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Strategy Update

By Elliott H. Gue on Sep. 8, 2017

To say that 2017 has proved a challenging year for energy stocks would be an understatement.

The ebullience that reigned in the aftermath of OPEC’s November 2016 agreement with Russia and other major oil-producing countries has dissipated, thanks in part to the rapid recovery in US onshore drilling activity and output, persistently elevated inventories and oil prices that have slipped below $50 per barrel.

Upstream-related subsectors have borne the brunt of this pain, with the Bloomberg North American Independent E&P Index giving up almost 36 percent of its value this year and the Philadelphia Oil Service Sector Index plummeting 35 percent.

This painful retrenchment reflects the lessons of OPEC’s agreement to cut production:

  • In roughly six months, US oil output had recovered to levels that offset about three-quarters of the 1.2-billion-barrel-per-day supply cut contemplated by OPEC’s deal with other major producers;
  • Any additional supply cuts would provide only short-term price relief, as US shale operators can take on hedges and ramp up activity levels relatively quickly when West Texas Intermediate (WTI) rallies; and
  • Oil prices, not OPEC, ultimately set the speed limit for US onshore drilling and completion activity in oil-rich basins.

With WTI hovering around $45 per barrel, the market doesn’t appear to price in much risk that lower prices could lead to a moderation in onshore activity levels and production growth. As expected, the handful of upstream spending cuts announced during second-quarter earnings season primarily came from operators focused on marginal areas or burdened with strained balance sheets.

Meanwhile, the US oil-directed rig count also appears to have peaked and has started to trend lower, suggesting that upstream operators have responded to the decline in WTI and creating the potential for supply growth to moderate down the line.

These dynamics likewise suggest that cycle times in US onshore may be shorter than in the past, making it difficult for oil-field service providers to gain pricing traction. At the same time, the growing number of wells awaiting completion in basins with robust activity suggests that operators could lay down drilling rigs to improve capital efficiency while they focus on hydraulic fracturing.

Given the extent to which the market punished production shortfalls and other disappointments during second-quarter earnings season, one wonders if the disruptions caused by Hurricane Harvey could give exploration and production companies that operate in the Eagle Ford Shale or deliver volumes to the Houston area a valid excuse for reining in completions.

Against this backdrop, we continue to favor midstream master limited partnerships (MLP) for their above-average yields and exposure to what we regard as a multiyear volumetric growth story where short-cycle US oil and gas production takes market share. In particular, basins that contain multiple hydrocarbon-bearing formations appear best-positioned for the long haul because of their superior economics.

The Alerian MLP Index has given up about 9.3 percent of its value this year, reflecting recent weakness in oil prices and concerns that the robust production growth expected.

Distribution cuts from industry heavyweights Kinder Morgan (NYSE: KMI), Energy Transfer Partners LP (NYSE: ETP), Plains All-American Pipeline LP (NYSE: PAA) and Williams Partners LP (NYSE: WPZ) likewise haven’t helped the group’s reputation among income investors. We regard recent weakness as a buying opportunity.

Although our outlook for oil prices and the US energy patch favors an overweight position in core midstream holdings, nimble investors can generate alpha in upstream names by buying when oil prices retreat to the low end of their range and taking some profits off the table when they recover. Timing and stock selection—easier said than done with shorter cycle times—will be critical to producing differentiated returns.

We also continue to explore investment ideas related to energy efficiency, renewable energy and demand-side related opportunities, a process that we began with our recent issue on the petrochemical complex. Expect more in coming issues.

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