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As OPEC Tightens The Spigot, Here’s How to Trade

By John Persinos on May 24, 2017

Unlike many previous OPEC summits that ended in squabbling, this week’s biannual gathering in Vienna seems to be on course for a foregone and happy conclusion: extended production cuts.

But as explained below, don’t pile indiscriminately into the energy sector. Stick to certain stocks that during the energy price slump showed prudence. Their debt-slashing discipline is about to pay off in a big way.

Saudi Arabia and Russia have been tipping their hands in recent days, giving investors a glimpse of their intentions ahead of the OPEC meeting scheduled to start on Thursday, May 25. The two major oil producers have announced their backing for a nine-month extension of the existing production cut of 1.2 million barrels per day from OPEC plus 558,000 barrels per day from a group of non-OPEC countries.

OPEC members also will consider the initial public offering (IPO) for part of Saudi Arabia’s state-owned oil company Saudi Arabia Oil Co., known as Saudi Aramco, which is slated for 2018. Saudi Arabia is OPEC’s de facto leader and it’s in the Saudi’s interests to keep prices high enough to bolster Saudi Aramco’s IPO. At the same time, Russia’s economy and government depend on a steady stream of petrodollars.

Another positive sign: the latest Baker Hughes (NYSE: BHI) rig count on May 19 showed that U.S. drillers added rigs for the 18th consecutive week, implying that the energy rally so far has legs.

These developments are in stark contrast to OPEC’s failed attempt to implement a production freeze at a meeting in Doha in April 2016.

However, in this unpredictable investment climate, your smartest strategy is to look for strong energy stocks, notably those with the lowest ratios of long-term debt-to-equity. They’re less vulnerable to wild oil price swings and they’ll grow the fastest if the oil rebound proves sustainable. Let’s take a closer look at how you should trade the energy resurgence.

A billion here, a billion there…

During the free-spending days of President Johnson’s Great Society, Senate Minority Leader Everett Dirksen (R-IL) famously said: “A billion here, a billion there, sooner or later it adds up to real money.”

Senator Dirksen was referring to the nation’s increasingly indebted finances during the 1960s, but he could have been referring to many beleaguered companies right now in the energy patch.

How colossal is the energy sector’s collective debt? According to recent analyst estimates, the amount of outstanding loans and lending commitments to the energy industry that large U.S. banks currently have on their books totals $123 billion.

With OPEC production cuts apparently sticking and oil prices resuming their upward trajectory, many investors looking for growth opportunities are eager to jump back into energy stocks. But many seemingly enticing energy plays are in reality ticking time bombs of debt.

Crude to the rescue…

Regardless, it appears that crude is playing the role of stock market cavalry. When broader indices are flagging, oil price rises tend to give them buoyancy.

After seesawing in recent weeks, the price of the U.S. benchmark, West Texas Intermediate, now hovers at about $50/bbl, while Brent North Sea Crude, on which international oils are priced, stands close to $54/bbl.

Robert Rapier, our in-house energy guru, is optimistic about energy’s prospects. He’s also cheered by the debt-reduction efforts of many key energy players, arguing that they’ve set the table for capital appreciation in coming months.

As chief investment strategist of The Energy Strategist, Robert deeply understands the dynamic of the energy sector. He points out:

“As far as U.S. oil producers go, they are mostly signaling that they are going to manage to be profitable even with an extended period of $50/bbl oil. Results for Q1 show that the majority has made significant strides toward improving cash flow and profitability…”

For laudable debt management, Robert singles out exploration and production giant Chevron (NYSE: CVX):

“All in all, it looks like Chevron will continue to be able to fund its capital needs and the dividend from a combination of cash flow and assets sales, while completion and ramp-up of three megaprojects this year should enable them to close the gap without the asset sales. That all assumes that oil prices don’t recover much from here, but also that they don’t collapse back below $40/bbl…

The 4% dividend looks safe at current oil prices, and you can pick up shares today for not much more than they were a year ago. I suspect that will no longer be the case a year from now.”

Hardy survivor…

Indeed, Chevron is a resilient major player that’s on the cusp of a breakout. Chevron’s latest operating results were encouraging, in large part because the company has been methodically pruning its portfolio, by selling non-performing assets, cutting expenses and emphasizing its most profitable operations.

During the first quarter of fiscal 2017, Chevron reported enhanced cash flow from operations of $3.9 billion, compared to $1.1 billion in the same quarter a year ago. The company also paid back $900 million in debt.

In addition to its fortress-like balance sheet, Chevron stands out for its diversification. With a market cap of $201 billion, the giant energy producer boasts a mix of assets, including liquefied natural gas, deepwater fields spread around the world, shale plays in North America, and downstream activities such as refining and retailing. The latter downstream assets confer high margins and somewhat buffer the company from oil price gyrations.

CVX’s total debt-to-equity ratio now stands at 30.62, considerably below the staggering debt levels incurred by many of its peers. Projected earnings growth is exceptional. The average analyst expectation is that year-over-year earnings growth at Chevron will reach 194.3% in the current quarter, 140.8% next quarter, and 374.5% in the current year.

My own estimates call for Chevron to generate a five-year earnings growth rate of about 76% over the next five years, on an annualized basis. That’s a stunning improvement from the annualized growth rate of -38.65% over the past five years, during the energy price slump.

In coming issues, I’ll pinpoint other standout opportunities in the recovering energy sector. After a long free-fall, energy prices are bouncing back. But energy rallies have faded before. You need to stay selective, especially with a broad market correction and perhaps recession looming in the wings.

Much ado in the House of Saud…

Also noteworthy this week regarding Saudi Arabia has been President Trump’s visit to the kingdom. A reader on May 21 asked this question:

“How will the arms sales to Saudi Arabia announced yesterday affect Honeywell specifically and other defense stocks generally?” — Paul D.

Paul, the $55 billion Saudi deal signed during Trump’s visit represents a windfall for Honeywell (NYSE: HON), Boeing (NYSE: BA), Lockheed Martin (NYSE: LMT), and other major defense contractors and their suppliers.

Boeing and the oil sheiks inked a major deal for Boeing’s Chinook helicopters and surveillance aircraft. The U.S./Saudi arms deal also includes procurement worth up to $6 billion for Sikorsky Aircraft (now owned by Lockheed Martin) to build 150 Blackhawk helicopters in Saudi Arabia.

This Sikorsky/LMT deal is significant because the Blackhawk is a highly versatile “aerial jeep” and a popular export product around the world. Through the Blackhawk, the Saudis are eager to build up the desert kingdom’s indigenous defense industry.

The Saudi agreement also calls for missile-maker Raytheon (NYSE: RTN) to start a branch in Saudi Arabia. By getting its nose under the Saudi tent, Raytheon will have an even more entrenched position in the strife-torn region. The company already was instrumental in building the Iron Dome missile defense shield for Israel.

The good news for Honeywell in these deals is that the company provides the electronics gear and sophisticated avionics — the internal high-tech “guts” — for many of these fixed-wing and helicopter programs. Honeywell is a member of the Personal Finance Growth Portfolio.

Got any questions or comments? I’d especially like to know how you’ve fared with our recommendations. Tell me your story: mailbag@investingdaily.com — John Persinos

 


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