Drilling Down for Bargains After Oil’s Decline

Oil Rig

Stocks have suffered lately, with year-to-date returns for U.S. equities once again negative. The most recent driver of the sell-off, and accompanying volatility, hasn’t been fears of a Federal Reserve (Fed) rate hike, but rather collapsing oil prices and the implications for energy-related debt.

Paying less at the pump might seem like a good thing for consumers, but the recent drop in crude prices has reinforced fears over slow economic growth and deflation, placing pressure on a range of asset classes related to energy.

According to Bloomberg data, amid concerns over energy issuers in the high yield market, high-yield spreads continued to widen last week. The fall in oil is also putting more pressure on already battered emerging market oil-exporting currencies, including those of Mexico, Russia and Columbia. Finally, and not surprisingly, any company in the energy space is feeling pressure. This includes not only oil production and service stocks, but also Master Limited Partnerships (MLPs).

However, while market sentiment has certainly turned more negative lately, many investors are wondering if it’s time to start bottom fishing, especially with regards to beaten-up energy assets.

Considerations for Energy Sector Stocks

My take: Though I would remain cautious toward the commodity and believe energy-related names are likely to come under more short-term pressure, I do see longer-term opportunities for those with little or no exposure to energy stocks.

The near-term risk for investors is that, regardless of the particulars of the business model, any stock even tangentially related to oil or energy is being thrashed. This is likely to continue to the extent oil prices have more downside. In fact, given the abundance of supply and bulging inventories, I’d be hesitant to call a bottom in oil prices.

While I believe that oil supply and demand will start to balance toward the middle of next year, absent a supply disruption from the Middle East or a much sharper deceleration in U.S. production, the simple truth is that there’s still too much oil supply relative to demand.

The outlook for Middle East supply remains undimmed, despite growing geopolitical risks. The Organization of the Petroleum Exporting Countries (OPEC) is unable to even set a production target, and Saudi Arabia and Iraq are producing record amounts of oil. Even a country like Libya, with no functioning national government, has dramatically increased production in recent months.

Making matters worse, non-OPEC oil production has remained resilient. In an attempt to generate much needed revenue, Russia is pumping a record amount of oil. In the U.S., while production has pulled back from the spring peak, production cuts have been modest thanks to improving efficiency. The number of U.S. rigs is down more than 60 percent from its 2014 peak, but U.S. domestic production is off by less than 5 percent, according to data accessible via Bloomberg.

Nor is a surge in demand likely to quickly rescue oil markets. For 2016, global demand growth is estimated to fall to 1.2 million barrels per day (bpd) from 1.8 million bpd this year, as data via Bloomberg show. It will take time to balance out oil markets, assuming we don’t see a more meaningful disruption in supply or a spike in demand, which is unlikely given the sluggish pace of global growth.

However, while an imminent V-shaped recovery in physical oil looks unlikely, some of the stocks in this sector may still represent a good long-term opportunity, especially considering that energy-sector valuations are now the cheapest we’ve seen in decades, according to data accessible via Bloomberg. There are two places in particular investors underweight the energy sector may want to start looking to add positions: U.S. drillers levered to low cost production sites and midstream MLPs.


The cratering in oil prices is hurting any and all energy companies, but I believe those with lower production costs, such as Exploration & Production companies focused in the Permian Basin in west Texas, are better positioned to ride out a period of depressed oil prices.


While MLPs aren’t immune to the energy market, as evidenced by the recent 75 percent dividend cut by Kinder Morgan, many MLP businesses are focused on natural gas storage and pipelines. These midstream businesses are less exposed to the daily fluctuation in oil prices.

The bottom line: While the energy sector comes with considerable near-term downside, the key for the long term is selectivity and a focus on those names best positioned to survive, or even thrive, in what may be a prolonged period of low energy prices.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.


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How Long Will the Energy Sector’s Struggles Last?

Energy Sector Performance

One of the largest upheavals in financial markets during the past year has been the plunge in the price of oil. The price of West Texas Intermediate crude oil (one of the main gauges of “the oil price”) has fallen from over $100 per barrel in July 2014 to around $45 per barrel. This decline has decimated the energy sector, which has lost almost 30% of its value over the past year while the overall US stock market has gained more than 10%. Is the energy sector’s underperformance a short-term aberration or part of a longer-term trend?

Part of that answer depends on the outlook for the oil price. After rallying a bit this spring, the oil price resumed its descent in July. The prospect of increased Iranian oil production following the country’s nuclear deal with the US and other countries, high levels of global oil production, and worries about a potential slowdown in China’s economy all likely contributed to the fall. Each of these factors could persist for a while, so the oil price may not bounce back any time soon.

Another part of that answer depends on whether energy companies can adapt to lower oil prices by reducing their costs, for example by decreasing the size of their workforces and investing less in new exploration. By some estimates there have been almost 200,000 layoffs in the global oil industry since the middle of last year. The lower supply resulting from these changes could help the oil price arrest its decline and at least partially restore energy companies’ profits.

But low oil prices probably don’t explain all of the losses for energy stocks. In fact, the sector’s 40% underperformance compared to the broader stock market during the past year is far more extreme than during other recent oil price declines, even the 70% collapse in the oil price during the second half of 2008. It’s therefore likely that longer-term factors have contributed to the sector’s recent struggles as well.

Two such factors that have accelerated recently are the rise of alternative sources of energy and more stringent environmental regulations. These may be more difficult for energy companies to adapt to than a changing oil price, and they could continue to be a drag on energy stocks even when the oil price rebounds.

How Long Will Low Commodity Prices Last?

Commodity Returns

Commodities as an investment haven’t done well in recent years, but this year has been especially bad. They’ve been the worst-performing asset class in 2014, with a return of -16% year-to-date. Barring a rebound in the next month and a half, that would be their worst performance since the financial crisis in 2008. So is the pain now over for investors with exposure to commodities? The answer depends on the key factors that have driven down commodity prices.

Perhaps the most important factor affecting commodities is the pace of global economic growth. Stronger economic growth translates into more demand for commodities, but the global economy has slowed as growth in emerging markets declines and the European economy continues to stall. While the global economy grew by more than 5% per year in the mid-2000’s prior to the financial crisis, it’s only averaged around 3% growth per year since 2012.

The good news for those hoping for higher commodity prices is that the global growth rate may partially bounce back. The International Monetary Fund projects that the global growth rate will increase to around 4% per year over the next few years, powered by stronger growth in the United States and emerging markets. There are a number of ways that such a potential rebound could be thrown off-course, however, such as a sharp slowdown in the Chinese economy.

The outlook for commodities is also affected by factors affecting supply rather than just demand. In recent years these supply factors have particularly hurt the prices of energy commodities (such as oil and gas), which are largely responsible for the poor performance of commodities so far this year. Techniques such as hydraulic fracturing (or “fracking”) have led to increased energy production, especially in the US. Supply could increase further as technology continues to improve and makes energy production more profitable.

Over time, however, commodity prices have a self-correcting aspect: lower commodity prices themselves help reduce supply by making commodity production less profitable. This process doesn’t occur instantaneously, which is why commodity prices sometimes move up or down dramatically. But it does suggest that as commodity producers adapt to lower demand, prices are unlikely to keep falling for too much longer.