These Could Be The Winners Of 2016

Conventional wisdom would have it that 2015 was a disastrous year for oil and other energy industry related stocks. Certainly for those that have a long term "buy and hold" mentality that is true, but for those of us who trade more actively the story is a little different. What traders need is movement, regardless of direction. In fact a market that follows a strong trend but bounces around a bit as it does so is just about perfect from a trading perspective and that certainly describes oil and natural gas futures this year. As a result stocks in the energy sector have tended to follow the same pattern, resulting in a lot of opportunity for profit.

The big picture, though, has been pretty dismal. Most commentators (and I will freely admit that I was in that group) thought at the start of 2015 that the worst of the drop in oil was over, and expected the strong support in the low 40s to hold. That looked like a decent prediction early in the year as futures bounced off of that level and recovered to above $60/Barrel, but then rapidly increasing supply and signs of weakness in global demand caused another push down.

(Click to enlarge)

This sustained weakness in oil, as well as a late year collapse in natural gas, put enormous pressure on many small producers. Most soldiered on though, in the belief that a recovery was imminent and that cash flow from very low and even negative margin production was better than shutting down. That, predictably enough, exacerbated the problem.

There are signs, though, that 2016 will see at least stabilization in oil prices, and could even be the start of a recovery of sorts. The mid-30s support for WTI is holding, at least for now. What gives hope for the price of oil going forward, though, is, ironically enough, something that is being cited as a sign of the apocalypse for the energy industry. The Fed's stated aim of a gradual normalization of interest rates has prompted ructions in the high yield bond market, meaning that borrowing to fund deficit production is now much more difficult for smaller producers.

Obviously that is not good news for some of those firms and bankruptcies are definitely on the cards early in 2016, but the resultant reduction in supply will help prices, even if that comes too late for some. In addition, recent data suggests that the problems in China are not as bad as was at first feared and the ECB's commitment to easy monetary policy is already beginning to have a stimulative effect in Europe.

Put all of these things together and it looks likely that both supply and demand will correct in the first half of 2016, forcing oil prices up. The wild card, of course, is OPEC. If the Saudis continue to get their way and the cartel errs on the side of production increases rather than cuts then, even with cuts in U.S. supply and global demand that is less weak than feared, prices will at best stagnate at current levels. The news this week, however, that the Saudi government posted a $98 Billion fiscal deficit suggests that they cannot continue to push prices lower, no matter how much they see that as a tactical weapon to use on their enemies in the region. Any such tactical plans could backfire rapidly if deficits force cuts in social programs and as a result there is unrest in their own country.

The odds are then that oil will recover, at least partially, in 2016. If you add to that the steep retracement that we have seen in natural gas in the last week or so (+33% from the lows) then prospects for U.S. producers that can survive a credit squeeze actually look pretty good. Midsized producers such as EOG Resources (EOG) and smaller firms that reacted decisively and quickly to the drop, such as Antero Resources (AR) could therefore be decent long term bets.

The large multinational integrated firms also look set to recover ground in the coming months. Because of the divergence in monetary policy that I mentioned above (the ECB and Japan cranking up QE and the Chinese government looking to stimulate the economy just as the Fed begins raising rates) firms with a bias outside the U.S. such as Total (TOT) and maybe BP (BP) will probably outperform domestic focused names so would be preferred.

There are, as always, factors that could disrupt even the most logical long term view. High profile terror attacks in either the U.S. or Europe could result is stepped up military action in the Middle East and force oil higher faster, for example. On the other side of the coin, the rumblings of problems in emerging market sovereign debt could develop into a full-blown crisis and force another plunge. Those scenarios or any one of a host of "unknown unknowns" as Donald Rumsfeld would say, could be the driving force this coming year. Absent any major drama, however, 2016 looks likely to be one of consolidation and steady recovery for the conventional energy business.