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  • Roger S. Conrad

Issues

This Pullback is Bullish for Strong Companies

Since the previous issue of Energy and Income Advisor, energy stocks have backed off a bit more from their June 8 recovery high. The S&P 500 Energy Sector Index finished last week down -21 percent from that level, though it’s still 60.7 percent above the March 18 low.

Super majors-focused NYSE Arca Oil Index (NYSE: XOI) has given back -20.4 percent and is now up 71.6 percent from mid-March. And the midstream-heavy JP Morgan Alerian MLP Index ETN (NYSE: AMJ) has retreated -23 percent to a point 113.2 percent above the recent bottom.

Pullbacks like this one come with the territory when a market has risen as far and fast as energy stocks have since March. If it does extend, we’ll consider it an improved opportunity to buy best in class companies at better prices, with an eye on our Dream Buy levels.

Dumping the Weak, Adding to the Strong

The rally in energy stocks from mid-March has taken a breather. On June 8, the S&P 500 Energy Sector Index reached its highest point since early February, up 97 percent from its March 18 low. A few days later, it was down more than 17 percent.

Other indexes have followed the same pattern. Super majors-focused NYSE Arca Oil Index (NYSE: XOI) returned better than 105 percent from mid-March to June 8, only to give back roughly 17 percent. And the midstream-heavy JP Morgan Alerian MLP Index ETN (NYSE: AMJ) retreated 16 percent, after running higher by 152 percent.

Quality is Still King in the Energy World

Energy stocks have rallied hard in the month of May. The S&P 500 Energy Sector Index is now up more than 70 percent from its March 18 low. The super majors-focused NYSE Arca Oil Index (NYSE: XOI) is higher by 82 percent plus. And the midstream-heavy JP Morgan Alerian MLP Index ETN (NYSE: AMJ) is now better by 140 percent.

None of these indexes is as yet anywhere close to where it started the year. The S&P Energy Index is 60 percent under its all-time high in mid-2014, the last time oil sold for more than $100 a barrel.

True, benchmark WTI Cushing crude will run you about one-third of that now. The same is true for natural gas at Henry Hub, and prices are lower still at hubs in Appalachia and Canada. Unlike oil, gas has not rebounded appreciably from the March low.

Q1 Earnings and Guidance: Here’s What’s Critical

The prospect of deep cuts in production has sparked a bounce in oil prices. And at least for the moment, crude is trading over $20 a barrel again across North America, with global benchmark Brent in the upper 20s.

The real action, however, has been in energy stocks, which have literally vaulted from last to first in terms of S&P 500 sector performance. The S&P 500 Energy Sector Index is more than 50 above its March 18 low. The super majors-focused NYSE Arca Oil Index (NYSE: XOI) is up 55 percent plus. And the midstream-heavy JP Morgan Alerian MLP Index ETN’s (NYSE: AMJ) has exploded upward more than 80 percent.

None of these indexes are close to erasing year-to-date-losses, let alone declines since this energy down cycle began in mid-2014. But they’re clearly demonstrating the upside leverage survivors will have in the eventual recovery.

Selective on Energy Stocks, Cautious on Commodities

Two weeks ago, we noted energy stocks appeared to be breaking out of a multi-year trend of underperforming oil and gas prices on both rallies and dips. That trend has solidified since.

Oil has continued to slide. The market disruption that pushed the expiring May futures contract into negative territory has eased. But benchmark WTI Cushing is at a low to sub-teens price per barrel. Crude from Alaska, the Bakken and Canada has been trading under $10, and global benchmark Brent has periodically broken under $20.

The price of natural gas has been somewhat more stable. But after a mild winter in most of North America, benchmark Henry Hub is still well under $2 per thousand cubic foot. Gas at Canada’s AECO and Appalachia’s Marcellus is mired in the $1.50 range, too low for many producers to be profitable.

Energy Stocks Off Their Lows, Now What?

It’s still very early days to actually call it a trend. But for at least the last month, energy stocks are actually outperforming oil and gas prices.

That may be temporary. But at least for now, it’s a sharp break from the rule of the past several years. Since oil broke under $100 a barrel back in mid-2014, energy stocks have consistently lagged when oil has jumped. And when the price of the commodity has slipped, they’ve fallen much further and faster.

As a result, energy stocks have finished every mini-cycle of the past six years at lower levels. ExxonMobil’s (NYSE: XOM) March 31 bottom price of $30 and change is its lowest point since 2002.

Energy’s Great Guidance Re-Set

US oil prices are back in the neighborhood of $20 a barrel. And they’re showing every sign of going lower as COVID-19 fallout depresses demand and Saudi Arabia ramps up output like there’s no tomorrow.

Natural gas prices, meanwhile, have sagged under $1.70 per thousand cubic foot. They may catch a break on the supply front this year, as cutbacks of shale oil production reduce output of associated natural gas. But that may be more than offset by sagging demand, should efforts to reduce COVID-19’s spread result in a big drop in electricity usage.

The bottom line is energy producers are facing their worst operating environment since the early ‘00s. And unlike the last time prices dipped in 2015-16, their list of allies on Wall Street grows thin, all but cutting them off from economic outside financing. In effect, they’re on their own to generate the cash they need to operate.

The Name of the Game is High Grading

Unless there’s a monster rally in the last 10 days of March, oil prices are headed for their worst one-month performance in history. In fact, the decline so far is almost 17 percentage points greater than the previous record of -33 percent in October 2008.

Then as now, energy prices have been hammered by the growing likelihood of a global demand shock. That time around, the cause for concern was the Financial Crisis, which then had unknown dire consequences for economic growth. This time, it’s COVID-19 and its highly uncertain eventual impact on human health and the global economy.

Oil prices, however, simultaneously face a supply shock, as Saudi Arabia ramps up production even as demand comes under pressure. A similar move by the Saudis in 2015 was enough by itself to drive US prices down to $26 and change. This time around, combined with the demand shock, we now see a probability of oil prices in the mid-teens before there’s a hard bottom.

Our Best Foot Forward in a Shaky Market

When global markets shake, not much does well. That’s certainly been the case the past several weeks, as worries about the potential economic impact of COVID-19 have spread.

Energy stocks were just beginning a recovery earlier this year when Chinese authorities first indicated an elevated threat to public health. What’s happened since is a full-on retreat in major sector indexes, with both the Alerian MLP Index and S&P 500 Energy Sector Index taking out the lows of early 2016.

That’s extraordinary for the fact alone that benchmark oil prices are still more than $20 above their February 2016 low point of $26 per barrel and change. Even North American benchmark natural gas is trading 8 percent higher than its March 2016 nadir of $1.61 per thousand cubic foot.

When the Going Gets Tough, Tough Energy Companies Get Going

Roughly half the companies in our Energy and Income Advisor coverage universe have now reported Q4 results—and a more or less equal percentage of our Actively Managed Portfolio and High Yield Energy List stocks.

That still leaves a lot of news and numbers to come in a quarter where mountains of filing requirements tend to delay their release. But from what we’ve seen so far, it’s clear that quality is asserting itself in the energy sector.

Mainly, despite multiple headwinds, the best in class are still thriving as businesses. In contrast, companies with real weaknesses as businesses are imploding, and almost at the same rate they were in 2016 when the price of oil sank to just $26 and change.

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      Our take on more than 50 energy-related equities, from upstream to downstream and everything in between.

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    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