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These Disconnects Create Opportunities In The Energy Sector

Disconnects happen in the stock market when investor expectations widely differ from how events ultimately play out. Recent developments in the energy markets have created several such situations in my view. Perceptions of value have declined in some cases even as underlying prospects have improved. These conditions create opportunities for investors. Here I present the biggest disconnects I see in today’s energy sector.   

Refiners

Since early April, the price of West Texas Intermediate (WTI) crude oil has declined by 20%. While this may be bad news for oil producers, refiners benefit from falling oil prices. A pure oil refiner purchases crude oil, refines that into diesel, gasoline, jet fuel, and other products, and then sells those into the market. 

Of course, the price of finished products will usually fall along with oil prices, but these price declines typically lag those of crude oil. This phenomenon is called “rockets and feathers” in the industry. Gasoline prices go up like a rocket when crude oil prices rise but fall like a feather when crude oil prices decline. The result is that refining margins typically grow when oil prices fall.

But some refiners sold off with the drop in oil prices. During the oil price decline Valero (NYSE: VLO), the world’s largest independent petroleum refiner, saw its share price drop by nearly 10% before recently rebounding. Phillips 66 (NYSE: PSX) saw its share price fall as well. Both companies are in negative territory year-to-date, even though prospects look better for them now with oil in the lower $40s than they did at the beginning of the year when prices were $10/bbl higher.

Sand Producers

One of the strangest sell-offs in my view has been with the companies that provide sand for hydraulic fracturing. Keep in mind the reason that oil prices have declined. It is primarily because the market is afraid that U.S. oil production will increase by so much that it offsets the cuts made by OPEC.  

In fact, U.S. oil production has risen by nearly a million barrels per day (BPD) since last fall and the Energy Information Administration (EIA) recently forecast that the average in 2018 would be 700,000 BPD higher than current rates. But a key enabler of this increased oil production is that oil producers are using more and more sand in hydraulic fracturing operations. So the very thing that is expected to depress oil prices is going to require a lot more sand.

Nevertheless, the sand producers have sold off sharply as oil prices declined. Hi-Crush Partners (NYSE: HCLP), Fairmount Santrol Holdings Inc (NYSE: FMSA), U.S. Silica Holdings (NYSE: SLCA), Smart Sand Inc (NASDAQ: SND) and Emerge Energy Services (NYSE: EMES) have all fallen 30% to 50% since early April. While it is certainly possible that an oil price crash will cause oil production to decline, and in turn result in falling demand for sand (clearly what the market is forecasting), it’s going to require a lot of sand consumption to reach that point.

Midstream

One of the most disappointing segments this year has been the midstream companies. The Alerian MLP Index (AMZ), which accounts for most of the midstream sector’s market capitalization, is down by 11% since the oil sell-off began. But, just like with the sand producers, the surge in both oil and natural gas production has been excellent for many midstream producers. Business is booming.

There are many examples in the space, but let’s consider one. Energy Transfer Partners (NYSE: ETP) is the company behind the Dakota Access Pipeline (DAPL). President Trump has made it a priority to push infrastructure projects like DAPL, and one of his first actions as President was to eliminate legal obstacles that allowed the pipeline to start operating. Earlier this month the pipeline went into operation, which will add cash flow to ETP’s operations this year.

Yet ETP’s unit price has drifted down all year along with the rest of the midstream sector. The sell-off accelerated with the decline in oil prices, and units are now 17% lower than at the first of the year when it wasn’t even certain that the DAPL would start up this year. (There are still ongoing legal challenges which are likely to be resolved in favor of DAPL, but the situation is far more settled than it was in January). 

Natural Gas Producers  

The price of natural gas today is just about where it was when the oil sell-off began. Yet natural gas producers are being dumped indiscriminately along with oil companies. While it is true that most natural gas companies derive some revenues from liquids production, there are many companies for which gas revenues are the only thing that moves the needle.

Consider EQT Corporation (NYSE: EQT), for instance. In 2016 EQT had revenues of over $1.6 billion for natural gas and under $100 million for liquids. But shares of EQT declined by 15% along with oil prices. Likewise, major natural gas producers like Range Resources Corp. (NYSE: RRC), Cabot Oil & Gas Corporation (NYSE: COG), and Southwestern Energy Company (NYSE: SWN) all declined with the price of oil. 

However, the market may have begun to recognize this disconnect, as all of these companies have been moving steadily higher since last week.

Betting on these disconnects can be rewarding, but it can require patience. Markets can sometimes remain irrational for long periods of time, but we exercise patience at The Energy Strategist.  Considering joining us for a risk-free trial.

Follow Robert Rapier on Twitter, LinkedIn, or Facebook.


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