“4Q14 Energy Sector Earnings Growth Estimates (YOY) Blended Earnings Actual and Estimates -22% as of 2/24/15”—(Fundstrat)
“The magnitude and speed of the collapse in oil has roiled markets; only the selloffs in 1997-98 (61%), 1986 (67%) and 2008 (73%) were larger than the recent one (60%)…..Importantly, the fall in bond yields (US 10y) that is typical in oil selloffs tends to be fairly sticky, with yields settling 15% below the higher levels prior to the oil selloff…..Global growth should get a 0.1pp boost for every 10% drop in oil prices based on our model, or 0.4-0.5pp in 2015 if oil prices stay in the current range. As the growth benefits tend to manifest with a 2-3 quarter lag, the market also prices the benefits with a lag; the S&P 500 rallies 12% on average the year after oil troughs.” —(Barclays Research as of 2/24/15)
Issues abound regarding the fall in the oil price and the drop in Energy sector stock prices. We get questions from clients, consultants, family office representatives, charitable organization trustees, pensioners, pension plan managers, and others. We find ourselves in constant dialogue over what weight should be held in the Energy sector. “Where is the bottom?” many ask.
Some bullets:
1. We are underweight the Energy sector in the US stock markets and the rest of the world. We hold this underweight position because we are not convinced that a bottom has occurred in the oil price. In the scenarios that we envision, we see more downside risk to the price than upside potential. That said, there are some scenarios with a strong upside, but they are event-driven, and the events are not predictable as to time or magnitude.
2. Saudi Arabia holds a key position. We do not know what will happen on the Arabian Peninsula. Yemen is destabilizing. Yemen’s long and porous border with Saudi Arabia exposes Saudi Arabia’s oil fields to risk of possible ISIL-related, terrorist events. The Saudis are certainly making strenuous defensive efforts, since the lifeblood of their economy and regime depends on those oil fields. How secure their fields are remains to be seen as conflict continues to intensify in the region. Remember, ISIL gets some of its money from oil revenues. A drop in the oil price driven by high Saudi production weakens ISIL’s revenue. And it weakens Iran, which the Saudis assuredly view as their most important and most threatening enemy. A terrorist event in Saudi Arabia would have immediate price-spike repercussions.
3. Venezuela is falling apart. The country is broke. There is a high potential for regime change, civil unrest, and hyperinflation. Venezuela’s problems must be factored into the global geopolitical oil price-risk equation. Imagine a new government coming in. It would not be able to pay its debts since its predecessor will have appropriated all foreign investment while sitting on a very large pool of oil. What would a new government do? We think the first thing the new government would do is lift whatever oil it can and sell it at whatever price it can obtain. Where will Venezuela sell that oil? The oil will go into tankers and move around the Gulf of Mexico. Some of it will come to the US for refining. How low could the price be? Some estimates say as low as $20-$30 for an emergency sale of Venezuelan oil as a new regime displaces the old one and seeks immediate cash. Do we know this will happen? No. Is it a plausible scenario? Yes.
4. The volatility associated with oil is now very high worldwide. Geopolitical risk factors in Venezuela, the Arabian Peninsula, the Persian Gulf, Nigeria, and elsewhere mean the direction of oil prices and the range of possible global outcomes is enormously wide. Wide ranges mean wide confidence intervals in any forecast.
5. In the US we see a gradual change in the Energy sector, with declining rig counts and deferrals of capital expenditures due to the falling prices of oil and gas. How much does this trend impact the US economy? We get some estimation help from an International Monetary Fund (IMF) working paper released in February 2015, entitled “Employment Impacts of Upstream Oil and Gas Investment in the United States.” This paper is a superb research effort. The authors estimate that, “Once dynamic effects are accounted for, we estimate that an additional rig-count results in the creation of 37 jobs immediately and 224 jobs in the long run, though our robustness checks suggest that these multipliers could be bigger.” The paper has technical components but is well worth reading if you are a serious investor. Remember that this paper is measuring the upside we have seen. It plots the impact of the US energy sector renaissance on employment rates and prospects for employment. Based on its findings, we can estimate the reverse effects: what may happen as the renaissance slows due to the drop in the oil price. The paper also provides a comprehensive list of the literature on this important topic of jobs related to oil and gas investment in the US.
6. We know the contraction in capital expenditures in the Energy sector is ongoing. That is what happens when a price shock cuts the price of a pervasively used commodity abruptly in half. We have some estimates of the negative impact of the shock on US Energy sector stocks. Fundstrat Global Advisors published an extensive research paper in February 2015 entitled “Contrarian to the Upside… Key Takeaways for 2015.” Thomas Lee and his team have assembled terrific research related to the US stock markets, especially the Energy sector. They estimate that the Energy sector earnings per share decline of 30% will amount to $36 billion, or $3.88 per S&P 500 share. Separately they estimate that the energy-related capital expenditure earnings per share decline will amount to $7 billion negative, or another $0.75 per S&P 500 share. Fundstrat’s conclusion is that there will be a $4.63 negative impact per S&P 500 share in the year 2015. This is the energy downside piece.
7. On the positive side, Fundstrat has made assumptions about what the reduction in energy costs for S&P 500 stocks means to non-energy-sector stocks. They find the direct positive effect of the reduction in energy costs to be $7.09 per S&P 500 share in 2015. They also look for non-S&P 500 oil and natural gas savings that would be reinvested by corporate America and estimate how these savings would translate into S&P 500 earnings. Their estimate is a positive $0.72 per share in 2015. Lastly, they estimate what consumers would gain in the way of extra disposable income and estimate that consumer spending of the savings resulting from lower gasoline, natural gas, and heating oil prices would ultimately amount to $2.23 per S&P 500 share.
8. Let’s summarize. According to Fundstrat’s estimate, the negative impact on S&P 500 earnings in 2015 will be $4.63. The positive impact on S&P 500 earnings will be $10.04. Thus the net impact is a positive $5.41. That is, the overall impact of the lower energy price on S&P 500 earnings in 2015 will be an improvement of $5-plus per S&P 500 share. Energy prices fall; the Energy sector is hurt; the rest of the economy improves; the net effect is positive. That is the conclusion of Fundstrat. We agree with them. The details of their report are exquisitely outlined in slides 41, 42, and 43. Anyone who is interested in Fundstrat’s work may contact them directly at www.Fundstrat.com. Our copy is confidential. It is not up to us to share the details of their work with the general public. Remember that this stock market effect is inter-temporal. There is the immediate down shock and the lag time to the positive outcome is two to three quarters. That is why Barclays (LONDON:BARC) is forecasting acceleration of recovery as the year progresses. We agree. Also, how does one price this shift of $5 in S&P earnings? Is it temporary, or is it more permanent? If temporary, the pricing change is small. If permanent, one could price it at 18-20 times, or a 5% permanent upwards shift in the S&P 500 Index trend baseline.
9. SPDR Energy Select Sector Fund (ARCA:XLE) is the sector SPDR that represents the Energy patch. It was established before the tech stock bubble broke and before the millennium rolled over. It has been around for a long time. Its composition – the makeup of the stocks within XLE – is transparent. The component weights and sub-sector industry breakdown are clear for anyone who wishes to do the detailed research. Energy has been the worst-performing sector in 2014. When the fundamental price of any commodity is cut in half in a matter of months, stock exposure to the sector has to suffer. It did. In our revised, second-edition book titled From Bear to Bull with ETFs, my co-author Talley Léger and I discuss the Energy sector. We take two different perspectives on its behavior. We take apart the component sub-sectors and refer to XLE in detail. We analyze it in a business-cycle format and in terms of market-movement relative performance. Those characteristics are beyond the scope of this commentary but are available to anyone who wants to spend $10 for the eBook or buy the paperback copy. The key is how one integrates XLE into the portfolio mix and decides when to overweight, underweight, or use a market weight.
10. On March 4, 2015, at the Hyatt Regency Sarasota, Talley Léger and I will be part of a program to discuss sector SPDRs and how they are used. One SPDR that will be specifically discussed is XLE. David Mazza from State Street Global Advisors (SSgA) will join us in this conversation. SSgA is the sponsor of sector SPDRs. Our models that offer discretionary options are currently underweight XLE and the Energy sector. We think the risk of another downward move in the oil price and related energy prices is serious enough to wait for entry. We do not know when oil bottoms or when it turns and starts a new upward trend.
11. There are also questions about natural gas. Some of the issues are when and how natural gas will expand, when and how long-term legal structures will force gas to displace coal, and when and how US exports of liquefied natural gas (LNG) will reach buyers elsewhere in the world. Are there impediments to the export of LNG? Yes. Capital investment coupled with returns on that investment, permitting and approvals of pipelines – these elements are all part of the equation.
Another factor is the proposed legislation that LNG be transported on ships governed by the Jones Act. The Jones Act has killed the US maritime industry over the years. Why? The act requires the carriage to be done on US-flag ships that are constructed in American shipyards by American unionized labor. If the Jones Act is fully applied to the US LNG export opportunity, the cost may be triple what it would be without the Jones Act. Legislation to broaden the Jones Act and apply it to LNG export has been discussed in the Congress but is unlikely to advance under present political construction. That said, the political risk of such legislation thwarts or slows long-term investment in LNG since the investor has to contemplate the risk of an adverse political change. Hat tip to Margo Thorning, a tax policy expert and Washington observer who also happens to be a fishing buddy on the annual Maine trip.
12. A side note, since “Audit the Fed” has been a topic of interest and since Janet Yellen is in the midst of her two-day testimony to Congress. Congress is very busy, as our readers know, auditing or trying to audit while failing to act once audits are performed. Query: has anyone introduced legislation to audit the impact of the Jones Act and how it has decimated the American maritime industry? Natural gas pricing is very uncertain even as it is a hugely developing portion of the US economy. The future oil price is unknown even as oil has been a successful portion of the US economy and growing. This is an area worthy of serious audit investigation.
13. Lastly, the Obama administration launched an attack to eliminate the master limited partnership (MLP). For 2015–6, that attack is condemned to failure in our view. MLPs are a form of capital raising and finance used in the development of natural gas and oil exploration, carriage, and other activities across the entire spectrum of the energy industry. The range of MLPs runs from coal to natural gas, oil exploration, propane pipelines, shipping, and terminals, including LNG. Cumberland Advisors manages MLPs. We have a team that explores them in great detail. Lo and behold, out comes the Obama administration attacking the underlying financing structure of US energy development by attempting to undermine the MLP. Instead of broadening the MLP to include alternate energy, the White House attempts to shut it down. This is really a form of class warfare and not a form of thoughtful energy policy. We do not expect that a tax law change will pass in 2015 or 2016. Between now and 2017, MLP structures seem safe from tax code changes. The proposal may be a “nonstarter,” but it has been introduced by the White House. The fact that the MLP structure has been attacked ensures that somewhere, someone is going to delay a long-term investment project in the Energy sector. Why? There are uncertainties in the capital finance ramifications of this proposed change in tax law. By suggesting this change, the Obama administration has already damaged the Energy sector. It has also damaged the Energy sector with its policies regarding pipelines and transmission. The results of those policies have now become dramatic, as we watch fires burning and waters polluted in West Virginia because oil is forced to move by rail. There will be more accidents in rail carriage of petroleum products. And we do not expect any resolution of these pipeline-related and other political impasses. That situation may change as more and more Americans realize how awful the present policy is and how dangerous it is becoming.
Our conclusion is that the Energy sector must remain underweight in our US stock market portfolios. The beneficiaries of the Energy sector price declines are overweighted. It is not yet time to go to an overweight position in the Energy sector.
Disclosure: Please note that, given uncertain scenarios in very volatile times, this weighting may change at any time.