This commentary previously appeared on Real Money Pro at 8:30 a.m. ET on Aug. 5, 2015. Click here to learn about this dynamic market information service for active traders.
We have been right on a number of market and sector calls this year. And while we were looking good on our energy call up until about seven weeks ago, the recent selloff in oil prices and subsequent swoon in energy stocks put us firmly in the red and very wrong year to date.
Many of the factors that we thought would drive oil's price higher came to pass, including slashed capital expenditures from the oil companies, sharply lower rig counts, and higher demand driven by an improving global economy and lower oil prices. This led to a sharp rally in West Texas Intermediate (WTI) crude from mid-March to mid-June from $43.46 to $61.43 per barrel (an increase of 41.3%).
But this better tone and market sentiment was derailed by Greece's near default, China's stock market selloff and economic slowdown, Saudi Arabia's policy-driven decision to pump as much oil as it can, and the feared re-entry of Iran's oil to the market.
For the very near-term, there is a lack of visibility as to what will reverse the current oil slide. We do believe, however, that the decline is overdone and that oil will end the year substantially higher than current prices. In light of Iran's likely return to the market, we are scaling back our outlook and are looking for prices of $60 to $68 per barrel in the December to March timeframe and $70+ oil by next summer.
Since oil peaked in mid-June, oil stocks have been moving sharply lower. The decline accelerated in the past two weeks reflecting a dismal second-quarter earnings season for the group and the particularly downbeat earnings calls and outlooks.
Based on the conference calls, as well as offline discussions with managements and analysts, our intermediate take on their outlook is as follows:
- Ultimately, company managements still expect oil prices to be substantially higher 12 to 24 months from now.
- Most still believe that oil needs to be at $75 to $85 on an intermediate-term basis for global supply and demand to ultimately balance.
- While there is currently excess capacity and more oil production is coming online, it's nowhere near the massive excess capacity of the mid-1980s.
- Capital expenditures and rig use worldwide are being drastically cut, and this will ultimately affect supply.
- Current under-spending in global drilling will lead to imbalances two to three years out.
However, most management presentations focused on the current market conditions, which are gloomy, and gave very conservative one -to three-year outlooks based on oil staying at these depressed levels indefinitely. As a result, the tone of the calls was very negative and few, if any, spoke about a light at the end of the tunnel. (We believe many believe there is one, but there is no mileage in them speaking publicly about it.)
We don't think the very bearish tone on the group's calls is the beginning of a new leg down, but more likely a capitulation at or close to the bottom of the cycle.
Talking with them offline, our view is that many are a lot more upbeat about oil, and surely their stock prices, from current levels over the next few years than they are communicating. It simply doesn't pay for managements to be upbeat in the face of the current storm.
In the meantime, they are running the businesses assuming the worst, conserving cash and making sure that they will get through this downturn. In terms of the majors, all have committed to their dividends and have the financial wherewithal to get through this tough time.
For investors that have a six- to 18-month timeframe, we think a basket of high-quality, diversified oil stocks makes great sense. We actually expect much better stock action for the balance of the year, but a longer timeframe increases the likelihood of success.
Our focus is on well-run companies with strong balance sheets that are absolute survivors and will be as strong when they enter the recovery phase as they were when they entered the downturn. All have healthy and safe dividends while you wait for the recovery in oil prices. The following is in order of our preference:
1. Schlumberger (SLB) is a world class oil services company and will exit the current slowdown stronger than when it went in. Based on the company's comments on its second-quarter call, it is looking for a bottom in the business in the next three to six months. Historically, it has been very profitable to buy SLB in the months prior to the market bottoming out.
2. Occidental Petroleum (OXY) is a very well run and shareholder-oriented company. Its dividend (recently yielding 4.3%) is safe and growing. (The company bucked the industry trend and raised its dividend this summer.) Also, it's one of the few oil companies that is repurchasing its stock during the current bear market. (Occidental is a holding in Jim Cramer's charitable trust, Action Alerts PLUS, with a price target of $86.)
3. Conoco Phillips (COP) is running its business well and is committed to maintaining and growing its dividend, recently yielding 5.95%. We believe the selloff is massively overdone and expect the stock to return to its highs from earlier this year.
4. Chevron (CVX) and 5. Exxon Mobil (XOM): We were not as happy with some of the comments made by these managements about not raising their dividends amid the current commodity uncertainty, or temporarily holding off on their buyback programs. However, their stocks are at multiyear lows, they are market leaders, and their stock prices are simply too cheap.
While it's no fun, we strongly suggest buying the group on this downturn and expect portfolios to be handsomely rewarded for making this non-consensus move in the upcoming year.