• Energy and Income Advisor
  • Conrads Utility Investor
  • Capitalist Times
  • Twitter
  • Seeking Alpha
  • Roger S. Conrad

Issues

What to Buy Now and an International Update

International energy stocks have done extraordinarily well this year, juiced by a recovery in oil prices and stabilization in the value of the Canadian and Australian dollars—currencies that had come under significant pressure in recent years.

On a year-to-date basis, the 13 holdings in our International Portfolio’s conservative sleeve have gained an average of 20.5 percent. The seven stocks in our aggressive sleeve, which entail more exposure to commodity prices and absorbed a harder hit during the down-cycle, have generated an average total return of 55.9 percent.

As part of our background work for this issue, we’ve updated our comments and ratings for the more than 90 names in our International Coverage Universe. We discuss our key takeaways from this exhaustive (and frequently exhausting process) and highlight our best investment ideas in this universe.

Top of the Pops

With third-quarter earnings season in the bag for much of the energy patch, we take advantage of the sudden break in the action to assess where we stand today and highlight the names that offer the best risk-reward propositions over the next 12 months.

The bulk of these picks hail from the upstream (oil and gas production) and midstream (pipelines and processing) links in the energy value chain–the two areas that stand to benefit the most from a modest recovery in oil prices.

One of the major themes that we’ve highlighted over the past year focuses not on trends in overall US oil production, but rather the low-cost shale plays that stand to take market share in an environment where energy prices remain lower for longer.

This analysis has informed our positioning in the upstream segment, with the high-quality exploration and production companies that we added to our model portfolio in January 2016 up an average of 80 percent over the subsequent months.

Our selection process targeted names with strong balance sheets, low production costs, a history of solid execution and franchise assets that can deliver output growth in a challenging environment. With oil prices a point of pain or profit for all upstream operators, names that can deliver on a volumetric growth story and take market share should outperform.

We continue to like our picks from earlier this year as solid holdings for 2017. But all three trade above our buy targets, while a handful of names that the market perceives as being a notch lower on the quality scale could offer superior upside potential in the new year.

Although the market continues to throw capital at any upstream name with significant exposure to the red-hot Delaware Basin, some midstream names that play in this field and the emerging STACK play offer high yields and significant upside potential.

Filtering the Earnings Deluge

Third-quarter earnings season is in full swing for the energy sector, providing a deluge of data and information to sort through and analyze.

As always, we approach this quarterly exercise with an eye toward identifying emerging opportunities where the risk-reward balance skews in our favor and checking up on the existing holdings in our Model Portfolios to make sure our investment theses remain on track.

Let’s Make a Deal

Merger and acquisition activity involving oil and gas companies has declined by about 19 percent from year-ago levels, based on the total value of the deals announced thus far in 2016.

North America remains the most active market, with about 61 percent of the targets and 69 percent of the buyers calling the region home.

With all the upheaval in the global energy patch, many oil and gas industries are ripe for consolidation, especially the hardest-hit portions of the value chain.

However, our long-standing rule of thumb when playing potential takeover targets is to focus on names that offer exposure to a compelling upside story; even if a deal never materializes, our position should appreciate in value.

Naturally Volatile

Much of the recent upside in natural-gas prices reflects the unusually hot summer weather, expectations for a cold winter and modest supply growth, as oil and gas producers have curbed their drilling and completion activity in prolific US shale plays. However, our intermediate- to long-term outlooks for gas supply and demand remain unchanged–nor has our investment strategy.

We prefer to buy shares of high-quality producers that have strong balance sheets and high-quality acreage in leading basins–names that will take market share over the long term.

However, timing is a critical component of our strategy.

Investors should buy when gas prices inevitably tumble because of excess production and an unusually warm winter–a confluence of events that has occurred on several occasions over the past decade. You might also consider taking smaller positions in some higher-beta names that we wouldn’t regard as the best long-term holdings.

It’s equally important to take some profits off the table when natural-gas prices rip higher. The time for such a move is imminent.

Investors should also maintain exposure to well-positioned midstream operators that stand to benefit from accelerating production growth in low-cost basins. With natural-gas demand expect to climb in coming years and the US boasting a world-class resource base, the potential volumetric growth is truly impressive.

Planning for a Pullback

An environment where oil prices remain lower for longer favors US independent exploration and production companies that own high-quality assets in the lowest-cost shale plays.

The best upstream operators continue to reduce their per barrel production costs through efficiency gains and enhanced drilling and completion techniques that boost per-well output. Some of the strongest names can generate a decent return on capital with oil prices in the mid-$30s per barrel.

Despite significant volatility, crude-oil prices have trended lower since the beginning of June. Our near-term outlook calls for West Texas Intermediate (WTI) to tumble into the $30s per barrel over the next one to three months, a period of seasonally weak demand.

This weakness could create another opportunity to buy our favorite exploration and production names.

 

A New Portfolio Holding and Revisiting Old Friends

Our International Portfolio has fared quite well this year, with our conservative allocation generating a total return of 28 percent in US dollars. All 13 of these stocks have hiked their dividends over the past 12 months, rewarding investors with an average increase of more than 8 percent.

The Portfolio’s aggressive sleeve, which took a harder hit during last year’s selloff, has rallied hard in 2016, generating an average total return of 39.6 percent in US dollars.

After poring over second-quarter results, we’ve updated our comments on the more than 80 Canadian and Australian energy stocks in our International Coverage Universe. Here are some of our key takeaways from this process. We also exit one of our hedges and add a new upstream name to the International Coverage Universe.

During our most recent Live Chat, we received a number of questions about liquefied natural gas (LNG) and shipping companies that specialize in transporting this commodity. All signs point toward the global LNG market remaining oversupplied for at least the next four to five years, which should help to encourage demand growth.

Midstream MLPs: Second-Quarter Earnings in Review

The Alerian MLP Index, a capitalization-weighted basket of 50 prominent master limited partnerships (MLP), has delivered a total return of almost 16 percent this year, topping the 6.9 percent gain posted by the Philadelphia Oil Service Sector Index and the 28 percent loss posted by the Bloomberg North American Refining and Marketing Index.

However, MLPs have lagged the Bloomberg North American Independent E&P Index, which has rallied 34.13 percent and includes only a minimal contribution from dividends.

After successive waves of indiscriminate selling and buying, the easy money has been made in the MLP space; going forward, investors must have a firm grasp on underlying fundamentals to achieve differentiated returns.

We scrutinized second-quarter results and earnings calls from every midstream MLP; this issue highlights our key takeaways from this exhaustive (and exhausting process) as well as our updated takes and buy targets for all of these names.

Key Takeaways from Second-Quarter Earnings

After Halliburton (NYSE: HAL) and Schlumberger (NYSE: SLB) reported earnings in late July, the financial media published innumerable articles screaming that the oil-field services giants had called a bottom for the recent down-cycle.

The headlines contain a kernel of truth. Halliburton’s management team indicated that the second quarter would mark the trough for some of its core businesses in the North American onshore market—namely pressure pumping and other service and product line related to hydraulic fracturing.

Schlumberger’s management team was less sanguine about the prospects for the North American market, but indicated that the company should be able to claw back some pricing concessions and improve profitability by bundling service offerings and introducing higher-margin technologies.

We agree with Halliburton and Schlumberger’s assessment. However, calling the cycle’s bottom misses the point. At this juncture, investors should be more concerned about the likely speed and slope of the recovery after the trough.

Many oil-field service stocks—especially Helmerich & Payne (NYSE: HP) and other onshore contract drillers—have priced in a rapid rebound in profit margins and earnings. However, the recovery more than likely will prove to be W- or bathtub-shaped instead of V-shaped.

Subscribe today to receive a sample issue of EIA
  • Live Chat with

    Elliott and Roger on Dec. 27, 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