Crude Realities Intrude
Bear markets happen because investors are a stubborn lot. We know that letting the market dictate our beliefs is a bad idea in the long run.
As distressed debt guru Howard Marks notes in a new column well worth your time, “market price merely reflects the average insight of the market participants.”
Short-term market direction, meanwhile, is determined by participants’ emotions, which as Marks notes tend to feed on and magnify those of others.
Those guesses at fundamental value and ever changeable emotions matter hugely to the price of Chevron (NYSE: CVX) shares tomorrow, but very little to their price five years of now, which will be set by new guesses and new emotions premised in large part on the future performance of both the company and the stock.
If we believe the stock will bounce back, we tend to hold on. Because even if it were to go down more, how do would we know to buy it at the absolute low? The reasons and excuses not to sell something that’s down a lot are legion. The most honest one is simply that people hate conceding large losses.
This is why bear markets can grind on for a long time: because it takes time for everyone who will eventually sell on the way down to lose hope. Or, less charitably, to adjust beliefs and pricing expectations anchored in a bygone era to the new reality.
The new reality isn’t that crude will permanently stay below $30 a barrel – we know it’s not economical to produce in the long run at that price in anything close to the volume the world uses. But the fact that this is where it’s trading now even as excess supply continues to pile up is all too real, as is the likelihood that supply could continue to exceed demand for another year or more.
Also real: the cash burn the publicly listed producers are suffering at these prices as more and more of their favorable hedges roll off. They’ll still be spending borrowed cash even if crude rebounds to, say, $40.
And that suggests the horse hasn’t left the barn after all: it’s never late to manage and limit growing risk to your invested capital. It was hard to pull the trigger and recommend the sale of many of the small and midcap producer stocks in our portfolios last year. But comparing their prices back then and right now shows just how much risk was still there to be avoided.
We ditched Oasis Petroleum (NYSE: OAS) exactly a year ago at $13.68, a long way from its 2014 peak above $57; it’s now at $4.32. Whiting Petroleum (NYSE: WLL) was shown the door in April near $35; it now fetches barely $5. And so on. You have 100% of your current capital to safeguard. Don’t make the mistake of sacrificing it in the name of getting even.
Here’s how we’re applying this thinking to our portfolios. Sometime over the next month or two we’ll be purging most of our remaining exposure to crude producers. The only reason that’s not happening now is that the market and the sector are so oversold as to be in line for at least a short, sharp bounce. We’d be sellers of the companies deriving their profits primarily from oil production on any strength.
At the same time, we’re downgrading all portfolio picks other than the newly ranked Best Buys to Hold. This will allow us to concentrate our research, and hopefully your bargain hunting, on the recommendations currently offering the best ratios of reward to risk.
The New Best Buys:
- Cabot Oil & Gas (NYSE: COG)
- EQT (NYSE: EQT)
- Energy Transfer Equity (NYSE: ETE)
- Magellan Midstream Partners (NYSE: MMP)
- Enterprise Products Partners (NYSE: EPD)
- Delek Logistics Partners (NYSE: DKL)
- PBF Logistics Partners (NYSE: PBFX)
- Global Partners (NYSE: GLP)
- AmeriGas (NYSE: APU)
- Capital Products Partners (NYSE: CPLP)
We’ll profile them in greater depth in the coming issues, but for the moment it’s enough to outline the predominating themes.
Cabot and EQT top the rankings because the decline in U.S. oil production is likely to intensify, which will limit the supply of associated gas in basins like the Eagle Ford and the Bakken. Production in the Marcellus is rolling over too, which should continue improving producers’ access to existing transmission pipelines even as new one come on line. The discount on Marcellus gas relative to its Gulf price has narrowed dramatically in recent months and should continue to do so.
Natural gas demand, meanwhile, is expected to increase as a result of LNG exports, shipments to Mexico and the construction of new gas-fired power and chemical plants. Unlike crude, domestically produced natural gas has no low-cost overseas rivals on the U.S. market. It also has more visible drivers of near-term demand dependent on growth in the U.S. and Mexico, not China.
Energy Transfer Equity has been trashed so thoroughly as a leveraged play on the midstream sector’s growth that it’s easy to forget how well diversified it is, and how resilient its cash flow should prove. Yet it’s been discounted worse some drillers in danger of going broke.
Magellan and Enterprise have suffered a lot less, deservedly so given their significantly lower leverage. Magellan is the safest midstream name in that regard, and still delivering distribution growth in excess of 10% annually. Enterprise has the best midstream assets and, like Magellan, limited downside from current levels.
Delek and PBF are well-financed and fast growing refinery-logistics providers with very sturdy fundamentals, dented recently because they’re MLPs and because of rather overblown worries about the domestic fuel demand.
Global and AmeriGas also benefit from low fuel prices, Global as the wholesaler and retailer of gasoline and AmeriGas as the largest propane distributor.
Capital Products mostly charters tankers hauling fuels and crude though it has long-term container ship exposure too, which is likely what’s likely placed it in the clearance bin on global growth worries.
All of the Best Buys other than the two gas drillers offer yields ranging from solid to outrageous, and all of them have the financial flexibility to weather this slump while delivering big capital gains.