Right now, there’s no more hated sector than energy.
It performed the worst of all stock sectors in 2014, ending the year with a -6.41% return according to Morningstar data. Compare that to the healthcare sector, which was up 20.74% over the same period.
Naturally, the energy sector seems like the last place you’d want invest money in 2015. However, I think you could miss one of the biggest opportunities for gains this year.
Before you skip to the next article, hear me out. Let’s look at a few contrarian signals that are “screaming buy” signs in disguise.
[ad#Google Adsense 336×280-IA]Contrarian Indicators
In an op-ed for The Globe and Mail, David Rosenberg, chief economist and strategist at Gluskin, Sheff and Associates, recently wrote: “We have never seen two down years [for the energy sector] in a row outside of a recession…
“So if you are indeed of a bearish mindset for the energy sector for the coming year, keep that in mind.
You are making an implicit bet on a U.S. or global recession (low odds, in my view).”
He brings up an excellent point. The chances of a global recession happening this year are low and getting lower. Europe is seeing signs of recovery and the U.S. economy is building up a full head of steam.
China and India should also experience robust growth this year, with record-setting auto sales expected for both countries.
And here’s another contrarian indicator: the closely watched weekly rig count from Baker Hughes Inc. (NYSE: BHI) just had its steepest drop in drill rig counts in 24 years. In total, the number of oil rigs operating in the U.S. fell by 61 last week – down to 1,421.
That’s a big shift from last October, when the oil rig count was at an all-time high of 1,609. And, despite the headlines, it’s a bullish sign for the oil sector. The fewer rigs drilling, the less oil produced.
Especially from unconventional plays.
But perhaps the best contrarian indicator is coming out of Washington. After 40 years, it’s bowing to growing pressure from exploration and production (E&P) companies who want to sell their crude overseas.
On the last day of 2014, the Obama administration finally heard the wishes of the oil industry and took two positive steps to help U.S. crude producers.
First, the Bureau of Industry and Security (BIS) – which regulates export controls – granted permission to some companies to export a form of lightly processed crude oil called condensate.
This will open them up to the global oil market.
Second, the BIS issued specific crude export guidance. The implication here is any crude producer who follows this guidance can export condensate.
It’s a major signal that the Obama administration is ready to allow more crude sales overseas… which will help alleviate the American supply glut.
Will the administration ultimately lift the export ban on crude oil? We’ll have to wait and see. But the steps the BIS has taken are certainly in the right direction, and they’re bullish for U.S. E&P companies.
What Happens if Oil Goes Even Lower?
In a few words, not much. Sure, some of the highly leveraged oil E&P companies aren’t going to survive. (In fact, I just published a “death list” of 19 oil and gas stocks about to bite the dust. It’s essential reading for anyone with holdings in the energy sector. Click here to see if any of the oil stocks in your portfolio are on the list.)
But many companies will make it through this rout.
In an article on Investing.com, oil analysts at Wood Mackenzie postured on what might happen if oil drops to $40 per barrel. Their conclusion might surprise you: They believe less than 2% of world crude production would be at risk.
How can that be? Most operators with existing wells online will produce oil at a loss rather than cease production.
Why would companies produce oil at a loss? Simple: Cash is king, and those wells represent cash flow. Even during times of low oil prices, companies need cash to continue to operate.
Once a well is completed and connected to a pipeline network, little human intervention is required. For large offshore platforms that service dozens of operating wells, the cost of shutting down and restarting is far greater than just continuing to operate.
Who Are the Winners Going to Be?
In a nutshell, the winners are going to be larger operators in profitable plays with little or no debt. Similar to what I did to create the industry’s “Death List,” I screened the E&P sector for operators that are financially healthy.
Here are the parameters I used:
- Must be in the E&P sector
- Must have a market cap greater than $500 million
- Price has to be greater than $10 per share (no penny stocks)
- Annualized debt-to-equity ratio has to be less than or equal to 0.25
- Price has to be more than 5% above its 52-week low.
My screen turned up 12 companies. I won’t list all of them, but a few caught my eye.
Gulfport Energy Corporation (Nasdaq: GPOR) is an active E&P company with its primary operations in the Utica Shale. Gulfport shares peaked at $75.75 back in April 2014.
Shares hit a 52-week low of $36.56 back in December 2014 and are trying to establish a bottom at this point. The short interest in Gulfport shares has been receding and now only 8.7% of the shares are sold short.
Gulfport’s debt-to-equity ratio is 0.14, but what does that really mean? It turns out the historic debt-to-equity ratio of E&P companies is about 3.1.
That makes sense, given drillers’ huge need for cash to finance the drilling and completion of wells. The past few years have been the perfect time to borrow money, given the low interest rate environment in the U.S.
On the surface, Gulfport looks like a company poised for a quick upturn once oil prices stabilize and begin to rise. I recommended it to subscribers of my Peak Energy Strategist back in July 2013. We had to pull out this past October because the stock was getting hammered along with the rest of the energy sector. But with shares still trading near that 52-week low, now could be a perfect time to buy.
Another company that met my qualifications was Hess Corporation (NYSE: HES). Hess is in a great position to weather the weak oil price environment, while at the same time growing production.
Over the last two years, Hess has sold more than $12 billion worth of assets. This has given the company a very strong balance sheet.
Right now, its cash reserves are $4.12 billion, up from $528 million in 2012. During the same period, Hess decreased its long-term debt from $7.2 billion to $5.9 billion.
Its cash flows have been negative for the last several years. However, in 2015, Goldman Sachs estimates that it will produce $52 million of free cash flow. Goldman expects that to grow to nearly $300 million in 2016.
Hess has four major offshore projects, which produce between 215,000 and 250,000 barrels of oil per day. Between now and 2018, Hess expects them to generate $17 billion in cash.
What’s the company going to do with all that money? Additional offshore projects will eat up some of it, but the rest will go toward debt retirement and the development of unconventional onshore assets.
While Hess has big plans for offshore development, it’s equally excited about its onshore assets. It owns 640,000 net acres in the Bakken in North Dakota. Hess has one of the highest 30-day initial production rates compared to other operators there.
That makes Hess more efficient than most of its competitors operating there. The company had a production target of between 92,000 and 97,000 barrels of oil equivalent per day from the Bakken by the end of this past December.
I expect them to meet or possibly even exceed that number when earnings are announced on January 28. Hess expects Bakken production to reach 175,000 barrels a day by 2020.
To achieve this, the company will have to drill roughly 1,000 wells over the next five years. However, I think Hess is being conservative with its estimates, and will reach its 175,000 barrel-per-day target in three years, not five.
Finally, Hess owns 44,000 net acres in the Utica Shale in Ohio. It’s developing this acreage in a 50/50 joint venture with Consol Energy (NYSE: CNX).
Hess’s acreage is located in some of the most lucrative areas of the Utica. Right now, it has fewer than 50 wells drilled, but expects that number to grow to 300 by 2020.
So there you have it: My contrarian take on oil during 2015 and two great ways to play it. I believe this is one opportunity you won’t want to miss.
Source: Investment U