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Issues

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.

 

The Case for Energy Stocks

A year ago, we reasoned that energy stocks could outperform the broader stock market despite our projections for weak oil prices in the first half of the year. Our thesis hinged on our view that oil prices would average about $50 per barrel in 2017 and that many US shale players, especially early entrants in the Permian Basin and central Oklahoma’s STACK play, could earn strong returns on capital in this environment.

Although we were consistently negative on some large-cap master limited partnerships (MLP) last year—including Energy Transfer Partners LP (NYSE: ETP) and Plains All-American Pipeline LP (NYSE: PAA)—we expected select midstream operators to fare well in 2017. Our preferred names offered exposure to the Permian Basin and other areas where temporary dips in oil prices wouldn’t affect activity levels.

This bullish outlook proved to be our biggest miss a year ago: Energy was the second worst-performing sector in the S&P 500, and the Alerian MLP Index gave up 6.5 percent of its value. Few energy stocks avoided the carnage that engulfed the sector over the first eight months of 2017. Even high-quality upstream and midstream names like Concho Resources (NYSE: CXO), EOG Resources (NYSE: EOG) and Enterprise Products Partners LP (NYSE: EPD) found themselves caught up in the bloodbath.

However, it’s always darkest just before the dawn. We thought that this indiscriminate selloff resembled the classic, panic-driven plunges that tend to occur toward the end of the bear market and positioned the Focus List accordingly. Energy stocks have outperformed in the new year, but we remain bullish on the sector for four reasons.

Selectively Bullish on Master Limited Partnerships

Fundamentals for midstream MLPs generally appear bullish in 2018. Third-quarter earnings season underscored the extent to which the group has followed Enterprise Products Partners’ lead and sought to limit equity issuance to focus on self-funding growth opportunities.

At the same time, many MLPs have taken their medicine, slashing distributions and shoring up their balance sheets by monetizing noncore assets. This process hasn’t entirely run its course, with Energy Transfer Partners LP (NYSE: ETP) and others still leaning against the winds of change. Contract expirations and dilutive conversions of preferred units will also present challenges for some names in coming years. However, many partnerships have taken the necessary measures to put themselves on a sustainable path.

Besides the prospect of outsized production growth in the Permian Basin and STACK plays, our favorites should also benefit from supportive crude-oil prices and the highest gas-processing margins in years.

This issue of Energy & Income Advisor reviews the headwinds buffeting MLPs, the promise of the new year, trends in mergers and acquisitions, our top picks, pockets of underapprecated risk, and some under-the-radar opportunities. We’ve also updated most of the comments in our MLP Ratings table.

Positioning for the New Year after a Topsy-Turvy 2017

We maintain our bullish outlook for oil prices and cyclical energy stocks as 2017 winds down. Although we won’t hesitate to modify our views and positioning in response to incoming data points and developments, we expect 2018 to be less tumultuous for the energy sector, making the stocks easier to own and requiring less trading to deliver differentiated returns. Energy stocks could also benefit from the ongoing rotation into value-oriented sectors.

Second Time’s a Charm? The Case for Selective Exposure to Oil-Field Services

Heading into 2018, we like the setup for US-levered oil-field service stocks, though investors will need to remain selective and avoid the problem spots and value traps that lurk in this industry.

What’s changed over the intervening months?

Our outlook for oil prices is certainly more bullish than in late 2016 and early 2017, when we warned that the US production response would surprise to the upside and offset OPEC’s production cuts.

Although oil prices have rallied on several occasions over the past three years, we (rightly) regarded these upswings as ephemeral because the oil market remained in contango—that is, longer-dated futures commanded a premium to near-term contracts. This environment encourages market participants to store oil for future delivery and makes it easier for producers to hedge expected output.

In addition to improving investors sentiment, the recent strength in crude-oil prices should support solid capital spending among US exploration and production companies, many of which have taken advantage of the rally in WTI to lock higher prices on expected production.

Nevertheless, sentiment toward the industry remains cool, with investors erring on the side of caution and viewing the group as a show-me story—one of the big reasons oil-field service stocks hadn’t participated in the rally in crude-oil prices until recently. At these levels, the downside risk in many oil-field service names appears limited in the event that our investment thesis doesn’t work out.

 

Today, crude oil is in the early innings of a cyclical recovery. The market for Brent oil (an international benchmark) entered backwardation earlier this year, with front-month futures trading at a premium of $2.89 per barrel to volumes slated for delivery 12 months later. This structure discourages market participants from paying to store oil and indicates a tightening supply-demand balance.

 

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      Balanced portfolios of energy stocks for aggressive and conservative investors.

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      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.

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      Roger Conrad’s coverage of more than 70 dividend-paying energy names.

    Experts

    • 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