Market Enthusiasm About Oil Stocks Tells Me to Wait

 | Sep 15, 2016 | 12:11 PM EDT
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In investing, there's a patience factor that can't be overstressed. We showed that kind of patience in the spring of this year, as we loaded up on solid U.S. independent exploration and production players like EOG Resources (EOG) , Cimarex (XEC) , Anadarko (APC) , Hess (HES) and Continental (CLR) -- all of which have paid fantastic dividends.

But even as we're counting winners, we have to find the right moments to add to winning positions or even cut back on some of them, waiting for another value moment. We've reached such a moment now. As I look over the entire energy sector today, I find an unwarranted enthusiasm that is representing itself in oil stocks, which is telling me currently to wait -- or even find other sub-sectors to focus on.

Last week at the Asia-Pacific Petroleum conference, all but one of the 15 senior traders polled expected oil to remain between $40 and $60 for the next 12 months. They pointed out the increase in supply from Iran and Iraq as forces keeping prices low, but in my mind the most important point has been the very unexpected resilience of U.S. independent oil producers to adjust to low prices. This has been the most surprising to me, as U.S. producers have managed to continually retain financing in cash-negative conditions for so long and even in many cases to produce oil while in bankruptcy.

The IEA has revised its forecast on global oil, now noticing a drop in the acceleration rate of demand that will require fewer barrels be added to supply in the next several years.

The hopes for a production cut from OPEC and non-OPEC members later this month in Algiers are fading fast, with particularly the Iranians throwing cold water on the idea again. This is in keeping with the strategy of the Iranians, who only now are beginning to approach the export levels they had enjoyed pre-sanctions.

These several factors have me reassessing the likelihood of a full rebalancing of oil in the original timetable I laid out in my book more than a year and a half ago. While I have not moved in the slightest from my belief that oil prices are ultimately unsustainable below $75 a barrel and destined to move again well above $100 a barrel, the timing of this move now is likely to come later in 2017 than when I originally thought.

None of this has weighed heavily on oil stocks, however -- particularly those with a focus on the white hot Permian basin. We've made some great profits on some of these, including Cimarex, and have been enjoying a big premium on the Mark Papa's Silver Run Acquisitions (SRAQU) , now invested completely in Permian producer Centennial Resource Development. But some of these have now run too far, too fast.

The most telling example is EOG Resources, an Eagle Ford shale specialist and one of the best, acquiring the private Permian producer Yates Petroleum for $2.5 billion. Immediately, despite a dilution of shares, a minimal cash outlay and the taking on of another $245 million in debt, shares of EOG increased.

Yates, it should be remembered, was operating at a significant negative cash flow during 2015 and 2016, unable to meet breakeven challenges of $40 oil. Yet because the acreage is in the super-hot Delaware basin, investors assume that EOG can apply the same efficiency magic to Yates' Permian acreage as they did to their own EFS land.

Perhaps they can, but in no world is that expectation worthy of the kind of share bump that they have so far experienced. Normally, these kinds of aggressive, forward-thinking acquisitions are at least met with the conservative and correct initial decline of shares.

We've benefited from this, but remain skeptical of the move.

I've recommended cutting back on some long-term investments in many of these names, including EOG, understanding that a fresh opportunity to buy them back at value may never reappear. That's the choice we make in investing -- and taking great profits while perhaps leaving a little on the table never made anyone poor.

Instead, I've recommended to subscribers to concentrate on natural gas stocks, which I believe hold better current value and, to a lesser extent, refiners -- despite their current margin difficulties. We'll center on some of those opportunities more fully in my next column.

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