Energy: Bet on Growth But Don’t Smoke “Hopium”

Investors are once again partaking of the “hopium” pipe and bidding up several energy companies that are fundamentally flawed and poised for future declines.

Hopium is a term that I like to use for unrealistic hope that’s pursued like a drug. This habit-forming investment behavior is dangerous to your portfolio. Indebted oilfield services companies, in particular, have been benefiting from these addictive delusions.

However, the recent surge in energy prices appears to have durable momentum. That’s why I’ve come up with two energy recommendations, one tailored to bullish trends and the other a prudent move that exemplifies the risks that still lurk in the energy patch. Read on for the details.

Back from the dead…

The energy sector has pulled off a Lazarus-like resurrection. After hitting a nadir of the mid-$20s in 2014, the per barrel price of oil now hovers in the low $50s.

Robert Rapier, chief investment strategist of The Energy Strategist, thinks oil prices have finally found a bottom.

As Robert points out, the Energy Select Sector SPDR ETF (NYSE: XLE) was not only the top performer in 2016, but as of year-end 2016 it’s also the all-time, top-performing Select Sector exchange-traded fund, with an annualized average return of 8.56%.

By comparison, the Technology Select Sector SPDR ETF (NYSE: XLK) and Health Care Select Sector SPDR ETF (NYSE: XLV) have generated all-time average annual returns of 3.81% and 7.48%, respectively.

Surprised? You’re not alone. As Robert explains:

“In speaking with investors, I find that the energy sector often gets a bad rap. That’s because we investors can have short memories. Too frequently we flock to a hot sector until the bubble bursts, and then we go searching for the next hot sector. But we sometimes lose sight of how detrimental this sort of sector chasing can be to our portfolios…

The reason is that despite generating huge returns at times, these sectors have experienced major corrections that wiped out years of positive returns.”

The big question is whether the energy price recovery has legs. Robert believes it does:

“I don’t think a price below $50/bbl is sustainable for very long… One thing is certain. The world’s appetite for energy will likely continue to grow. History suggests that if you aren’t investing in the energy sector, you could be missing out on long-term market-beating returns.”

Well played…

Which brings us to my bullish bet: Devon Energy (NYSE: DVN), an independent oil and gas producer based in Oklahoma City, Oklahoma. Devon is different from its debt-laden peers, because during the energy sector’s lean years management carefully pruned the balance sheet to keep it strong and lean.

By sloughing off non-performing assets and focusing on high-quality projects, the company has sidestepped the fate of many shale producers that are now fighting to stave off bankruptcy.

With a market capitalization of $21.26 billion, Devon’s drilling rigs are exploiting proven shale formations in Oklahoma and Texas and tar sands in Canada. The company’s largest energy reservoirs lay under the prolific fields of the Permian Basin of West Texas.

Devon is operating 19,000 producing wells throughout 1.3 million net acres in the Permian. The Permian is no Johnny-come-lately, with origins as a crude oil producer that trace back to the early 1920s. The total recoverable resource potential of the largest formations in the Permian is about 75 billion barrels of oil equivalent, second only to the vast Ghawar Field in Saudi Arabia.

The earnings growth estimates for Devon are staggering. According to Wall Street’s latest consensus forecasts, the company’s year-over-year earnings growth is expected to reach 175.5% in the current quarter, 633.3% in the next quarter, 1,592.3% in the current fiscal year, and 40.7% next year. Jump aboard this momentum stock now.

In the deep end…

When reality catches up to an overextended company, the spectacle can be ugly.

Shares of Seadrill (NYSE: SDRL) have been plummeting in recent weeks, after the offshore drilling contractor warned that its debt restructuring process would result in significant losses for its shareholders and bond investors. The likely outcome is bankruptcy.

The stock’s plunge came in the wake of the company’s announcement this month that it had cobbled together an agreement with its banking group to extend its debt restructuring process to July 31 from April 30. The company stated:

“We currently believe that a comprehensive restructuring plan will require a substantial impairment or conversion of our bonds, as well as impairment, losses or substantial dilution for other stakeholders. As a result, the company currently expects that shareholders are likely to receive minimal recovery for their existing shares.”

During the exuberant moneymaking days in the energy patch, before the price collapse started in 2014, energy companies such as Seadrill piled on the debt to expand. Now, scores of companies in the energy patch face bankruptcy and many banks are grappling with toxic loans on their balance sheets. Seadrill is only the latest victim.

Many investors had been overly optimistic about Seadrill’s prospects — the oil price recovery had prompted these poor souls to hit the hopium pipe. But Seadrill’s earnings trajectory appears grim.

The average analyst expectation is that the company’s year-over-year earnings growth will come in at -100% in the current quarter, -104.6% next quarter, -125% in the current year, -300% next year, and -49.1% over the next five years on an annualized basis (if the company lasts that long).

That sort of profit performance is hardly sufficient to cover the company’s staggering debt. SDRL’s total debt stands at $10 billion, for a total debt-to-equity ratio of 99.7, compared to the ratio of 69.6 for its industry. Operating cash flow is a paltry $1.1 billion.

Year to date, Seadrill stock is down 78%. Some analysts are actually arguing that Seadrill now constitutes a “value play.” (Hopium is an insidious narcotic.) Don’t you believe it. If you own Seadrill, dump it as quickly as possible. If the stock isn’t in your portfolio, resist the Siren’s song of the contrarians and steer clear. This energy stock is a dog… with fleas.

Got a question about energy stocks or investments in general? Drop me a line: — John Persinos

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