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Strategy Update

By Elliott H. Gue on Jan. 16, 2016

How do our outlooks for energy prices inform our investment strategy over the coming year?

Hedges

We took profits in American Airlines (NSDQ: AAL) and Royal Caribbean Cruises (Oslo: RCL, NYSE: RCL) in November 2015 because of our growing concern about a bear-market correction—a view that looks prescient when you consider the price action in these two stocks and the S&P 500 thus far in 2016. (See Trimming Some of Our Hedges.)

As for our 45 percent gain in ProShares UltraShort Oil & Gas (NYSE: DUG), investors should consider cashing out a quarter of their position at $90 per share, another 25 percent at $100, a third tranche at $108 and the remainder at $114. This approach enables us to lock in a partial profit in a topsy-turvy market while retaining some upside leverage to further downside in energy stocks.

Upstream

Although many of our decisions in 2015 necessarily reflected our outlook for significant downside in crude-oil prices during the fall and winter turnaround seasons, investors should take a longer view when positioning their portfolios this year.

We stood aside on oil and gas producers last year, exiting higher-risk names such as Vanguard Natural Resources LLC (NSDQ: VNR) and Memorial Production Partners LP (NSDQ: MEMP) at much higher prices than their current quote.

Our call for oil prices to range between $40 and $60 per barrel for an extended period may appear bearish for the energy sector, but investors should consider the action in energy stocks in the late 1980s and early 1990s.

From the end of 1989 to the end of 1995, the S&P 500 Energy Index managed to eke out a 76.7 percent gain despite a prolonged period of weak commodity prices.

Energy stocks underperform when oil prices plummet; however, the sector can also deliver solid returns when oil prices are lower, provided that they trade within a range.

In a scenario where oil prices remain lower for longer, investors should focus on upstream operators with strong balance sheets, low production costs, a history of solid execution and franchise assets that can deliver output growth in a challenging environment. Names that can expand their output and win market share should outperform, while their cash-strapped peers or those with inferior assets will struggle.

Extended periods of weak oil prices traditionally have encouraged mergers and acquisitions, as well-capitalized companies look to build scale and drive growth–these are the names investors should own.

The universe of exploration and production companies that meet our criteria is relatively small; don’t misconstrue this call as open season to buy upstream names indiscriminately. Not every oil and gas producer has the potential to outperform, let alone survive.

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