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  • Roger S. Conrad

Issues

Recession Risk Rising but Energy Still Shining

The S&P 500 has now lost more than -20 percent of its value since January 1. But despite recently increased volatility, the S&P 500 Energy Index still boasts a year-to-date total return north of 40 percent. The midstream stock-laden Alerian MLP Index is up around 26 percent. And the Philadelphia Stock Exchange Oil Service Sector Index is ahead by more than 22 percent.

That’s a staggering outperformance. And it comes in a year when the bond market continues to melt down in the face of a Federal Reserve all-out assault on inflation, with the benchmark 10-year Treasury note yield rising by 132 percent to over 3.5 percent.

Energy is a highly capital intensive industry. And even the strongest companies’ cost of debt has risen sharply this year, as low valuations have kept equity issuances to a minimum outside of dividend reinvestment plans. Model Portfolio member ExxonMobil (NYSE: XOM), for example, still yields nearly 4 percent and sells for less than 7.5 times its expected next 12 months earnings, as well as barely 10 times trailing 12 months free cash flow per share.

Energy Stocks: Earnings Power and M&A Mean it’s Still a Time to Build Positions

Phillips 66 (NYSE: PSX) is offering $34.75 per unit in cash for DCP Midstream (NYSE: DCP) it doesn’t already own. That follows Phillips’ swap of crude oil assets for natural gas related infrastructure owned by Canadian midstream company Enbridge Inc (TSX: ENB, NYSE: ENB).

For both companies, this deal making is about increasing scale and therefore efficiency in areas they’ve chosen to focus on. For Phillips, consolidating DCP follows the pattern of its 2021 buyout of Phillips 66 Partners, reducing cost of capital to fund further expansion. And S&P has now upgraded DCP Midstream’s credit rating to BBB+ from BBB- in anticipation of full asset integration.

Stay Patient as Energy Values Appear

So far this month, Berkshire Hathaway (NYSE: BRK/B) has announced purchases of 27 million and 12 million shares of long-time EIA recommendation Occidental Petroleum (NYSE: OXY). As a result, the giant investment and insurance firm now owns 18.7 percent of the oil and gas producer—that’s nearly as much as the next two largest holders combined.

Why load up on a still highly leveraged commodity producer just as an inflation-focused Federal Reserve appears to be tipping the US economy into recession? We suspect it’s the same basic reason for all of Mr. Buffett’s investments since he became Berkshire’s Chairman and CEO way back in 1970: He sees truly massive free cash flows in Occidental’s future.

A Recession Won’t Repeal the Energy Cycle

Let’s be clear. Neither oil and gas prices nor energy stocks will be immune if the global economy slides into recession later this year. And damage to prices would be compounded if Russian, Iranian and/or Venezuelan oil re-enters the market in a meaningful way.

But that said, what the Federal Reserve and other central banks are attempting now to quell inflation will not end the energy up-cycle that began in spring 2020. Neither would a return to the market of supply from what are currently pariah countries.

In fact, any energy sector retreat we see in coming months is far more likely to result in the long-term cycle being both longer and stronger. And means much higher prices for favored stocks than we saw at the top of the up-cycle that ended in 2014.

The Earnings Issue

The Nasdaq 100 has lost about -27 percent of its value so far this year. And the almost as technology-stock heavy S&P 500 isn’t far behind at roughly -18 percent. Throw in the collapse of the bond market—led by a near doubling of the benchmark 10-year Treasury bond yield—and it’s small wonder so many have already proclaimed a bear market is underway.

We won’t argue stocks aren’t due for one, given the last period that really qualified was back in 2007-09. And the worst inflation rate in over 40 years, China’s pandemic lockdowns, the increasingly hawkish Federal Reserve, fallout from Russia’s Ukraine invasion and signs consumer spending is slowing are certainly reasons for worry.

Equally, however, 2022 so far has been among the best of times for energy investors. Led by continuing gains in best in class oil and gas stocks, the S&P Energy Sector Index has returned better than 48 percent. And even sector laggards are revving their engines, with the Philadelphia Stock Exchange Oil Service Sector Index (OSX) higher by nearly 42 percent and the midstream laden Alerian MLP Index returning more than 20 percent.

Energy’s Expanding Winners’ Circle

We’re now roughly two years into the energy upcycle—which began with North American benchmark oil prices actually in negative territory.

For most of that time, it’s paid to focus solely on the very best in class. They were the only energy stocks that were still profitable at the bottom. They were first to adjust to the current environment. And they were able to build market share during the downturn, even while less adept rivals were slashing dividends and filing for bankruptcy.

US/EU Natural Gas Pact and Two New Portfolio Additions

You’ve probably seen the headlines about a deal between the US and European Union aimed at reducing Europe’s dependence on Russian fossil fuels.

One centerpiece of this agreement, unveiled on March 25th, is a US promise to work with international partners to ensure additional liquefied natural gas (LNG) volumes of 15 billion cubic meters (BCM) of natural gas for 2022 with “expected increases going forward.”

So, does this mean a surge in US natural gas prices and increased demand for US liquefied natural gas exports?

Russia and the Next Stage of the Energy Cycle

Earlier this month, global oil prices hit a 13-year high of nearly $140 a barrel. This week, they’ve backed off substantially.

As this issue of Energy and Income Advisor goes to post, Brent crude has dropped back to a level just north of $100. And West Texas Intermediate Crude at the Cushing hub has come back to the mid-$90s.

Energy stocks by and large have lagged the gains in commodity prices thus far in the cycle. But while holding their ground better on the retreat, they’ve also sold off from the highs of earlier this month. The S&P Energy Sector Index, for example, is still up almost 30 percent year to date. But it’s also down more than -10 percent from the high point earlier this month. The Alerian MLP Index of major dividend-paying midstream stocks has also lost about -10 percent of its value from the same date, reducing its 2022 gain so far to about 9 percent.

The Earnings Issue

The highest inflation rate in 40 years, increasingly hawkish global central banks, US/Russian “saber rattling” in Eastern Europe, lingering coronavirus uncertainty, approaching elections: All of these and more have contributed to a shaky opening for stocks this year, with the S&P 500 underwater by -8.6 percent.

The S&P Energy Sector Index, however, has continued to advance since our previous EIA issue and is now up nearly 23 percent for 2022. And while midstream continues to generally lag producers, refiners and other energy stocks, the Alerian MLP Index is still ahead by about 13 percent.

Bottom line is energy’s outperformance in 2021 is so far powerfully carrying over to 2022. And the simple explanation is the sector has decidedly entered a cyclical uptrend—one that based on what we’re seeing so far could be as explosive as any that have preceded it to date.

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  • Live Chat with

    Elliott and Roger on Sep. 27, 2022

  • Portfolios & Ratings

    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