The Organization of the Petroleum Exporting Countries’ (OPEC) extension of production cuts is good news for energy-stock bulls, even though oil is tanking Thursday.
Some traders and investors were expecting a longer time frame or larger cuts. But, still, lower production will eventually lead to higher prices — supply and demand. July Brent crude futures LCON7, +0.66% tumbled.
But the possibility of higher prices in the months ahead isn’t the real reason you should be bulking up on energy shares.
Instead, overweight the sector because corporate insiders have been big buyers all year as their stocks have lagged behind the broader market.
I offer, below, 16 of the best energy-insider purchases to consider. But first, here are the top six reasons why energy insiders are buying, according to investment pros who also favor the group.
Reason 1: Oil stocks have fallen a lot, but oil has not
Energy stocks are the worst-performing group this year. The Energy Select Sector SPDR exchange traded fund XLE, -1.82% is down 10%, compared with a 7.4% gain for the S&P 500 Index SPX, +0.44% But this isn’t even the most interesting divergence.
Instead, that distinction goes to the gap between energy stock and oil. Energy stocks have tanked, but oil today trades where it did at the start of the year. “There is a huge disconnect,” says Eric Green, director of research at Penn Capital. “The pessimism on the stock side is unique.”
The gap is even more startling for many individual stocks. One Penn Capital holding, Sanchez Energy SN, -7.79% is down over 50% from its January highs. “Where has oil gone? It has gone from $51 [a barrel] to $51,” says Green. “It doesn’t make sense.”
This kind of disconnect helps explain why Green’s Penn Capital Small Cap Equity PSCNX, -0.43% is overweight energy. I think Green is worth listening to because his small-cap fund and the Penn Capital Opportunistic High-Yield Fund PHYNX, +0.00% have both significantly outperform their benchmarks over the past year, according to Morningstar.
“Something is wrong. Either the price of oil is unsustainable or these stocks are underpriced,” says Green. Let’s look at why it is probably the latter.
Reason 2: Global petroleum inventories are declining
The last time OPEC agreed to curtail production, in late 2016, it delayed the start date until Jan. 1.
“So a lot of countries overproduced in November and December,” says Mike Breard, an energy analyst at Hodges Capital Management. That flooded the world with crude oil, a lot of which wound up in U.S. inventories. The U.S. is the go-to market for sellers, in part because storage is cheaper.
The spike in inventories alarms oil analysts, who take it as a bearish signal for crude. Now, though, inventories in the U.S. and around the globe are shrinking. The data on global inventories are opaque and delayed. This means analysts disagree on global inventory trends. To cut through the noise, I like to consult Greg Armstrong, the CEO of Plains All American Pipeline PAA, -2.77% who offers running commentary on oil markets in investor presentations. His take is that global petroleum inventories are trending down in a significant enough way. If he’s right, investors will catch on and get more bullish on oil.
Reason 3: Service companies want more money
After years of making concessions to customers, energy-services companies are starting to raise prices.
“We are seeing signs of cost inflation,” says Jonathan Waghorn, who helps manage the Guinness Atkinson Global Energy Fund GAGEX, -1.88% “Producers are hiring services companies, then the company says ‘I can’t give you the crew because someone bid them away at a higher price.’ ”
Energy analysts at Barclays expect average cost inflation of 10% for 2017. This will limit production growth. And that supports higher oil prices, says Waghorn. He thinks Brent crude oil will trade at an average of $55 a barrel this year, $65 next year and $70 after that.
Reason 4: Energy production is in a constant state of natural decline
“The one thing in the oil industry that never stops is depletion,” says Breard, at Hodges Capital Management. “You have to keep drilling. It’s like a treadmill.”
Penn Capital’s Green puts the natural production decline rate at about 3% a year. On average production of around 96 million barrels a day, that means daily production declines by around 2.9 million barrels over the course of a year. Meanwhile, because of rapid growth and an emerging middle class in developing countries, there’s an equivalent natural consumption growth of around 1 million to 2 million barrels. In other words, there’s a big gap to fill.
Because of energy-services bottlenecks and cost increases for U.S. shale producers, Green thinks oil bears overestimate how much the U.S. can make up the difference.
Reason 5: Big oil has under-investment in big projects
In response to the sharp oil-price decline during 2014-2016, major producers and big national oil companies around the world cut back investments in long-term projects in 2015 and 2016. That’s unusual.
The sector hasn’t seen two consecutive years of cutbacks since 1986. And the magnitude of the cutbacks is much bigger this time around, says Armstrong, the CEO of Plains All American Pipeline. Investment was cut by 26% and 23%, respectively, in 2015 and 2016. Armstrong thinks this could create a supply-demand gap that causes an oil-price spike over the next two to three years.
Reason 6: Geopolitical instability threatens supply
Major oil producers face problems at home that could disrupt supply at any moment. Venezuela is in turmoil because of protests against the government. Political uncertainly there makes it more difficult for the country to borrow or sell assets to raise funds, which increases the risk of default, says Barclays analyst Michael Cohen. A cash crunch could hurt oil production. Nigerian supply regularly gets disrupted by anti-government protestors. In Libya, production is either inconsistent or threatened by ISIS.
Saudi Arabia, the second-biggest oil producer after the U.S., needs high energy prices to fund government-benefits programs and jobs, which help keep the peace. Saudi Arabia is in a bind, which supports the outlook for higher oil prices. Saudi Arabia is at or near maximum production. This means if oil prices decline sharply, it has little room to increase production to boost revenue. This gives it a big incentive to favor higher prices.
What could go wrong for energy-stock bulls?
Energy analysts at Goldman Sachs cite the following three reasons why oil prices could fall from here — and possibly by a lot.
1. They doubt production costs in the U.S. will increase enough this year and next to derail shale-production growth.
2. Back in 2011-13, before oil prices started to fall in 2014, big energy producers around the world funded lots of large-scale projects. They never canceled them. So that supply will hit the market soon.
The years “2017 to 2019 are likely to see the largest increase in mega-project production in history,” says Goldman Sachs energy sector analyst Michele Della Vigna.
An added twist: Since these companies cut back on new projects starting in 2014-15, they have more time to focus on making those 2011-13 projects coming on line now even more productive.
3. About a fifth of the U.S. shale production is funded by cheap credit. Producers borrow at just 7%, one of the lowest rates for these kinds of relatively risky loans in recent years, says Goldman Sachs. The high-yield credit market “is not yet forcing capital discipline,” says Goldman Sachs credit analyst Jason Gilbert. “We believe a tighter credit market will be required to avoid an oversupplied oil market in 2018-19.” He estimates yields on shale-related debt will have to rise to 10%-13% to bring that discipline about. Will that happen in a low-interest-rate environment? So far, the Federal Reserve is raising interest rates gradually, so maybe not.
An insider take
At least one experienced industry insider agrees that it’s no sure bet oil goes higher from here. As the founder and former CEO of Cheniere Energy LNG, -0.81% Charif Souki has been closely watching energy markets for decades. Souki left Cheniere last year and founded Tellurian Investments TELL, +0.79% an early-stage liquid natural gas export company. In this capacity, he’ll be a buyer of natural gas in the U.S. at some point. So he’s watching shale oil and gas production developments closely.
We are in the early innings, but the developments continue to be spectacular, he says. “Things can go very right in the U. S. This could be a very significant game changer,” says Souki. “So I don’t like the risk that this could put pressure on oil prices. Production can increase quickly. They keep getting better.”
On the other hand, he agrees the lack of big-project investments by the majors combined with political risks in producing countries could spark significant supply shortages, driving up oil prices. The bottom line? Given the balance of the risks in either direction, he thinks oil is priced about right in the $50-$60 range.
“But the risk of getting it wrong on the upside or downside are very large,” he says. That level of risk and uncertainty may be the best explanation of why so many investors have simply abandoned energy stocks.
If you want to take the other side of that trade and bet alongside energy insiders, then the following stocks are the best names to consider, since they’re the ones with some of the most compelling insider buying.
They are Continental Resources CLR, -4.11% Occidental Petroleum OXY, -0.74% Helmerich & Payne HP, -3.96% Nabors Industries NBR, -9.52% Dominion Energy D, +0.85% Hess HES, -3.53% Matador Resources MTDR, -3.32% Oasis Petroleum OAS, -7.30% Murphy MUR, -4.15% Spark Energy SPKE, +9.37% Carrizo Oil & Gas CRZO, -3.16% SM Energy SM, -5.23% Parsley Energy PE, -1.10% Energy XXI Gulf Coast EXXI, -0.58% Chesapeake Energy CHK, -6.67% and Superior Energy Services SPN, -10.85%
At the time of publication, Michael Brush held TELL and CRZO. Brush has suggested TELL, CRZO, CLR, OXY, HP, HES, MTDR, OAS, SM and PE in his stock newsletter, Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.