Since last summer, investing in energy has been all about playing defense. In The Energy Strategist I've focused mainly on energy-oriented stocks paying large dividend yields as well as traditional defensive groups such as the integrated oil companies.
These groups have outperformed and look likely to continue doing well going forward. In particular, the master limited partnerships (MLP) such as Enterprise Products Partners (NYSE: EPD) have been big winners in 2009. The industry benchmark Alerian MLP Index is up 25 percent this year compared to a 2.4 percent decline for the S&P 500 and 5.3 percent slide for the S& P 500 Energy Index.
Better still, the MLP group has an average dividend yield over 10 percent and offers a way to avoid President Obama's new tax proposals.
But over the past month and a half, I've become more aggressive in the TES model portfolios. Specifically, I've been adding to our exposure in oil services and equipment plays.
My rationale is simple: The stock market is forward-looking, always trying to anticipate future business conditions. It appears that the low for oil prices is already in and that the nadir in drilling and exploration activity will likely be either the third or fourth quarter of 2009. Energy stocks are already rallying in anticipation of the recovery late this year and into 2010. That means now is a great time to get more aggressive investing in the group.
The current outlook for oil and natural gas prices isn't particularly bullish; after all, US crude oil inventories stand at record levels, and natural gas is barely holding the USD3 per million British thermal units level. Moreover, global drilling and exploration activity remains almost universally weak.
Consider this comment from oil service giant Schlumberger's (NYSE: SLB) April 24 first quarter conference call:
…Schlumberger first quarter revenue declined sequentially as activity continued to weaken around the globe in response to reduced customer spending …the rate of decline in revenue at oilfield services accelerated considerably compared to the fourth quarter, largely due to the precipitous drop in the North American natural gas rig count.
Long-time readers know I pay careful attention to Schlumberger's earnings reports and conference calls. Schlumberger is the world's largest oilfield services firm and has an unparalleled bird's eye view of trends in the industry.
Clearly, from Schlumberger's standpoint the services business got a good deal worse in the first three months of the year. During the question-and-answer session, the company went on to state that activity continues to decelerate at this time.
But this is a backward-looking viewpoint. For the past nine months, the crude oil market has been governed primarily by demand, not supply. A rapidly weakening global economy has catalyzed a significant outright decline in oil demand from developed countries and a severe slowdown in the grow rate of oil demand in developing nations. The demand-led slump in prices in turn hit drilling activity which is Schlumberger's bread-and-butter.
Going forward, however, the oil market will see a shift in focus from demand to supply. Specifically, the decline in oil and natural gas drilling activity is bringing about a decline in global crude oil production. The longer oil prices remain under the critical USD70 to USD80 per barrel range, the longer activity will remain subdued, and the more dramatic the fall-off in supplies will be.
This will sow the seeds of the next leg-up in prices and the next big boom in drilling activity. The key will be stabilization in global demand; consider the following quote from Schlumberger CEO Andrew Gould:
…[W]e need to see a stabilization of demand before the supply decline is really going to bite….to me it's the timing of the stabilization of demand. And even if there is a slight increase in demand that is going to tip the scales [for crude oil].
In other words, once it becomes clear that global oil demand is stabilizing, the market will shift its focus to the outlook for supply. The supply side of the equation is ugly--drilling and development activity has declined sharply and isn't sufficient to sustain current rates of production. Major producers such as Russia could see production decline rates reach unprecedented levels given the near stop in new field development.
Schlumberger's oil services rival Weatherford International (NYSE: WFT) suggested in its own conference call that producers are already worried about the potential for a supply collapse.
Weatherford is hearing from some of its big clients that Russia and select markets in Africa and the Middle East may have already troughed. What appears to have happened is that companies cut back activity too far amid the credit crunch in the fourth quarter and are now having to adjust activity levels to more normal levels.
I suspect the stabilization in oil demand is nigh. As I noted in the last issue of TES , the US economy is still shrinking, and the recession that began in December 2007 continues. Nevertheless, there's been an important change for the better in recent weeks as the economy is no longer shrinking at as fast a pace. Economists call this a second derivative effect or, more commonly, a change in the rate of change of economic deterioration.
Several reports released over the past month illustrate that the US economy is now shrinking at a slower pace than was the case just a few months ago. My favorite indicator, the Conference Board's Leading Economic Index (LEI), was released on April 20. Long-time readers know I watch the year-over-year rate of change in the LEI carefully.
The basic interpretation of this chart is that when the indicator drops below zero, the US economy is in recession. A rally back above zero traditionally presages a recovery. This simple indicator has been effective over the years in flagging economic downturns; LEI forecast a recession in late 2007, when most economists were still looking for the US economy to skirt a recession entirely or see only a shallow retrenchment.
The latest reading on LEI: -3.8 percent year-over-year as of the end of March. That's still a negative number, indicating continued contraction in the US economy, but it's an improvement over late 2008 or January 2009 readings.
Although March LEI fell 0.3 percent more than the -0.2 percent expected, the February data was revised higher from -0.4 to -0.2. The net change for LEI is roughly in line with what most analysts were looking for.
I'm looking for an even bigger improvement when the April number is released late next month. Several of the 10 indicators that make up the LEI have shown significant improvement this month.
The Federal Reserve's Beige Book , a periodic economic survey put together by the 12 Federal Reserve districts designed to help aid the Fed in setting monetary policy, also indicates improvement in certain areas of the US economy. Though the overall tenor of the April 15 edition wasn't at all bullish, five of the 12 districts noted general moderation in the pace of the economic decline.
Particularly interesting is the fact that even the residential real estate market--the epicenter of the current downturn--is showing signs of life in some districts.
The Beige Book also included a handful of data points of particular relevance to energy markets. Here's what the Federal Reserve Bank of Dallas, seat of the 11th District, had to say about the outlook for petrochemical demand:
Petrochemical producers generally indicated that the free fall of late last year is over and there was growing stability and even a small turnaround in operating rates. Contacts reported that ethylene and a number of other chemical and plastic products have clearly bottomed out after a massive industry destocking last fall. Contacts said that no one is buying inputs without an order in hand, leaving demand still erratic and unpredictable. Operating rates are slowly moving up however, from 70 to 75 percent.
This commentary is interesting for two reasons. First, the petrochemical industry is a key source of demand for both oil and natural gas liquids (NGL). Even though the recovery looks weak, any stabilization in petrochemicals demand is a positive for oil and natural gas.
Second, plastics and chemicals are basic commodities used in a wide variety of industries. The fact that there's been a turn to the upside in demand suggests these industries are reviving.
All of this is consistent with the outlook I've outlined in the past few issues of TES : The US will likely see a tepid recovery either late this year or early in 2010. The quality of this growth is low, and we're hardly going back to boom times, but it will be enough to stabilize US oil demand.
Meanwhile, the recovery overseas and, more particularly, in China and other key emerging markets, has legs. I'm looking for oil to trade back into the USD60 to USD70 area by the end of 2009. We'll likely see triple-digits again sometime in 2010.
The Energy Information Administration (EIA) and the crude oil market itself have begun to reflect this economic stabilization. In its April Short-Term Energy Outlook , the EIA revised upward its 2009 average crude oil price assumption from USD42 to USD53 and its 2010 assumption from USD53 to USD63. The EIA bumped up these estimates despite the fact the same report mentions bloated global oil inventories and continued demand destruction, particularly in developed markets.
I'll add that the EIA's estimates of total global oil production are overly optimistic. The EIA admits this, saying that “…even this pessimistic forecast [on global oil production] still contains considerable downside risk, especially from additional project delays and higher-than-anticipated decline rates.” This is why I'm more bullish on oil prices than the EIA; I suspect that the longer oil trades below USD70, the more global oil supply will surprise investors on the downside.
More importantly, consider the action in the crude oil market itself. Crude continues to follow the stock market to some extent. Both the S& P 500 and crude oil prices reflect traders' attempt to forecast future economic conditions. But it's encouraging to see crude shrug off continued negative news on US oil inventories. This suggests that news is already priced into the market.
From an intermediate-term perspective, I always look to buy markets that rally on what appears to be “bad” news. This is a key characteristic of washed-out markets at key turning points.
Finally, on the demand front I found another point from this year's Beige Book particularly striking; consider this comment from the Federal Reserve Bank of San Francisco, the 12th District:
While demand for new automobiles continued to be feeble, sales strengthened further for used vehicles, especially large pickups and SUVs. Unit sales of gasoline have firmed and were running slightly above their levels from 12 months earlier.
This is further evidence that US consumers largely view the USD4-plus gasoline prices of last summer as a temporary, one-off phenomenon, not a long-term condition. My guess is that consumers have bought hook, line and sinker the political line that last summer's oil spike was due solely to excess speculation and the activity of “greedy” speculators, not fundamentals of supply and demand.
Consumers are in for a nasty shock once again in 2010 when demand for oil returns with a vengeance and supplies remain curtailed because of lingering impacts of this year's slowdown in exploration and development activity.
This is also a bullish development for longer-term prices. Last summer's rush for fuel-efficient small cars and hybrids was just a blip.