Ah, nostalgia. Can it really be less than six months since we were agonizing about higher crude oil prices and how they would wreck the US economy?
Back then, chaos in Iraq had propelled the global price of crude to north of $113 a barrel while the US benchmark price soared to nearly $107 a barrel.
That was then. Now, oil has dropped to $72 a barrel and it’s taking a lot of other things down with it: the stocks of energy companies, the Russian ruble, junk-bond prices, and maybe even a host of bonds of US corporations.
Anyone who has an investment in US energy stocks may be forgiven for looking back in time longingly. The apparent excess of supply – more than 700,000 more barrels a day – has driven oil to levels not seen since 2010 and heading rapidly toward prices last recorded way back in 2006.
As for the energy stocks, the effect has been even more dramatic. When oil prices sneeze, this sector of the market comes down with pneumonia.
Unsurprisingly, therefore, energy stocks are the worst performers in the S&P 500 so far this year. In the last three months, the S&P 500 has climbed 3.73%, while energy stocks have continued to languish. Giants like Exxon Mobil and Chevron have fallen 4.3% and 8% in value in the last three months, respectively.
Former highflyers, like Anadarko Petroleum and Cimares Energy, while still in positive territory for the year, have fallen further in the same period, losing 17% and 14%, respectively.
Why does this matter? Because this is the US, where energy independence has been a concern since the 1970s, and energy stocks have an outsize power.
These days, energy stocks account for about 9% of the Standard & Poor’s 500 index – a bit less than they did a few weeks ago, true, but still not an insignificant grouping.
And they generate a larger proportion of the profits of the powerful index – 11%, says Steve Rees, global head of equity strategy at JP Morgan Private Bank, most of whose clients still have smaller portions of their portfolios than that allocated to the sector.
So does the fall of energy stocks create a signal for investors to start buying cheap stocks – or serve as a warning sign to run for the hills?
It depends on two things: how confident investors may be that the oil market’s woes will prove to be fleeting; and how high the tolerance for the volatility of the energy sector, as stocks whipsaw up and down after every oil move.
“This group always tends to be a volatile mover; always reacting way too much or too little,” says Brad Sorensen, the Denver-based head of market and sector analysis for Charles Schwab. “Investors have to be willing to ride the ups and downs.”
That’s one thing to understand intellectually, and another when the value of a stock portfolio or retirement fund is shrinking. Every move downward in the price of oil creates a new surprise – and a new headache – for investors. US and global energy stocks have priced in a scenario in which oil prices tumble to $70 or so. That already looks outdated.
“The market has already taken them out to the woodshed already,” says John Canally, investment strategist at LPL Financial, who believes that many US oil production projects are still viable as long as crude prices stay at $60 to $65 a barrel. “As long as you think oil prices can stay here or recover from these levels, it’s more of an opportunity than a risk.”
Whether you end up deciding that the selloff in energy stocks – one that has been even more violent and dramatic than that in the underlying commodity price – as representing a tremendous buying opportunity or a risk from which to flee as rapidly as possible, it’s a question that most investors probably should at least be asking themselves.
Rees, from JP Morgan, sees this as an opportunity for a patient investor to tiptoe back into energy and begin picking up bargains.
The market, he argues, “has done a poor job of differentiating between high-risk companies and those with lots of cash on their balance sheets, low operating costs and protections in place so they don’t lose money on falling oil prices”. But risky stocks and high debt are best avoided, he says: “This is not a time to move down the quality spectrum”.
Rees declines to discuss specific stocks. But JP Morgan’s investment research team, from another corner of the financial institution, has honed in on a couple of companies they believe offer strong balance sheets and operational momentum. Not surprisingly, shale oil – the product of the controversial fracking movement – figures prominently.
One of these companies is Anadarko Petroleum; another is EOG Resources, a major player in the Eagle Ford Shale formation, as well as both the Bakken and Permian basins, where its costs to drill and complete a well have plunged.
That means that, all things being equal, EOG is in better position to withstand a further drop in the price it gets for the oil it produces. Pioneer Natural Resources owns its own “fracking” equipment, helping it cut its costs and boost margins.
Some of these companies also show up on the list of the ten largest holdings of Fidelity Select Energy Portfolio, a top quartile energy fund run by John Dowd. He invested in companies like EOG and Cimarex Energy precisely because they had dominant land positions, a history of reducing costs and increasing well productivity.
And now that the crude prices have fallen? Dowd isn’t a raging bull: he keeps looking for oil companies able to cut costs and compete at lower oil price levels and finds it tough. “Many companies are reporting improved production or efficiency per well, but once you add exploration and other expenses, you’re not seeing their [overall] cost structure come down.”
So the long-term outlook still circles back to what happens to the price of crude oil –short term, to the pesky OPEC negotiations; mid-term, to the ability and willingness of producers, from Middle Eastern nations to higher-cost US producers, to shut down output; and longer term, to higher demand triggering a price recovery.
“When exploration and production companies are losing money, history has proven that it’s an attractive time to invest,” Dowd argues.
He points to early 2009 as the most recent example of this: the period was followed by a boom in the price of oil and big gains in energy stocks. In the two years ended December 31, 2010, the S&P 500 gained almost 35%; Cimarex soared 207% and Pioneer rallied 381%, thanks to the rapid increase in their reserves and the increase in the oil price, while Anadarko climbed 87.5%.
“The solution to lower crude prices already is in motion – we already are seeing companies cut capital spending budgets and production estimates,” Dowd adds.
That doesn’t mean there aren’t plenty of risks out there. In the short term, there will be earnings disappointments: even if they have been priced into the stocks, emotion and not logic governs reaction to news events.
There’s the chance that stubborn producers could blind themselves to the market signals and keep producing at high levels, triggering the kind of death spiral that has afflicted the market for gold mining companies.
And then we have the wild card: the news out of the Middle East, which unless your crystal ball is functioning particularly well, has the potential to destabilize everything.
So anyone who decides to bet big on “Crude $100” might also want to load up their medicine chest with Valium. It could be a while, and it’s a wild ride.
