selectivity remains the key to outperformance.

In this issue, we review the latest batch of MLPs to go public and three-quarters of the prospective publicly traded partnerships that have filed their initial registration statements with the SEC.

MLP Class of 2014, Part 3

Over the past three years, investors seeking differentiated returns have found recent initial public offerings (IPO) in the MLP space to be a fruitful hunting ground.

In 2011, two fledgling MLPs–Golar LNG Partners LP (NYSE: GMLP) and Tesoro Logistics LP (NYSE: TLLP)–cracked the list of that year’s top 10 performers. This number increased to six in 2012 and four in 2013. And thus far in 2014, IPOs that priced within the past 12 months have accounted for four of the top-performing MLPs.

Why do newly listed publicly traded partnerships tend to outperform?

MLPs often grow their distributions at an accelerated rate in their first two years as a publicly traded entity. These rising quarterly payouts, coupled with a raft of positive research reports from Wall Street analysts, tend to attract investors’ attention and drive the stock price higher.

At the same time, brokerage and financial websites often misreport recently listed MLPs’ yield until the firm has paid a full year’s worth of distributions. This quirk gives investors an opportunity to buy these stocks before the herd realizes how much the units yield.

In the past, investing in fledgling publicly traded partnerships has proved to be a winning proposition and an opportunity to find value. However, investors should be forewarned selectivity is critical to this strategy’s success.

Picking the Pockets of Opportunity

Although the S&P 500 has endured its fair share of volatility over the past week, the energy sector endured the deepest selloff, reflecting a 21 percent decline in the price of West Texas crude oil and a 23 percent drop in Brent crude oil since the end of the second quarter.

The selloff accelerated quickly on Oct. 9, prompting us to issue an Alert to subscribers highlighting our top seven stocks to buy during the energy bloodbath.

After today’s rebound, the Alerian MLP Index is down 7.8 percent since the start of September, while the Philadelphia Oil Service Sector Index has given up 18.4 percent of its value and the Bloomberg North American Independent E&Ps Index has tumbled 25.6 percent.

In this issue, we explain why our best ideas in today’s market include refineries, airlines and midstream operators.

Tackling the Big Issues

In this issue, we tackle two of the topics about which readers frequently ask: our outlook for crude-oil prices and our assessment of the major integrated oil companies, including which ones are our favorites.

The recent collapse in the price of Brent and West Texas Intermediate (WTI) crude oil has investors running scared and trying to figure out exactly what’s going on.

We dig into the complex dynamics driving this trend, from surging North American output and declining US imports of crude to trends in the futures markets and regional oil imports, and explain our near-term forecast for WTI and Brent.

When casual investors think of the energy stocks, one of the Seven Sisters—BP (NYSE: BP) NYSE: BP), Chevron Corp (NYSE: CVX), Eni (NYSE: E), Exxon Mobil Corp (NYSE: XOM), Royal Dutch Shell (NYSE: RDS B), Statoil (NYSE: STO) and Total (NYSE: TOT)—likely springs to mind.

But these Western energy giants have come in for a great deal of criticism over the past several years, as investors lose patience with the industry’s massive capital investments and limited production growth.

We dig into each of these names, assess their growth prospects, potential to unlock value for shareholders and highlight our favorites.

Deepwater Drillers Revisited and an International Update

The most recent boom and bust cycle in the tanker market provides useful insight into the deteriorating fundamentals in the offshore drilling market.

Consider the similarities between Frontline (NYSE: FRO), a formerly high-flying tanker owner, and SeaDrill (NYSE: SDRL), a leading offshore contract driller.

Both companies levered up aggressively and paid a generous dividend. Like Frontline at its peak, SeaDrill offers a double-digit dividend yield, has posted impressive gains over the past several years and remains a popular stock among income investors. Readers also frequently ask me about the name and its prospects.

Moreover, SeaDrill and Frontline both took advantage of surging demand to expand their fleets dramatically and reaped the rewards of a tight supply-demand balance.

Although we don’t expect the market for offshore rigs to collapse in the same manner as the tanker market, an influx of new drilling units has skewed the supply-demand balance in customers’ favor, putting the day-rates that these vessels earn under pressure.

MLP Roundup

Since their inception on Nov. 15, 2013, our MLP Model Portfolios have generated solid returns.

Our Conservative Allocation has delivered an average total return of 29.2 percent over this period, outperforming the 23.1 percent return generated by the Alerian MLP Index.

Meanwhile, Our Aggressive MLP Portfolio has delivered a total return that’s on par with the Alerian MLP Index, as the big gains posted by our turnaround picks have been offset by higher-yielding fare that has lagged the market.

In this issue, we assess each holding’s second-quarter results and update our outlook for their future growth prospects.

  • Live Chat with

    Elliott and Roger on Jan. 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