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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.

Kicking the Tires on Large-Cap MLPs

Over the past several months, we’ve fielded innumerable questions about whether specific master limited partnerships (MLP) will be able to maintain their distributions, with readers focusing on higher-yielding Portfolio holdings and names that we highlighted when we ran The Energy Strategist and MLP Profits. (Roger and I have covered MLPs for almost a decade.)

Our focus has always been on the quality of an MLP’s underlying assets and cash flow—the foundation for long-term wealth building. But in this environment, liquidity and cost of capital can also exert a profound influence on a partnership’s distribution policy, particularly for names with significant capital spending needs.

In this issue, we delve into many of the popular large-cap MLPs to evaluate the pressure points in their underlying businesses if energy prices remain lower for longer and their ability to meet near-term debt maturities and planned capital expenditures.

Tackling the Big Questions

All the upheaval in global energy markets has many investors scratching their heads about what the future holds for oil and gas prices, what to do with their existing positions in this sector and which groups within the space look attractive at current valuations.

Making sense of the constantly shifting energy landscape becomes all the more challenging in a 24-hour news cycle where history is dead, sensationalism rules the day and the loudest (or most controversial voices) get the most attention–regardless of their track record or the validity of what they’re saying.

Over the past year, we’ve consistently warned that elevated US oil inventories and steady production would squeeze oil prices lower in the fall and winter–a period of seasonally weak demand when many refiners idle capacity for upgrades and maintenance.

Our three-part strategy has also remained consistent: Taking advantage of short-lived recovery rallies to exit risky positions; hedging remaining energy exposure through positions in inverse exchange-traded funds, airlines, cruise operators and convenience stores; and waiting patiently for an opportunity to buy select names at dream prices.

This buying opportunity could be around the corner if oil and gas prices tumble further in coming months. Although oil prices remained relatively flat from 1985 to the mid-1990s, select energy stocks managed to outperform the broader market over this decade–a trend that could repeat itself if the price of West Texas Intermediate remains lower for longer.

Tactical Maneuvers

With few exceptions, energy stocks have been taken to the woodshed this year.

Fortunately, some proactive hedging has helped to offset some of the downside in our Model Portfolios. In January 2014, we began to take profits in some of our riskiest holdings and add exposure to airlines and other industries that tend to benefit from lower oil prices.

In this issue, we reassess our picks in the airline, cruise, convenience store and petrochemical industries in light of the increasing risk of a bear-market correction in 2016.


US Natural Gas: Outlook and Investment Guide

We’ve remained bearish on US natural-gas prices for the past several years, asserting that any short-term rallies induced by a cold winter would fail when prices approach $4 to $5 per million British thermal units.

The floor for the commodity sits around $2 per million British thermal units, though elevated inventories and production levels suggest Henry Hub prices could fall below this threshold this winter.

Nothing on the horizon suggests that US natural-gas prices will escape this trading range, while the near-term risks skew decidedly to the downside.

We expect front-month prices at the Henry Hub, the official delivery point for natural-gas futures that trade on the New York Mercantile Exchange, to struggle to top $3 per million British thermal units in 2016. The thermal fuel could also tumble to $1 per million British thermal units or less if a warm winter swells the volume of natural gas in storage.

In this issue, we delve into a handful of popular gas-focused producers, but opt to stand aside on even our favorite names for now. However, a buying opportunity could emerge in coming months if this winter ends up being warmer than usual.

We’re more bullish on midstream names that stand to benefit from growing demand for US natural gas at home and in Mexico.

Those Who Misinterpret the Past Are Doomed Not to Profit

Market pundits and talking heads who use the 2008-09 collapse in energy prices and related stocks as an analogue for the current downturn fail to distinguish between a demand-driven correction and a longer-lived one where the imbalance occurs on the supply side.

Whereas the financial crisis and Great Recession sapped demand, the severe downdraft in oil prices that began in the second half of 2015 reflects an upsurge in non-OPEC production, driven primarily by the North American onshore market.

Investors who followed our lead and bought the dip in energy stocks in late 2008 and early 2009 booked huge gains, with the S&P 500 Energy Index soaring almost 40 percent from the end of 2008 to March 2010.

However, those who fell prey to recency bias—the tendency for humans to use patterns from the proximate past to predict the future—and bought energy stocks in anticipation of a V-shaped recovery in oil prices haven’t fared well this time around.

Based on our fundamental analysis of the oil market and lessons from the 1980s and 1990s, we repeatedly warned readers to resist the urge to buy energy equities that looked cheap on traditional valuation metrics. We underscored this risk during the energy sector’s spring relief rally, which far too many investors misinterpreted as an all-clear signal.

After an almost 18-month bear market in energy prices and related stocks, we appear to be on the verge of an epic buying opportunity for a select group of upstream names that have the balance sheet and asset base to win market share and grow in an environment where prices remain lower for longer.

Our strategy, which we outlined in the Sept. 26 issue of Energy & Income Advisor, is based on lessons from the mid-1980s and early 1990s. Elevated US oil inventories, coupled with reduced demand during refinery turnarounds this fall and in early 2016, increase the likelihood of another selloff in crude-oil prices even though domestic output has started to roll over.

To take advantage of this coming buying opportunity, we’ve narrowed the universe to our top picks and setting dream buy prices for these stocks. Note that our strategy doesn’t aim to pick a bottom for these equities; rather, our goal is to identify valuations that represent good entry points.


Getting Ready for a Real Buying Opportunity

Over the past two years, oil and gas producers have accounted for the bulk of the energy sector’s bankruptcies, laid low by excessive leverage, the collapse in commodity prices and inferior assets. Exploration and production companies haven’t emerged from the woods yet—but they’re not all goners. In fact, the buying opportunity that investors have awaited appears to be around the corner.

In a scenario where oil prices remain lower for longer, investors should focus on upstream operators with strong balance sheets, low production costs, a history of solid execution and franchise assets that can deliver output growth in a challenging environment. Names that can expand their output and win market share should outperform, while their cash-strapped peers or those with inferior assets will struggle.

The universe of exploration and production companies that meet our criteria is relatively small; don’t misconstrue this call as open season to buy upstream names indiscriminately. Not every oil and gas producer has the potential to outperform, let alone survive.

In this issue, we highlight a handful of our favorite names to scoop up during the coming buying opportunity. To help with timing, we’ve included dream buy prices for these stocks that reflect trough valuations in previous downturns and our outlook for commodity prices.

MLP Madness

During our August Live Chat with subscribers, readers inundated us with questions about master limited partnerships (MLP), specifically which ones were at risk of cutting their distributions and which names were worth buying after the most recent pullback.

To address these concerns, we’ve dedicated this issue to the MLPs, highlighting the risk factors that have driven the group’s painful re-rating and identifying a number of popular MLPs that could cut their distributions or could be at risk for significant downside.

However, the universe of publicly traded partnerships still contains a number of appealing total-return stories–and the potential for further downside in crude-oil prices this fall and in early 2016 could create an excellent buying opportunity for savvy investors.

To help readers take advantage of this opportunity, we’ve created a list of dream buy prices for our MLP Portfolio holdings. The next issue of Energy & Income Advisor will include dream buy prices for names that we would consider adding to our model Portfolios if the stocks get cheap enough.

Ripping Off the Band-Aid

Throughout the energy sector’s recovery rally earlier this year (a false spring), we warned of a second leg down for crude-oil prices, with the selling pressure intensifying in fall and winter, when refineries usually shutter some of their capacity for maintenance and upgrades.

Valero Energy Corp (NYSE: VLO) and other refiners have warned that this year’s turnaround season could involve more outages than usual because the industry ran flat out in the spring and summer to take advantage of robust demand for gasoline and favorable crack spreads.

And even after record refinery runs and gasoline demand this summer, resilient production and overseas imports have ensured that US crude-oil inventories remain about 26 percent above their five-year average for this time of year.

This overhang, coupled with the prospect of reduced demand, suggests that oil prices could suffer significant downside this fall. Albeit painful, such a correction could accelerate the process of squeezing production from marginal acreage and ratchet up the pressure on those with stretched balance sheets.

The potential for crude-oil prices to slip into the $30s per barrel (and perhaps even lower), coupled with slowing production growth in some basins and outright shrinkage in others, suggests that the energy sector could be in for more pain this fall and into early 2016.

Exploration and production companies likely face the most downside in this scenario, and we would continue to steer clear of onshore and offshore contract drillers and other equipment providers. Even midstream master limited partnerships face near-term uncertainties related to counterparty and volumetric risk.

However, we remain bullish on US oil and gas production over the next three to four years, as we expect reductions in non-OPEC drilling activity and reduced capital expenditures in international markets to create an opportunity for short-cycle shale plays to fill the gap and win market share.

Rest assured, there’s more pain coming for the energy sector in the near term, creating a real buying opportunity for investors with a longer time horizon. Keep your powder dry and your head level.

  • Live Chat with

    Elliott and Roger on Feb. 23, 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.


    • 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