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Issues

Second Time’s a Charm? The Case for Selective Exposure to Oil-Field Services

Heading into 2018, we like the setup for US-levered oil-field service stocks, though investors will need to remain selective and avoid the problem spots and value traps that lurk in this industry.

What’s changed over the intervening months?

Our outlook for oil prices is certainly more bullish than in late 2016 and early 2017, when we warned that the US production response would surprise to the upside and offset OPEC’s production cuts.

Although oil prices have rallied on several occasions over the past three years, we (rightly) regarded these upswings as ephemeral because the oil market remained in contango—that is, longer-dated futures commanded a premium to near-term contracts. This environment encourages market participants to store oil for future delivery and makes it easier for producers to hedge expected output.

In addition to improving investors sentiment, the recent strength in crude-oil prices should support solid capital spending among US exploration and production companies, many of which have taken advantage of the rally in WTI to lock higher prices on expected production.

Nevertheless, sentiment toward the industry remains cool, with investors erring on the side of caution and viewing the group as a show-me story—one of the big reasons oil-field service stocks hadn’t participated in the rally in crude-oil prices until recently. At these levels, the downside risk in many oil-field service names appears limited in the event that our investment thesis doesn’t work out.

 

Today, crude oil is in the early innings of a cyclical recovery. The market for Brent oil (an international benchmark) entered backwardation earlier this year, with front-month futures trading at a premium of $2.89 per barrel to volumes slated for delivery 12 months later. This structure discourages market participants from paying to store oil and indicates a tightening supply-demand balance.

 

Why Canadian Midstream Stocks Have Outperformed Master Limited Partnerships

In US dollar terms, the Solactive Canadian Midstream Oil & Gas Index has outperformed the Alerian MLP Index by more than 15 percentage points so far in 2017 and almost 25 percentage points since the energy down-cycle began in mid-2014.

Nine of the 10 Canadian midstream companies in our International Coverage Universe have increased their dividends at least twice since oil prices peaked in 2015. The lone exception, Kinder Morgan Canada (TSX: KML), completed its initial public offering on May 30, 2017.

Equally important, none of these names have cut their payouts since energy prices started to break down in mid-2014—a remarkable feat when you consider the pain that Canadian oil-field service companies and producers have suffered relative to their US peers.

Cross-border transportation constraints, coupled with surging US energy production, have ensured that Canadian upstream operators’ price realizations on crude oil, natural gas and natural gas liquids come at a significant discount to prominent benchmarks.

The group’s outperformance and steadily growing dividends stand in marked contrast to the turmoil afflicting US midstream master limited partnerships (MLP), where many prominent names such as Energy Transfer Partners LP (NYSE: ETP), Plains All-American Pipeline LP (NYSE: PAA) and Williams Partners LP (NYSE: WPZ) have slashed their distributions at least once.

All told, the 25 companies in the Alerian MLP Infrastructure Index have reduced their aggregate quarterly distribution by 14.5 percent from year-ago levels and almost one-third since early 2016. These payout cuts have reduced investors’ income streams and resulted in sharp selloffs in their stock holdings. Even Enterprise Products Partners LP (NYSE: EPD) and other higher-quality names have underperformed, suffering for the sins of their profligate counterparts.

We explore why Canadian midstream stocks have outperformed the Alerian MLP Index and the aspects of their business model that could provide a model for their counterparts south of the border.

 

MLPs: The Quest for Sustainability

With investor confidence in master limited partnerships (MLP) at low ebb, inflows to the group have slowed significantly, reducing the market’s capacity to absorb equity issuance. Many debt-constrained MLPs with higher yields have responded to this challenge by pursuing private placements of preferred units to finance growth projects or asset drop-downs.

A strong balance sheet and excess distribution coverage enabled Enterprise Products Partners LP (NYSE: EPD) to take a slightly different tack: reducing its rate of quarterly distribution increases to retain more cash flow.

With Enterprise Products Partners not getting credit for its consistent growth, management indicated that reducing the rate of distribution increases would put the MLP closer to being able to self-fund the equity portion of its growth capital in 2019—a major point of differentiation. Management asserted that any excess cash flow eventually could be used to buy back stock, depending on the valuation and how this option stacks up relative to other uses of capital.

This announcement from an industry bellwether raised questions about whether the traditional model of pushing the envelope on distribution growth while relying primarily on equity issuance to finance expansion opportunities still makes sense.

Given the pain of the past several years, a focus on building distribution coverage and improving leverage metrics should help to shore up confidence in the group. And any MLP that can grow its per-unit cash flow without leaning heavily on the equity market will have a distinct advantage as competition for volumes intensifies.

Enterprise Products Partners wasn’t necessarily the first MLP to go down this path—Magellan Midstream Partners LP (NYSE: MMP) hasn’t issued equity since 2010—but this announcement has changed the conversation this earnings season, with many partnerships tapping the breaks on distribution growth to build coverage and reduce the need to issue equity.

Thus far, third-quarter results suggest that most of our MLP Portfolio holdings will be able to make this transition with relative ease, though two names with tighter distribution coverage could face more of a slog.

International Energy Outperforms

We’ve completed our quarterly update to the ratings and comments in our International Coverage Universe. Key takeaways from this exercise include ongoing cost-cutting, deleveraging and consolidation in Canada. Meanwhile, natural-gas prices in Australia have soared, as the upsurge in exports has limited the supply available to the domestic market.

Against this backdrop, the names in our International Portfolio reported solid second-quarter results and affirmed or increased their guidance. All these stocks benefited from the US dollar’s weakness this summer.

The latter tailwind has made it a good year for our International Portfolio, with the conservative sleeve delivering an average total return of 12.6 percent and the aggressive sleeve up 0.5 percent. Over this period, the S&P 500 Energy Index gave up 8.8 percent of its value.

But solid fundamentals also contributed to these returns; all our conservative holdings increased their dividends at least once this year.

Power Plays

Recent improvements in global oil inventories and stronger-than-expected demand growth have bolstered oil prices—especially outside the US—and prompted value-focused investors to return to cyclical segments of the energy sector.

Meanwhile, the Energy Information Administration’s downward revisions to its outlook for US oil output and the decline in the oil-directed rig count have provided early indications that drilling and completion activity may obey the speed limits imposed by commodity prices.

Although these trends have lifted upstream-related energy stocks in recent weeks, the break-neck volatility of the past few years and the likelihood of shorter cycles in the energy sector argue for diversification into secular growth stories that depend less on commodity prices and timing your entry and exit points.

This approach has served us well over the years, with our exposure to that own renewable-energy capacity delivering particularly strong returns relative to the S&P 500 Energy Index over our extended holding periods.

To varying degrees, all the stocks that we highlighted in December 2014 that stood to benefit from lower oil prices also outperformed in a challenging tape. (See The Demand Side Beckons.)

We cashed out of Portfolio holdings Delta Air Lines (NYSE: DAL) and Royal Caribbean Cruises (Oslo: RCL, NYSE: RCL) for solid gains in November 2015, while anyone who followed our lead on Casey’s General Stores (NSDQ: CASY), Alimentation Couch-Tard (TSX: ATD/B, OTC: AQUNF) and Berry Global (NYSE: BERY) also fared well. (See Trimming Some of Our Hedges.)

With oil prices likely to range between $40 and $60 per barrel over the next few years, our playbook for late 2014 and early 2015 no longer holds the same appeal. At the same time, many of the renewable-energy companies in our Portfolios have rallied above our buy targets.

Fortunately, the ever-shifting energy landscape isn’t bereft of secular growth stories, including the specialized engineering and construction company and precision-power specialist highlighted in this issue.

Strategy Update

To say that 2017 has proved a challenging year for energy stocks would be an understatement.

The ebullience that reigned in the aftermath of OPEC’s November 2016 agreement with Russia and other major oil-producing countries has dissipated, thanks in part to the rapid recovery in US onshore drilling activity and output, persistently elevated inventories and oil prices that have slipped below $50 per barrel.

Upstream-related subsectors have borne the brunt of this pain, with the Bloomberg North American Independent E&P Index giving up almost 36 percent of its value this year and the Philadelphia Oil Service Sector Index plummeting 35 percent.

With WTI hovering around $45 per barrel, the market doesn’t appear to price in much risk that lower prices could lead to a moderation in onshore activity levels and production growth. As expected, the handful of upstream spending cuts announced during second-quarter earnings season primarily came from operators focused on marginal areas or burdened with strained balance sheets.

Meanwhile, the US oil-directed rig count also appears to have peaked and has started to trend lower, suggesting that upstream operators have responded to the decline in WTI and creating the potential for supply growth to moderate down the line.

Against this backdrop, we continue to favor midstream master limited partnerships (MLP) for their above-average yields and exposure to what we regard as a multiyear volumetric growth story where short-cycle US oil and gas production takes market share. In particular, basins that contain multiple hydrocarbon-bearing formations appear best-positioned for the long haul because of their superior economics.

Although our outlook for oil prices and the US energy patch favors an overweight position in core midstream holdings, nimble investors can generate alpha in upstream names by buying when oil prices retreat to the low end of their range and taking some profits off the table when they recover. Timing and stock selection—easier said than done with shorter cycle times—will be critical to producing differentiated returns.

We also continue to explore investment ideas related to energy efficiency, renewable energy and demand-side related opportunities, a process that we began with our recent issue on the petrochemical complex. Expect more in coming issues.

Chemical Reaction

One of the most important features of the US shale oil and gas revolution has been the rolling wave of oversupply that has moved through the energy value chain, creating market imbalances and distorting long-standing price relationships between various hydrocarbons.

Over the past several years, oil and gas companies’ overzealous production of natural gas and natural gas liquids has restored the fortunes of domestic petrochemical producers, an energy-intensive industry that relies on these commodities to generate power and as feedstock.

Within this space, olefin producers have benefited the most thus far, thanks to extraordinarily low feedstock prices. But the multiyear boom in profit margins for US polyethylene producers appears to be winding down, with the baton of profitability likely to move further downstream.

Midyear Outlook: Top-Down View

At the end of 2016, Wall Street analysts’ median forecast called for West Texas Intermediate (WTI) to average $56 per barrel in the third quarter of 2017 and for Brent to approach $60 per barrel by early 2018.

Whereas most investors cheered OPEC, Russia and a handful of other oil-producing countries’ “historic” agreement to cut output, we took a less sanguine outlook in an Alert issued on Dec. 12, 2016:

OPEC would lose credibility next year as the regulator of the global oil market. Meanwhile, WTI will range between $40 and $60 per barrel for at least the next two to three years. In the near term, we continue to expect WTI to tumble to less than $40 per barrel, once these realities become apparent.

In subsequent writings, we called for oil prices to spend much of the next two years between $45 and $55 per barrel, with spikes outside that range ultimately proving to be relatively short-lived.

This macro view has played out thus far, with sentiment on the efficacy of OPEC’s production cut beginning to sour in March, reflecting concerns about the rapid growth in US oil output in the first half of 2017. Against this backdrop, WTI tumbled to about $42 per barrel in June, before enjoying a modest oversold bounce.

With second-quarter earnings season set to begin in earnest later this month, we update take advantage of the pause before the deluge to review and update our outlooks for commodity prices and energy stocks.

International Opportunities

After updating our commentary and ratings for the more than 80 stocks in our International Coverage Universe, we continue to favor midstream names that offer exposure to volumetric growth stories and our top bets on renewable energy. All offer above-average yields that should juice investors’ total returns.

Even better, Canadian pipeline owners have operated more conservatively than their US counterparts and boast stronger balance sheets.

Ongoing takeaway constraints mean that crude oil, natural gas, and natural gas liquids produced in Alberta continue to fetch significantly lower prices than their US benchmarks. These wide price differentials represent a headwind for Canadian oil and gas producers, but underscore the opportunity set for midstream operators.

The Lay of the Land

After OPEC and other major oil-producing countries agreed to curb production in fall 2016, specialist and generalist portfolio managers alike bet heavily on West Texas Intermediate (WTI) rallying to at least $60 per barrel this year.

This shot of confidence prompted investors to move down the quality chain in the search for value and alpha, with marginal equities rallying hard and high-yield energy bonds acting as though the 2014 collapse in oil prices was an aberration, never to be repeated.

However, in 2017, the story has shifted to how the surge in US oil output and stepped-up drilling and completion activity in prolific shale plays—abetted by upstream operators’ aggressive hedging when WTI fetched more than $50 per barrel—have threatened to overwhelm the extended OPEC and non-OPEC supply cuts.

Two weeks of disappointing data on US oil and refined-product inventories have reinforced the market’s negative sentiment toward WTI and energy stocks, while the International Energy Agency’s most recent forecast called for growth in non-OPEC output—led by the US—to offset projected growth in global demand next year.

A string of bullish inventory reports from the Energy Information Administration with larger-than-expected drawdowns in crude and refined-product inventories—a distinct possibility during the summer driving season, a period of strong demand—could catalyze a near-term pop in energy stocks and oil prices.

But ultimately the market will need to come to grips with a US onshore rig count that has increased by 425 drilling units since May 2016 and the Energy Information Administration’s (likely conservative) projections that domestic oil output will increase by an average of 340,000 barrels per day this year and 500,000 barrels per day in 2018.

At this point in the recovery, the US onshore rig count sits at levels (about 900) that Halliburton’s (NYSE: HAL) former CEO, Jeff Miller, last year asserted would have the equivalent productivity of about 2,000 drilling units at the previous cycle’s peak.

Barring further supply cuts from OPEC or security-related disruptions, oil prices could adjust to levels—potentially in the $30s per barrels—that would prompt the US shale complex to rein in drilling and completion activity.

A decline in the US onshore rig count would be the first sign of a US response, while a moderation in the pace at which the industry works off the inventory of drilled wells awaiting completion would also help.

Despite the near-term uncertainty and volatility in the energy sector, we can draw several firm conclusions from developments during the previous down-cycle and the recent up-cycle that will inform our investment strategy in the near term and long term.

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      Balanced portfolios of energy stocks for aggressive and conservative investors.

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      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.

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      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