Energy investors continue to be more skittish than a cat on the loose at the Westminster Dog Show.
Permian Basin energy companies reported reasonably good results in early August — not surprising since this oil patch stretching through West Texas and New Mexico is one of the best places in the world to produce crude.
But there were negatives as well, like some well delays, reports of higher costs, and a rising percentage of less-profitable natural gas in the production mix, from Pioneer Natural Resources PXD, -1.80% and Parsley Energy PE, +0.53% among others.
Skittish energy investors latched on to the negatives and sold the group, even though the Permian is no less an energy production marvel than it was in July. “It’s just crazy the way these stocks are moving around,” says Mike Breard, a seasoned energy analyst at Hodges Capital Management. “Companies can say six things in a press release, and investors will pick out the one negative thing.”
That is bad enough, but energy investors are making another mistake. Many are embracing myths that implant the deadly trio of fear, uncertainty and doubt in their minds. This naturally increases skittishness.
Pity them for a moment. After all, energy is the worst place to be so far this year. While their investment colleagues are enjoying great gains in Netflix NFLX, -3.85% Amazon.com AMZN, -2.53% Alphabet GOOG, -1.43%GOOGL, -1.48% Facebook FB, -2.17% or even the S&P 500 SPX, -1.28% the S&P energy index is down by over 13%.
But also look on the bright side. This creates some wicked volatility in the energy space that allows you to pick up some of these names either as swing trades or multiyear plays on rising oil prices.
Barring a global recession, oil prices are headed up over the next few years as supply shrinks due to project cutbacks and natural production declines, but demand continues to march higher. Raymond James analyst John Freeman predicts an average oil price of $65 a barrel in 2018. Will Riley, who helps manage the Guinness Atkinson Global Energy Fund GAGEX, -0.35% thinks crude will hit $60-$70 by the end of the decade.
Investors don’t really want to believe it, because they embrace the following myths about crude prices. But they will come around as these myths fade — and so will energy stocks.
Energy investors remain hyperfocused on U.S. inventories. This is dumb, because they only makes up about a quarter of global inventories. But investors also focus on the wrong baseline — 10-year historical averages of around 350 million to 390 million barrels. This makes little sense since U.S. production has risen 80% in the past six years. So naturally the U.S. energy distribution system needs more tanks and pipes to move crude to market.
This suggests the natural steady-state inventory level should be more like 465 million barrels (excluding the strategic petroleum reserve), maintains Freeman at Raymond James. That’s not far below recent inventory of around 475 million barrels. This narrowing of the gap hasn’t improved sentiment on crude that much. But it will once this myth explodes.
Reports on global inventories due out soon might help as well if they show declines, which I expect.
Investors are worried about excessive U.S. shale production because the “break-even” production cost is $35-$40 per barrel. This is pretty superficial marginal cost analysis that excludes expenses like overhead and interest. These costs matter. Include them, and very few U.S. companies can really make money below $50 a barrel, says Raymond James energy sector analyst J. Marshall Adkins. Sooner or later this will become apparent, and the $35-$40 per barrel production-flood myth will go away.
Meanwhile, large global energy companies cut back on investing in long-term projects starting in 2014, when the price of oil fell sharply. These projects take about four years to bring on line, so the hit to supply will soon be evident. “The longer the current underinvestment carries on, the more severe the cliff-like decline trend will likely be,” Schlumberger CEO Paal Kibsgaard said in his company’s July conference call. “As you go into 2019 and 2020, we are going to have potentially significant supply challenges.”
First, let’s address the elephant in the room. Until the costs of solar and wind power come down and we have storage devices to feed the grid with electricity from these sources at night or during peak demand, we need to call “electric “ vehicles what they really are. They’re coal and natural gas vehicles. That’s because the electricity they run on comes from those sources. As long as this is the case, electric vehicles actually help energy companies.
Next, all of the electric vehicles sold between 2012 and 2020 will only displace 270,000 barrels a day of petroleum demand. That is just 0.25% of expected 2020 oil demand, according to Adkins. Besides, global population growth and the emerging middle class in developing countries mean that vehicle demand will rise sharply over the next few decades, points out Riley, at the Guinness Atkinson Global Energy Fund. So even if electric vehicles become more popular, there will still be a lot more traditional vehicles on the roads.
This has been a popular myth during the past year. But because of fairly robust global population and economic growth, peak oil usage is years away.
“It is exceedingly unlikely to materialize within what the vast majority of investors would consider an investible time frame,” says Raymond James analyst Pavel Molchanov. He thinks peak demand is unlikely before 2030.
This is true. But both countries are plagued by domestic political unrest and even outright civil war. So the constant ebb and flow of supply here means supply will most likely ebb again at some point. Given the challenges in these countries, foreign investment will likely remain scarce.
What are some of the best trading names or, better yet, long-term positions to consider? Here are three categories.
• Among the big global energy names, Goldman Sachs analyst Michele Della Vigna favors Eni E, -0.85%ENI, -0.07% Total TOT, -0.94%FP, +0.21% and Royal Dutch Shell RDS.B, -1.27%RDSB, -2.02% Riley, the Guinness Atkinson Global Energy Fund, adds BP BP, -1.87%BP., -2.37% to this list.
• Steve Schuster, a value investor at Bridge Street Asset Management, likes companies that supply sand used in fracking, like Hi Crush Partners HCLP, -0.91% and U.S. Silica SLCA, -1.81% They’re so beaten down on worries about new sand mines opening up in Texas that they now trade for enterprise value to cash flow ratios around half their normal levels. That’s excessive, considering that they provide grades of sand that the Texas mines cannot offer. And considering how much energy production has increased in the region which boosts demand for sand. “There’s enough demand, even considering the new supply coming online,” he says.
Michael Brush is a Manhattan-based financial writer. At the time of publication, he owned shares of MTDR and PE. He has suggested MTDR, PE, RSPP and REI in his stock newsletter Brush Up on Stocks.