Thesis Pays Off Big for Small Energy Stocks

 | May 05, 2017 | 3:13 PM EDT
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The thesis behind my Real Money column yesterday was: The underlying strength in global demand for oil made this week's pullback (West Texas Intermediate crude was down 11% at one point yesterday) a buying opportunity for U.S. exploration and production stocks. E&P stocks gyrate based on oil's machinations, and when one sees a correction that is so clearly overdone, one should buy. 

In yesterday's column I focused on Gastar Exploration (GST) , and, sure enough, it has jumped 11% today. In fact, GST shares have risen nearly 25% since yesterday's intraday low. I was buying for my clients at that point, ($1.06/$1.07 per GST share) and sometimes it seems that trading smaller energy stocks is just a never-ending game of mean reversion. Buy them when they plummet, sell them when they pop. 

I have learned this through years of experience and through writing my newsletter, MicroCap Guru. 

Micro-caps will always overcorrect in both directions. 

The financial valuation skills I have honed through 25 years of experience and earning the CFA charter just aren't as relevant as one moves down the market-cap scale. I wish that weren't true, but it is. 

That said, one must always have an investment thesis behind each individual holding. I am still constructive on the outlook for energy prices. I'm bullish on oil and even more so on natural gas. But is today's West Texas Intermediate rebound from Monday-Thursday's plummet (the WTI price actually dropped below $44 a barrel in overnight trading last night in Asia) just a classic oversold bounce? I don't think so. In yesterday's column, I detailed the robust growth in Chinese oil demand as the key factor being ignored this week by the oil bears. 

I believe those figures are unassailable, but in finding a clearing price for a commodity, one must focus on supply as well as demand. At 1 p.m. ET today, Baker Hughes released its North American rotary rig count data. The headline figures showed a seven-rig increase in the U.S. oil count, and that has been the bears' key talking point for the past three weeks: Increased U.S. oil production would offset the supply reductions coming from OPEC. 

Of course it would. But you know what? I don't care. I don't own oil, and I would never buy U.S. Oil Fund (USO) in a time of contango. The diminution in principal value from continually having to roll into higher-priced next-door contracts is just painful. Also, the size of my New York City apartment does not allow me to physically store crude on premises. 

I want Gastar to produce as much as possible. I'm sorry if that doesn't aid the oil industry's "greater good," but I'm long GST and I just don't care about the geopolitical machinations that drive crude oil prices. Gastar is well hedged with 64% of this year's oil production protected on the downside and I believe overhedged on the nat-gas side with 100% of production hedged for 2017 at $3.08 per million Btu. 

GST's financing has been quite inventive with a "DrillCo" setup arranged with an investment fund in last year's fourth quarter, and a PIPE investment at the corporate level from Ares Management in this year's first quarter. Gastar management had to be slightly more creative than the finance team at Exxon (XOM) would have had to be, but in the end they found the money. Now I want them to put all that money into the ground, especially given the relative attractiveness of their core acreage in Oklahoma's STACK formation. 

There are many other companies like Gastar, and they are all increasing their drilling activity, as shown in the Baker Hughes numbers. Does that imply oil won't get back to $60 a barrel this year? Yes, it probably does. But the strong underlying demand from emerging economies meant that oil had no business settling below $45 a barrel, as it did yesterday. 

The truth is somewhere in the middle. Gauging that while following massively volatile share prices isn't always easy. As my experience with GST over the past few days shows, however, mean-reversion is the most powerful force in investing. 

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