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Issues

Permania And MLP Madness

The Energy & Income Advisor team has recovered from the DUG Permian Basin conference, which we attended in Fort Worth, Texas. Readers can find our top takeaways and best investment ideas from the event in the slide deck and video presentation that we put together earlier this month.

As we mentioned in our presentation, we left the conference impressed with the quality of the stacked resource base in the Delaware and Midland basins, plays that we expect to continue to take market share over the long run because of their superior economics and ample midstream infrastructure. Our Focus List and Model Portfolios include a number of names that offer exposure to this growth story, though we prefer the midstream segment in the current environment.

With the DUG Permian Basin Conference done and dusted, our focus shifts to first-quarter earnings season and the MLP Association’s annual investor conference—an event that gives us an opportunity to put management teams through their paces and talk shop with analysts and portfolio managers. Historically, this conference has produced a good crop of investment ideas.

In preparation for earnings season and this event, we went through the exhaustive (and frequently exhausting) process of updating our comments for all the names in our MLP Ratings table. For your convenience, we have appended the results to the PDF of this issue.

Northern Exposure

Canadian oil and gas producers continue to contend with lower price realizations than their counterparts south of the border, reflecting intensifying competition from US shale plays and, in the case of crude, takeaway constraints.

This challenging environment means that investors should place a premium on quality and remain disciplined.

In the upstream space, Canadian Natural Resources (TSX: CNQ, NYSE: CNQ) and Suncor Energy (TSX: SU, NYSE: SU) continue to consolidate and build economies of scale as integrated oil companies and diversified independents seek to monetize their oil-sands assets.

Based on current valuations and the macro outlook, we continue to prefer best-in-class midstream operators and power producers for investors looking to add exposure to Canada’s energy patch. Many of our favorite Canadian midstream players also tend to trade with less volatility than their peers in the US.

More important, Alberta’s Climate Leadership Plan, which calls for the province shutter its coal-fired power plants by 2030, creates a longer-term opportunity for low-cost natural-gas producers and midstream operators to grow their volumes. We break down the names that are best-positioned to take advantage of this shift. Investors should also check out our International Coverage Universe for update comments and ratings.

Alternative Fracks

Fourth-quarter results and 2017 guidance from the big four oil-field service companies—Schlumberger (NYSE: SLB), Halliburton (NYSE: BHI), Baker Hughes (NYSE: BHI) and Weatherford International (NYSE: WFT)—highlighted recovering drilling and completion activity in the US onshore market and ongoing challenges in international markets.

Once again, the prospect of increased upstream capital expenditures appears most robust in prolific US shale oil and gas fields, where exploration and production companies have taken advantage of the recovery in oil prices to hedge future output and ramp up spending.

The Permian Basin in West Texas may be the hottest area in terms of drilling activity, asset acquisitions and media coverage. That said, the recovery in the US rig count looks broader that one might expect, with the formerly out-of-favor Eagle Ford Shale and the Haynesville Shale posting surprisingly impressive gains.

In contrast, international capital expenditures are expected to remain flat to slightly down in 2017, with the Middle East and Russia regarded two markets with any upside.

Although we struggle to identify a compelling reason to buy any of the big four at current valuations, recent weakness in the energy sector—and questions from readers—have prompted us to delve into names that offer concentrated exposure to the US onshore market.

The bullish case for US oil-field services hinges on accelerating drilling and completion activity helping to relieve the capacity overhang built up during the boom years, potentially setting the stage for a recovery in pricing.

Industry survivors with superior scale and balance sheets may have an opportunity to take market share from smaller operators. Oil-field service companies have also slashed costs aggressively, providing earnings leverage to a recovery in volumes.

At the same time, investors must remember that many of these companies operate cyclical businesses and consider the extent to which current valuations have priced in any incremental upside in earnings.

We continue to expect short-cycle US shale plays to take market share in coming years, as underinvestment in deepwater plays and other complex developments manifests itself in the international decline rate. Chevron Corp (NYSE: CVX) and Exxon Mobil Corp’s (NYSE: XOM) plans to allocate a growing portion of their budgets to US shale development underscore this point.

Midstream Focus And An Upstream Update

A little over a year ago, we added three high-quality oil and gas producers to the model Portfolio. 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.

This strategy has played out to perfection thus far, with our positions in Anadarko Petroleum Corp (NYSE: APC), Concho Resources (NYSE: CXO) and EOG Resources (NYSE: EOG) up an average of 86.9 percent over the intervening months.

In light of this run-up and the risk of rising service costs, the Jan. 25 issue of Energy & Income Advisor suggested that readers consider taking a partial profit off the table, especially with hedge funds’ aggregate long positions in West Texas Intermediate futures reaching record levels and creating a significant liquidation risk.

Our Model Portfolios also contain four legacy upstream names that we held through the down-cycle: Noble Energy (NYSE: NBL), Occidental Petroleum Corp (NYSE: OXY), Eni (Milan: ENI, NYSE: E) and Total (Paris: FP, NYSE: TOT). Here are our latest thoughts on these positions.

The Oil-Field-Service Industry Is A Battlefield

Each earnings season, we look forward to poring over quarterly results from the two largest oil-field-service companies–Schlumberger (NYSE: SLB) and Halliburton (NYSE: HAL).

These industry giants’ earnings calls–particularly the wide-ranging discussions hosted by Schlumberger, the world’s largest oil-field services company–provide invaluable insights into other aspects of the energy patch.

Because of Halliburton’s strong presence in the US and Canada, its management team tends to take a more bullish view on the North American market than Schlumberger, which usually emphasizes international activity. Evaluating both companies’ results and commentary helps investors to form a complete picture of key energy markets.

The read-through from Schlumberger and the other major oil-field services companies’ earnings reports and subsequent conference calls are particularly useful because they occur before many other energy-related names announce quarterly results.

The Skinny On Drop-Down MLPs

The so-called drop-down transaction—where a sponsor sells an asset to its associated master limited partnership (MLP)—has a long history (dating back to 1983) as a strategy for energy companies to monetize their midstream (pipelines and processing) assets.

Not only does this approach unlock the value of midstream assets that a refiner or upstream operator may not have run for a profit, but the parent also retains control of this critical infrastructure and garners a growing stream of cash flow via their incentive distribution rights.

The number and total value of drop-down transactions announced surged in 2010 and continued to climb in subsequent years, peaking in 2015. Deal flow slowed considerably in 2016 but remained elevated relative to historical norms.

Although this overweight position worked for a time and these stocks held their value reasonably well during the down-cycle, MLPs that rely heavily on drop-down strategies have underperformed since the start of 2016.

We explore the factors driving this underperformance, explain why all drop-down stories aren’t created equal and make the case for some of our favorite names in the current environment.

Riding The Petrochemical Wave

Although the mainstream media tends to focus on natural gas and crude oil when discussing the energy sector, natural gas liquids (NGL) are an important, if often overlooked, part of North America’s energy landscape.

This group of hydrocarbons, which occur underground with natural gas (methane) and crude oil, comprises five distinct commodities: ethane, propane, butane, isobutane and natural gasoline.

Rising US ethane exports, coupled with the start-up of the first wave of large-scale ethane crackers on the Gulf Coast in 2017, could dramatically change the supply-demand dynamics in this part of the NGL market. We highlight the best ways for conservative and aggressive investors to profit from this trend.

 

Risk Avoidance

Our goal with Energy & Income Advisor is to identify the sector’s best total-return opportunities, a goal that underpins our recently completed list of our top energy stocks for 2017.

In addition to making judgments about what will do well in the current environment, we also keep in mind what names have a higher likelihood of underperforming to help our subscribers steer clear of potential value traps.

This issue of Energy & Income Advisor highlights eight energy stocks for investors to avoid in 2017, a year where equity selection will become increasingly important after successive waves of indiscriminate selling and buying in the sector.

Knowing which stocks not to buy becomes increasingly important after the recent rallies in oil and gas prices and OPEC’s agreement to reduce crude production improved investor sentiment toward the sector.

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.

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    Elliott and Roger on Apr. 27, 2017

  • 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