Are Energy Stocks A Good Buy In Today’s Market?

Nodding oil pump in prairies

Energy stocks are not keeping up with the S&P 500. What’s going on?

MarketWatch provides a 10-year chart for XLE, an Exchange Traded Fund (ETF) specializing in the energy sector.

Over ten years the price dropped from $57.52 to $54.16.

Macrotrends shows us the S&P has almost tripled during that same time:

What happened to the energy sector? With the Fed cutting rates again, are energy stocks a safe bet for investing retirement money?

At Casey Research, I worked with a sharp analyst named Vedran Vuk. He has a Master’s Degree in Finance from Johns Hopkins University, worked on Wall Street in investment banking and equity research covering the energy sector. He was a patient and competent educator. He now works for an oil & gas company in Houston. I corralled him for an interview.

DENNIS: Vedran, on behalf of our readers, thank you for your time. I know a lot of our loyal readers remember you. Please bring us up to date about what you are doing now?

VEDRAN: Hi, Dennis. Thank you, I’m happy to reconnect with our old readers. Currently, I’m the Director of Finance at a private equity-backed oil & gas company. Our private equity sponsors have funded us with a commitment of $1.0 billion, and we are in the process of evaluating onshore acquisitions in the US lower 48.

DENNIS: In my first career, I served two major oil companies and also Schlumberger, an oil field service company. I’ve seen the industry boom and bust a couple times. As I look back, when things were bad, energy stocks were really on sale. Of course, no one can time the market. If XLE is a guide, the energy sector is currently down. Can you give us a quick assessment of what’s going on?

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VEDRAN: You’re definitely right about being on sale, but then again many of those companies dug themselves into this hole

It’s been tough for XLE, but even tougher for XOP which is an ETF representative of US shale companies. A big reason is low commodity prices. In 2014, oil was over $100 per barrel, and going back to 2008, natural gas was well over $10 per mmbtu. Now, oil is hovering around $50 per barrel and natural gas is dismal, below $2 per mmbtu – below the break-even price for some of the most efficient producers.

However, prices are not the only problem. While oil was in the high $20’s per barrel in January 2016, equity prices were not much worse than now. XLE and XOP touched $51.77 and $23.87 per share back then. Oil prices have doubled since then yet XLE has almost stayed flat (~$55 per share), and XOP is actually down (~$19 per share). Price, along with other factors, are driving the underperformance.

Another problem was the land grab phase of the industry. As horizontal drilling, hydraulic fracturing, and shale became hot, oil & gas companies paid exorbitant prices for acreage. The focus was on leasing acreage, drilling a few wells, and then flipping the leases.

Also, investors chased rapid production growth with little focus on positive cash flows and paying dividends. Instead, companies would outspend their budgets and then some. With plenty of cheap money available, the industry leveraged itself with debt to pay for the acreage acquisitions and fund the aggressive growth budgets.

This worked for a short time, however, for many the aggressive growth never translated into positive cash flows and returns of capital. Investors realized many would never produce enough cash flow to service their huge debt, and headed to the exits.

That wasn’t the only conundrum. Many companies learned they had underestimated the diminishing returns of drilling multiple wells on a single acreage unit. If you drill one well, it might come in very strong. If you drilled two wells, they’re both weaker. If you put in 8 or 16 wells per section, it’s an even bigger problem.

Reservoir engineers and geologists expected some performance degradation however, in many cases the actual well results were significantly worse than their forecasts. Combine poor well performance, irresponsible and bloated management teams, huge debt burdens and lower prices and you understand what happened.

DENNIS: Top quality well log data used to be invaluable. Companies took their data to the bank, and borrowed the necessary capital to move to the production phase.

It sounds like the traditional log data is not as effective in these types of wells. If Schlumberger or Haliburton developed new tools providing more accurate data, might they be a good investment?

VEDRAN: The industry has done much of that already. At $100 per barrel, few people thought the industry could operate at current commodity prices, but the industry grew more innovative. Shale oil companies can still be profitable at $50 per barrel.

Today’s industry has a much better understanding of well performance across basins. Horizontal drilling and hydraulic fracturing are no longer in their infancy, we’re done picking the low-hanging fruit. The next game-changing technology will be much harder to discover.

DENNIS: I remember your lessons about mining stocks. You talked about companies looking for hidden gold treasures as high risk, high reward bets – not an area for risking a lot of retirement money. On the other hand, established mines with proven reserves and regular dividends were considered safe.

Does that also apply to energy companies?

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VEDRAN: Yes, it’s very similar.

With small mining companies, you’re hoping they will discover some big bonanza and quadruple overnight. Shale oil is generally past that phase of the resource capture cycle. While there will be additional pay zones found, I doubt any of the publicly traded companies will get rich quick overnight.

Investing in energy is starting to look more like a marathon – we’re halfway through the race, the runners all look beat up and ragged, and a speculative investor has to pick ones that can finish the race. If you can pick the companies that will maintain positive cash flow, that will distribute profits to investors, and that will stay lean and disciplined, then you could certainly get a high reward. However, that’s going to be tough given the poor track record of so many management teams in the industry.

DENNIS: Much of the cyclical nature of the industry was based on supply and demand. As supply diminished, the price would rise. Additional supply would come into the market and prices would drop. Wars and other political events could temporarily disrupt the supply cycle.

Is it possible for you to determine where the world sits in that cycle today?

VEDRAN: Good question. Here is what we know.

The first issue is that the market has become less sensitive to political disruptions. Blowing up production in Saudi Arabia and blowing up Iranian generals, barely moves the price of crude these days. A lot of investors were conditioned over the years to buy oil when it was cheap and then sell when something went nuts in the Middle East. Maybe that can still happen, but it’s not a slam dunk bet like days past.

The second issue is, at some point this decade-long economic boom is going to end. When it eventually happens, a recession is likely and in turn a drop in the demand for oil. In a recession, I would not be at all surprised to see $30 per barrel again. Business cycles are not dead – this is coming at some point.

On the natural gas side, things look a little better in terms of the cycle. Gas is below $2 per mmbtu which makes you wonder if it can possibly get any worse. A lot of companies could go bankrupt from here which would lower supply, yet demand is continuing to grow. So, in gas, you could say with some degree of confidence that we’re at the bottom of the cycle or at least very near it.

DENNIS: You know our audience well. Many times, you said, “This is what I would tell my dad”. For those investors trying to get some yield from their 401k, does investing some money in energy make sense?

VEDRAN: For institutional/private equity investors, there is still opportunity during this period of adjustment in the industry as everyone recalibrates and begins to produce positive cash flows.

I’d recommend your average mom and pop investor stick to diversified funds of larger companies like XLE or big names like Exxon, Shell, and Chevron. For the record, my dad owns some XLE! These companies have been paying steady dividends for a long time. They are already in a place where the shale industry would like to get to over the next decade.

Thankfully, I see the industry improving. For example, our company only evaluates acquiring assets which have the capability of producing positive cash flows and distributions to our sponsors within the first year of operation. The days of buying acreage, drilling a few wells, and flipping it are over. The focus is back on realistic estimates, positive cash flow and a reasonable return on investment.

I feel it’s a little too early for most retail investors to allocate a lot of money to the space. Let the dust settle. I think that oil & gas will again be a great area for investment. Until then, stick to the biggest names in the sector or XLE.

DENNIS: Thank you very much for your time.

VEDRAN: My pleasure Dennis.

Dennis here. While XLE has dropped in the last year, check out their dividends. I bought some….

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On The Lighter Side

Spring training baseball has begun. Spending $40+ to go watch teams practice sounds silly. At Cubs park, the outfield grass is full of Chicagoans who escaped the cold, came to AZ to get a tan to take home and impress their friends. By the 5th inning, most all of the regulars are on their way home and you are cheering for kids you have never heard of.

I believe spring training symbolizes spring itself. It signifies the start of a new season, full of optimism and regeneration of life. The flowers in the yard are starting to bloom and it is beautiful.

Our friend Phil C. got us tickets for the Cubs in Surprise, AZ on the 27th, the same day I was scheduled for my immunotherapy infusion. Understanding our priorities, we moved the infusion to Friday. I fear I may not last the entire game, but I am looking forward to being out in the sunshine, with scorecard in hand, cheering my hometown heroes. This will be my 76th year of rooting for my beloved Cubbies!

And Finally…

Friend Tom G. sent me some cool tee-shirts ideas, but I’d probably never have the courage to wear them:

I can really relate to this one…

Until next time…

Dennis Miller

“Economic independence is the foundation of the only sort of freedom worth a damn.” – H. L. Mencken


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