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Issues

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.

Embracing Relative Strength and Avoiding the Land Mines

Oil prices fell alongside the stock market during the late January to early February selloff as part of a global risk-off trade. Oil prices have also recovered alongside the S&P 500 since the Feb. 9 low.

We remain sanguine about crude-oil prices over the short to intermediate term. Backwardation in the Brent futures curve continues to point toward a tight supply-demand balance. Twelve-month Brent futures trade at a discount of $3.76 per barrel to the front-month contract, just off the January high of $4.56 per barrel.

That said, we don’t expect oil prices to rally to $70 or $80 per barrel. Such a move would be self-defeating, as the surge in shale production would overwhelm demand.

At the same time, we don’t expect a repeat performance of last year’s big selloff back into the $40s per barrel. OPEC and Russia remain disciplined on their supply agreement, and tight labor and services markets in the North American oil patch are raising costs for shale producers. At the same time, investors are demanding greater capital discipline, which means producers require higher prices to incentivize stepped-up activity.

Recent disruptions in Libya and plummeting Venezuelan production—down 300,000 barrels per day since September alone—represent additional potential upside catalysts for oil prices this year. We expect WTI to average about $60 per barrel this year.

Although the upside potential in oil prices appears limited, energy equities offer a better risk-reward proposition. The stocks on our Focus List remain our favorite bets and have held up well in a challenging tape and an earnings season filled with land mines.

Déjà Vu for the Oil Market and Energy Stocks?

Last week’s spike in volatility was difficult for every investor, especially after a period of unprecedented placidity during which many market participants forgot the terror that these swoons can induce, even if US equities were overdue for some profit-taking.

For better or worse, the highs and lows of this down-cycle have accustomed energy-focused investors to bouts of sharp volatility. Nevertheless, the selloff in energy stocks was still harrowing, with the S&P 500 Energy Index giving up all the gains it had chalked up in the first month of the year.

Energy stocks appear to be suffering from a case of déjà vu. Last year, the sharp recovery in US crude production and the oil-directed rig count, coupled with money managers taking profits on their sizable long positions in Brent and West Texas Intermediate (WTI) futures, conspired to send WTI tumbling to as low as $42 per barrel.

On the surface, a similar dynamic is at play today.

 

2018 Macro Outlook

At the outset of each year, the Energy & Income Advisor team reviews its big-picture calls from the previous 12 months and digests the lessons from our successes and failures. This self-reflection on what went wrong and what went right helps us to hone our investment strategy.

We also highlight our outlook for the coming year to set a basic framework that informs our positioning and helps to remove some of the emotion from the investment process. As always, none of our forecasts are set in stone; rather, these views necessarily will evolve as economic and market conditions change over time. In a dynamic market, what’s right at the outset of the year might no longer hold at the midway point.

Recent issues of Energy & Income Advisor have highlighted our outlook for energy stocks, master limited partnerships (MLP), and our International Portfolio. This time around, we’ll delve into four macro topics: the economy, the US equity market, crude-oil prices and natural-gas prices.

 

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    • 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