February 15, 2018|

By Michael Brush

Energy stocks have declined more than the broader market, suggesting there’s money to be made as they eventually rebound


National Oilwell Varco is among favorite energy investments discussed by Colin McWey, who helps manage the Heartland Mid-Cap Value Fund.

If you’re buying U.S. stocks as they rebound, don’t forget energy companies.

One reason is that they’ve fallen more than the broader market, and they’ve failed to bounce back as much — at least for now.

The S&P 500 Index SPX, +0.94%  was recently off 6% from its January peak. At the same time, the Energy Select Sector SPDR Fund XLE, -0.48% was down over twice as much. The top five holdings in this exchange traded fund (ETF) are Exxon Mobil XOM, -0.54% Chevron CVX, -0.27% Schlumberger SLB, +0.24% EOG Resources EOG, +0.81% and ConocoPhillips COP, -1.98%

Here’s another reason to favor energy names. The recent sharp decline in oil and energy stocks is more about over-exuberant traders exiting the group than it is about fundamentals, says Will Riley, who helps manage the Guinness Atkinson Global Energy Fund GAGEX, +1.97% He thinks oil could rise 5% to 10% over the next one to two years.

Leaning against the crowd often makes sense in the market, and that’s what you’re doing if you bet that oil prices will go higher.

“There are still a lot of people who don’t believe it because they have been fed nothing but negative news for three years,” says Mike Breard, an energy sector analyst at Hodges Capital Management. In other words, oil, and oil stocks, are climbing the proverbial wall of worry.

The bullish demand-supply fundamentals are still intact, and ultimately that is what will prevail. Let’s take a quick tour.

The demand side

The International Energy Agency (IEA) is predicting an extra 1.4 million barrels per day in demand in 2018. (For context, the world uses about 98 million barrels a day.) But this estimate, which plays a big role in creating the consensus outlook, may be light given the robust global economic strength.

If global GDP growth comes in at 3.9% this year, as the International Monetary Fund (IMF) forecasts, actual daily oil demand could grow more than the IEA estimates, says Riley. That matters, given the supply constraints.

The strongest demand gains come from large, high-growth emerging market economies like China and India. A big factor here is the emerging middle class. Some of the first things people do when they make more money is get wheels, use more electricity and take more trips by airplane.

Citing strong global growth, fueled in part by growing emerging economy debt, Goldman Sachs analyst Jeffrey Currie predicts Brent oil will reach $82.50 a barrel in six months, compared to the low-$60 range now.

The supply side

The rap on the Organization of the Petroleum Exporting Countries (OPEC) is that they are a bunch of cheats. They set production targets, and then break them on the sly to make more money. But this isn’t always the case. Right now, OPEC compliance with production cuts has been very good, says Riley. A key factor here is Saudi Arabia, which wants a solid floor under oil prices to support the partial floatation of its giant oil company, Saudi Aramco. This is a big component of the country’s experiment with diversifying away from oil. The Saudi’s don’t want to flub the floatation.

Next, U.S. production growth will likely be less dramatic than expected. The consensus fear is that U.S. shale producers will once again greedily ramp up production sharply — and shoot themselves in the feet by killing off oil-price gains. This probably won’t happen, for these reasons.

First, a common theme at energy conferences now is that shale producers want to attract and maintain a stable shareholder base. To do so, they’re pledging to avoid overspending their cash flow and borrowing too much. “It’s different this time” are the scariest words in investing. But things might really be different this time in the oil patch.

Here’s why. The last time U.S. producers ramped up debt and production, oil prices plunged as Saudis retaliated with a flood of supply. Many U.S. companies had a near-death experience they don’t want to repeat.

“There will be better capital discipline,” predicts Riley. “Permian producers say they will ramp up more gradually.” One obstacle is a shortage of skilled workers. “There is a real labor crunch in the Permian basin,” says Breard. “It is not as easy to get a fracking crew as it was last year.”

Another factor limiting global oil supply growth is the underinvestment by the majors in long-term projects. They’ve held back during the past few years because oil prices were so low and the oil outlook so bleak. Now the chickens are coming home to roost.

This third bucket of supply — or the non-OPEC and non-U.S. oil projects in places like the North Sea, Brazil and West Africa — is important because it makes up about half of world supply. These projects take around four years to develop. So the projects that the majors started balking on in 2014 would have started kicking in this year. They won’t. Since world production naturally declines, this “lost” production will hurt supply growth for at least the next three or four years — the number of years producers have been on an investment strike, so far.