EnergyInsights.net

Why Oil Stocks Could Rebound

02-01-2016 6:54 pm

Prospects for a rebound in hammered-down energy stocks appear grim. But given how far they’ve fallen, 2016 could see them stir to life again.

By Ben Levisohn

A hope and a prayer is rarely a solid investment strategy, but that’s exactly where we are with the beaten-down energy sector. Even stranger: It might just be enough.

There’s almost no fundamental reason to get excited about energy stocks right now. The price of oil dropped 30% in 2015, thanks to a combination of too much supply and not enough demand. Saudi Arabia, which could usually be counted on to control the supply of crude, has abdicated its leadership role. It’s pumping away, as is Russia, and Iran will be doing the same once sanctions are lifted. As a result, U.S. energy companies are now in a race to cut costs before they run out of cash. No wonder, then, that the S&P 500 Energy Sector Index dropped 24% last year—and few analysts are predicting a turnaround in 2016.

The setup for energy, however, might not be as hopeless as it looks. That’s because the bad news might finally be priced into energy bonds and stocks, and investors have soured so much on the sector that valuations are starting to look compelling. Sure, it might sound a little bit too much like faith-based investing, but with the right catalyst, energy stocks could be the surprise outperformer of 2016.

Let’s get one thing straight: Things are bad in the energy patch—really bad. More than 25 energy companies defaulted on their debt last year, including Hercules Offshore (ticker: HERO), which filed for Chapter 11 bankruptcy protection, and Halcon Resources (HK), which carried out a distressed exchange, both in August. Things could get worse in 2016. Fitch Ratings predicts that the high-yield energy sector default rate based on the dollar amount of debt outstanding will hit 11% in 2016—topping the 9.7% hit it took in 1999 after oil dropped 60% from its peak in 1997 to its trough in 1998. The bad news, however, isn’t unexpected, says Martin Fridson, chief investment officer at Lehmann Livian Fridson Advisors, who estimates that investors have priced in defaults closer to 14%, nearly double what they’d priced in at the end of 2014. It could get worse, but that’s still a lot of bad news.

Equity investors, too, are preparing for the worst. The S&P 500 energy sector now trades at 1.4 times its book value, a measure that often reflects what would be available after a bankruptcy, well below the 20-year average of 2.6 times and lower than even at the depths of the financial crisis. Small-caps have it even worse: The Russell 2000 Energy Index trades at just 0.9 times book value.

Nor are energy’s tough straits exactly a secret. Mutual funds are underweight energy stocks, and JPMorgan analyst Dubravko Lakos-Bujas notes that what he calls speculators—commodity trading advisors, hedge funds, and the like—have put on record bets against oil and natural gas that would have to be covered if a surprising piece of good news hit the market. Commodity trading advisors alone would be forced to put some $10 billion into energy futures if prices rose by just 5%, Lakos-Bujas estimates. “Speculative positioning in energy is already extremely short,” he says, “and a reversal in technicals could provide a significant lift for all assets tied to the energy complex.”

BEING CHEAP AND HATED, however, has never been enough to send stocks higher. For that to happen, something else needs to change, and James Paulsen, chief investment strategist at Wells Capital Management, thinks he knows what it is: the unemployment rate. It has been at 5% for the past two months, and is expected to stay there when December data are released this week, before falling during the rest of 2016. Paulsen says that usually signals “full employment,” when wages start rising and resources grow scarcer. It also signals a start of energy outperformance, he says. Since 1948, the sector has underperformed the stock market by one percentage point when unemployment is above 5%—the second-worst performer, behind utilities—but outperforms by a whopping 6.6 points when the unemployment rate is at 5% or lower. “While energy is among the worst performing at less than full employment, it is the best performer once full employment is reached,” he says.

Now the caveats. Oil prices can always fall further, and even if they don’t, energy stocks will be plenty volatile, even if the sector ends up outperforming this year. For that reason, Lakos-Bujas says it’s best not to chase oil stocks when they have big bounces but instead wait for a pullback—and yes, there will be many—before jumping in. JPMorgan also created what it calls a Defensive Energy Basket, which focuses on companies that have stronger balance sheets, better asset quality, and lower costs. These include integrated oil companies like Chevron (CVX) and Occidental Petroleum (OXY), exploration-and-production companies Devon Energy (DVN) and Noble Energy (NBL), and drillers Nabors Industries (NBR) and Patterson-UTI Energy (PTEN).

Know hope.

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