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Issues

Oil Services: Timing the Inflection Point

We eagerly anticipate earnings results from diversified service giants Halliburton and Schlumberger each quarter because no companies have a better big picture 30,000-foot view of industry conditions and trends in all major oil and gas-producing regions of the world.

In fact, careful analysis of comments and industry “read-through” from these two companies were a major factor in our 2014 call for a major decline in oil prices. In the most recent quarter, comments on the conference calls for both companies have important implications both for existing Focus List recommendations and a new addition to our Focus List and Active Portfolio.

Canada and MLPs: Time to Buy

In this issue of Energy & Income Advisor:

1 | We offer our outlook for the ongoing recovery in Canada’s long-suffering energy patch and the emerging favorable impact of expanding takeaway transportation capacity for natural gas and natural gas liquids (NGLs), as well as oil.

2 | We look at prospects for our favorite Canadian exploration and production companies, as well as oil and natural gas midstream, and we offer an addition to our Focus List.

3 | Per our July 19, 2018 Alert, we view as very bullish for the entire MLP sector this week’s clarification of a previous Federal Energy Regulatory Commission proposal on treatment of tax items in pipeline rates. We see a “table pounding buy opportunity” for readers who are light on our favored MLPs:

Oil Prices Lead an International Renaissance

Despite talk of a trade war, an OPEC-Plus agreement to boost oil production starting this summer and a rally in the US dollar, Brent oil prices ended the second quarter just under $80/bbl, the highest level since late 2014.

Even better, energy stocks were the top-performer in the S&P 500 for the second quarter with the S&P 500 surging 13.5% compared to a gain of just 3.4% for the S&P 500.

Over the past few years, oil prices and energy stocks have experienced numerous false dawns when investor attempted to call a bottom only to get burned as it became clear supply and demand fundamentals for oil remained weak.

We continue to believe this move is for real and, unlike most rallies over the past few years, it’s supported by real improvements in fundamentals. And, ironically, the OPEC-Plus agreement to boost output in late June may be the most bullish development for the energy patch in more than 4 years.

However, dangerous abound due to rapid changes underway in the global energy patch and it remains important to be selective.

Picks, Pans and Takeaways from the 2018 MLP & Energy Infrastructure Conference

As we have for more than a decade, we attended the 2018 MLP & Energy Infrastructure Conference (MEIC) in late May.

This year, we had the occasion to listen to presentations, participate in breakout sessions and one-on-one conversations with senior management at roughly 30 of the largest midstream energy companies in the US.

This week’s issue of Energy & Income Advisor will follow a slightly different format than usual.

During and following the conference, we compared notes and discussed some of our key questions and takeaways from MEIC.

Many of these discussions were recorded and, in this issue, we present an edited transcript of our conversations surrounding 7 key talking points: General takeaways from MEIC, MLP to corporation conversions, the FERC ruling on cost of service rates, US energy infrastructure bottlenecks, our picks (recommendations) coming out of MEIC, our main pans (stocks to avoid).

What Drives Performance for Exploration & Production Companies?

When I analyze any industry group I like to start by attempting to answer one simple question:

What are investors looking for?

In other words, it’s crucial to understand which quantitative metrics and/or stock characteristics drive stock market returns over time. Answer that one question and you’ll be well-positioned to select stocks that outperform their peers and the broader market.

However, these key metrics change over time and nothing drives changes in investor preferences quite like a bear market. That’s certainly been the case for the upstream energy industry in the wake of the big 2014 to 2017 bear market in oil prices.

In the last major energy bull market – leading up to the 2008 top for crude oil – production growth was the most important metric to watch. Companies that grew production the fastest often generated the strongest stock market returns even if growing production required financing via secondary share issuance or debt. And production growth – particularly oil production growth – remained a powerful metric in the 2009 to 2014 era of steady, high oil prices.

However, that relationship has now broken down for good and investors must change tactics accordingly, throwing out the growth-driven playbook that worked so well in the last bull market for energy. Simply put, investors are now looking for a balance between energy producers’ capital spending, free cash flow and production growth.

In this issue, we develop one key metric for analyzing exploration and production (E&P) companies that’s been strongly correlated to stock market returns over the past two years. While investors should never rely exclusively on any single quantitative metric in selecting stocks, we use this research as a starting point to identify some of the best-positioned E&P stocks to buy now as well as a few names to avoid.

Reaping the Rewards and Preparing for the Future

The majority of the names on our Focus List have benefited from the recent strength in crude-oil prices, a tailwind that has propelled several stocks above our buy targets—a high-quality problem and a welcome development after the energy sector’s performance last year.

Although we’re glad that our bullish outlooks for oil prices (an out-of-consensus view in the back half of 2017) and energy stocks have panned out, the forward-looking market doesn’t reward self-congratulation and complacency. Accordingly, the big question centers on what will come next for oil prices and energy stocks.

As we noted in the April 30 issue of Energy & Income Advisor, the fundamental backdrop for oil prices appears favorable over the next few years, as recent under-investment in exploration and development outside the US results in a steepening decline rate.

We’ve launched an actively managed model portfolio to help readers prepre for what’s next.

The Decline Curve Never Sleeps

Oil-field services giants Schlumberger (NYSE: SLB) and Halliburton (NYSE: HAL) perform work for large integrated oil companies like Exxon Mobil Corp (NYSE: XOM), national oil companies like Saudi Aramco, and smaller independents. These two giants operate in just about every oil- and gas-producing country in the world and provide indispensable services.

By virtue of their geographic reach and diversified service and product offerings, Halliburton and Schlumberger’s management teams have a bird’s-eye view of the oil industry that they often share during their quarterly earnings calls.

In the almost 20 years I’ve covered the energy sector, the insights gleaned from their conference calls have furnished countless investment ideas and read-throughs throughout the energy value chain. The first quarter was no exception.

During Schlumberger’s first-quarter earnings call, CEO Paal Kibsgaard discussed the looming air pocket in global oil supply–a consequence of the industry slashing spending on exploration and development. We’ve discussed this risk at length in Energy & Income Advisor, but early evidence of this shortfall has emerged.

 

Electric Vehicles: Semiconductors Offer the Best Near-Term Opportunity

Although the global push to break away from the internal combustion engine continues to gain traction, this process won’t take place overnight. Widespread adoption of fully electric vehicles will require improvements in driving range, battery cost and charging times. There’s also the need to build out sufficient charging infrastructure.

A large-scale shift toward electric vehicles would also necessitate significant investment in the grid. Simulations conducted by Matteo Muratori, a transportation and energy systems engineer at the National Renewable Energy Laboratory, found that uncoordinated charging of plug-in electric vehicles could present challenges for the grid. Potential solutions to this quandary reside in the application of big data and machine to machine communications to balance the load.

In addition to electric vehicles, the auto industry and leading technology players continue to pursue autonomous driving, an innovation that leverages advances in processing power as well as data storage and transmission. Early efforts in this direction have produced some tragic results, with Tesla possibly overstating—or drivers misinterpreting—the capabilities of its autopilot function.

These developments, coupled with the rise of ride-sharing services such as Uber and Lyft, have contributed to visions of a future where a fleet of autonomously driven vehicles starts to erode individual ownership of automobiles, especially in urban areas.

Speculating and arguing about these potentialities can be a stimulating experience; however, investing based on a concretized view of an uncertain future often results in more pain than profits. We would remind readers that a good story doesn’t always make for a good investment.

The transportation segment appears ripe for disruption, but this evolutionary process will take place over a longer time frame than some overexuberant investors expect.

In picking stocks with exposure to this theme, we aim to identify names that also offer leverage to near-term upside catalysts; the slice of pie on your plate offers more sustenance than the pie in the sky.

 

Peak Oil Myths and Realities

Over the past two years, a new concept of peak oil has become popular. This time, the idea isn’t peak supply, it’s peak demand: The view that electric (EV) and autonomous vehicles (self-driving cars) will soon erode demand for crude oil.

Whereas peak supply translated into a sharp rise in oil prices, peak demand implies a terminal decline in crude prices, a rapid erosion in the value of energy reserves worldwide and disastrous economic consequences for both energy companies and oil-dependent nations like Saudi Arabia.

Two decades ago, the idea of peak oil supply was flawed but contained a kernel of truth. Much the same can be said of the new fad of peak oil demand.

Over time, electric vehicles will gain in popularity, and the world will become less dependent on oil. However, the idea that fossil fuels are dying or that oil demand will enter a phase of terminal decline in the next 10 to 20 years is fantasy: Fossil fuels have decades of life ahead, and the transition is unlikely to result in a sudden erosion in the value of oil and gas reserves and energy-related stocks.

Our outlook for a gradual energy transition implies two major profit opportunities are at hand:

  • We expect at least one more major up-cycle in energy and commodity prices over the next few years, driven by supply costs and growing global demand for crude and refined products; and
  • Although we regard calls for EVs to take significant market share in the near term as overblown, investment opportunities exist to profit in the near term from the growing electrification of automobile subsystems—a trend that’s already underway and doesn’t depend on hopes and dreams for the global energy mix in 2040.

In this issue, we explore the macro implications of the intersection between peak oil demand and electric vehicles. Part two of these series, which will come out next week, will explore investment opportunities (and potential pitfalls) related to electric and autonomous vehicles, as well as government efforts to improve automobiles’ fuel efficiency.

Whither the Inflection?

Despite recent volatility in the broader market, the S&P 500 Energy Index managed to eke out a slight gain in March—an encouraging sign of relative strength. Nevertheless, the sector is down 6.8 percent on the year after traders took advantage of the sharp rally from mid-December to the end of January to sell the rip.

With energy stocks generally trading at undemanding multiples, the big question centers on what catalysts might prompt generalists and value-focused investors to allocate more capital to the sector on a sustainable basis. The answer requires a consideration of the factors keeping investors on the sideline.

Energy stocks appear to be suffering from a case of déjà vu, having burned generalist portfolio managers too many times during the down-cycle. Stable oil prices and mounting evidence of a balanced global oil market will be critical to shifting investors’ perception of the group, though this process will take time.

Commodity prices have remained supportive this year, with West Texas Intermediate (WTI) crude oil averaging more than $62 per barrel, compared with $51 per barrel in 2017.

Against this backdrop, the Bloomberg consensus revenue estimate for energy stocks in the S&P 500 has increased by a median of 4.1 percent over the past three months, one of the largest positive revisions and above the 0.9 percent bump for the overall index.

But higher prices and higher sales estimates haven’t been enough to lure investors back to the energy sector, reflecting all the false dawns that have occurred in the oil market since 2014.

When will the market come around to our view on the oil market and grow comfortable with the sustainability of current oil prices? Therein lies the question. Sticking with the names on our Focus List should ensure that you’re well-positioned for when sentiment turns.

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    Elliott and Roger on Aug. 27, 2018

  • 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

    • Elliott H. Gue

      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor

    • Roger S. Conrad

      Founder and Chief Analyst: Capitalist Times and Energy & Income Advisor