How to Play the Cheaper Oil

I warned during the previous quarter that I couldn’t see any short term catalysts that might prop up the price of oil in the fourth quarter, and that West Texas Intermediate (WTI) could test $90 per barrel by year end. After exceeding $110/bbl in early September, WTI has steadily declined and last week closed below $100 for the first time since early July.

Barring a major Gulf Coast hurricane over the next month (in what has thus far been a very quiet 2013 hurricane season), I don’t see anything on the horizon that might keep WTI above $100 in the near term. Geopolitical events could change that equation in a hurry, but right now the factors seem to be lining up for continued lower oil prices over the short term. In fact, an analyst at Raymond James recently forecast $70/bbl crude in 2014. While I don’t believe such a price could be sustained for long, a move down to $70 would have major ramifications for investors in the energy markets. Yet some winners in the sector are still possible — even likely — in this scenario.

Brent crude has shown more strength than WTI in recent months, as it is more fully exposed to rising demand in developing countries. WTI prices have been weakened by growing US supplies, weak domestic demand, and insufficient access to global markets. Brent crude supplies haven’t grown at the same pace, and the international benchmark better captures global demand. So, although Brent crude has also weakened, it has held up better than WTI.

The result of the recent movement in Brent and WTI is that the Brent-WTI price differential — which had nearly vanished in the third quarter — has now rebounded above $10/bbl. We warned subscribers in January that this differential would likely vanish this year. With the Brent-WTI differential still near $20/bbl, I wrote in the Jan 9 issue of The Energy Strategist:

Why do I believe the differential will disappear? Because there are a number of projects in the pipeline that will relieve the bottleneck in Cushing. In May 2012, Seaway Crude Pipeline Company — a 50/50 joint venture between Enterprise Products Partners LP (NYSE: EPD) and Enbridge (NYSE: ENB) — reversed the flow direction of the Seaway Pipeline. This allowed the transport of 150,000 bpd of crude oil from Cushing to Gulf Coast refineries near Houston. While this helped stem the growth of inventories in Cushing, it represented a small fraction of the increased US oil production that flowed into Cushing over the past four years.

That will change this year. This month the capacity of the Seaway pipeline will be increased by 250,000 barrels a day. Later this year the southern leg of the Keystone pipeline — which President Obama endorsed from the campaign trail in 2012 and which should not be confused with the proposed Keystone XL expansion that would cross the US/Canadian border — should come onstream. This Keystone-Cushing extension will have an initial capacity to transport 700,000 barrels of oil per day from Cushing to Gulf Coast refineries. These three projects have a total capacity of 1.1 million barrels per day — which amounts to most of the increase in US oil production capacity over the past four years.

As I explained, the most obvious investment opportunity would have been for commodity traders to take advantage of a return to historical norms by implementing various spread strategies. But for equity investors, we recommended the pipeline companies and oil producers EOG Resources (NYSE: EOG), and for more aggressive investors Oasis Petroleum (NYSE: OAS). Since the publication of that issue, these two companies are up 48 percent and 59 percent, respectively.

But that was then and this is now. Investors should heed the changing conditions and make the appropriate moves according to their time horizon and risk tolerance.

While we warned in that January issue that the refiners were at risk as the Brent-WTI differential shrank, many analysts waited until the horse was already out of the barn to downgrade refining stocks. Many turned bearish on refiners during the last quarter, when the Brent-WTI differential had already collapsed. Simmons downgraded the sector to Neutral because of concerns about refining margins in Q3 and into 2014. JPMorgan, Cowen, and Credit Suisse also downgraded refiners in recent months, and other brokerages lowered their price targets.

Without a doubt, refiners are going to turn in disappointing year-over-year results for Q3. In Q3 2012, the Brent-WTI differential averaged $17.43/bbl. In Q3 of this year, the differential averaged $4.43/bbl. That is going to significantly drag down quarterly earnings of refiners relative to a year ago. Integrated oil companies will also see their refining segments take a hit as Q3 earnings are reported. But this may create some buying opportunities for investors. (To understand why the differential impacts upon refiners’ profits, see Refiners Feel the Squeeze.)

Several refiners report earnings this week, including Valero (NYSE: VLO) and Phillips 66 (NYSE: PSX), and they won’t be pretty. But because the Brent-WTI differential has increased significantly since Q3, fourth-quarter results should prove an improvement over the third quarter. Q4 results will still almost certainly be below the results from a year ago, when the Brent-WTI differential averaged $22/bbl, but the differential is now back above $10/bbl and poised to head higher if WTI prices continue to weaken. I would be a buyer of select refiners on weak results, as you stand a good chance of seeing improving conditions in this quarter.

While the weakening WTI price may be positive news for the refiners, it is potentially bad news for domestic oil companies. Companies that have had huge run-ups this year will be susceptible to large corrections if WTI prices continue to weaken. For example, pure Permian Basin play Diamondback Energy (NYSE: FANG) is up nearly 180 percent year-to-date. High flyers like these will be able to defy gravity only for so long should WTI continue to decline.

There are still many companies worth buying if the sector experiences a pullback (and I think the odds of this are high with WTI prices drifting down), but I would not be a buyer of high fliers or highly leveraged companies at today’s prices given the weaker fourth-quarter outlook for WTI. If you are sitting on a large gain in a pure oil producer, and your time horizon is relatively short (less than two years), I would consider pulling some or all of that money off the table or at a minimum setting stop losses to protect your gains.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Updates

Cameron Torpedoed

Normally booming demand for a company’s products should be great news for its stock. But that wasn’t the case last week for Growth Portfolio holding Cameron International (NYSE: CAM), which was the single worst-performing S&P 500 stock Thursday, diving 14 percent in response to a third-straight disappointing earnings report, compounded once again by poor guidance.

The order backlog jumped 47 percent in a year to more than $11 billion, amid soaring demand for deep-water drilling rigs and production systems. But revenue rose a disappointing 13 percent as midstream projects Cameron planned to supply got pushed out, and profits also missed the mark as the company resorted to deploying third-party contractors .to meet its deep-sea commitments.

Management was contrite, and sweetened its promises of better execution with a new $1 billion share buyback. But the next year’s hardly looking like a cakewalk with the expected drop of revenue from Brazilian subsea production trees and increased spending on research and development for Cameron’s offshore reservoir optimization joint venture with Schlumberger (NYSE: SLB).

The news wiped out nearly all of the stock’s gains in the last year, as previously bullish analysts rushed downgrades. But the underlying demand for the company’s technology and equipment remains robust, and with the stock trading at 12 times trailing cash flow this is not the time to bail out. Now that the stock is back below our buy target we’re sticking to our guns. But this is an investment that will require lots of patience. Buy CAM below $62.

Cabot Comes Through Again

No excuses were needed following last week’s strong results from Cabot Oil & Gas (NYSE: COG), as the leading Marcellus driller edged past high expectations with a 60 percent cash flow surge powered by comparable growth in production. Some of the highest return gas wells in what might be the nation’s highest return shale formation are delivering above expectations, even as Cabot ramps up crude production in another ultra-profitable basin, the Eagle Ford.
The company is now generating excess cash flow above its investment needs, and while some of that will go to pay the recently raised dividend, management made clear that it currently sees buybacks of what it sees as unjustifiably cheap stock as an even better use of the money. Shares jumped 6 percent Friday in response to the report, and could appreciate significantly more into year end. We’re restoring Cabot’s designation as a Best Buy in place of EOG Resources (NYSE: EOG) which recently hit a buy below target we’ve already raised twice this year. Buy COG below $42.50.

— Igor Greenwald

Stock Talk

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