This week, earnings season in the U.S. unofficially began when Alcoa (AA) reported first quarter earnings. For traders and investors who take an active role in managing their portfolios, earnings season is usually what they look forward to. However, most expect the next few weeks to be a trying time for those with a focus on energy. There will certainly be some bad news as the full effects of the drop in oil prices are felt in that sector, but it may not be as bad as some fear.
First and foremost, much of the bad news is already priced in. The fact that WTI crude was below $55 for the entire first quarter will have escaped no one, and analysts’ estimates of Q1 earnings for anybody in the energy sector have been falling for some time. The companies concerned, however, have had around seven months to adjust to the reality of falling oil prices. Now that things seem to have stabilized, the gloomiest outlooks are past us and those needing or hoping to raise capital, either through the issuance of equity or debt, have presumably already done so.
In other words, how much bad news can there be?
That said, it is still not certain that oil will hold at current levels, so wholesale buying of E&P companies in front of what is still likely to be generally low earnings represents a risky strategy. Those who, as I suggested, started to average into stocks in the sector when oil first reached the mid $40s may even want to hold off on some purchases until the earnings picture becomes clear.
Even so, now may be a good time to allocate some of your “risk capital” to buying into some of the worst hit, highly leveraged firms. Many of those are being priced as if bankruptcy was just around the corner. Anything short of a disastrous earnings report will cause a short term pop in those stocks.
There is another thing that could give certain oil stocks some support in the coming months. They are logical takeover targets, and now that Royal Dutch Shell has got the ball rolling with their buyout of BG, speculation regarding consolidation in the U.S. will no doubt start to rise. Actual deals may materialize, but just talk of them will be enough to give a boost to the most obvious targets.
When shopping for potential takeover targets it pays to cast as wide a net as possible. Not only does that increase your chances of finding the company that will actually get bought, but you also stand to benefit from the inevitable pop in similar companies once the first deal is announced.
Among the seriously depressed, small companies suitable for the strategy would be the likes of Halcon Resources (HK) or Exco Resources (XCO). Neither of these companies represents a long term prospect until oil starts to recover, but both are cheap enough and own rights to enough oil and natural gas to make them tempting to a big company on the prowl.
As I said, there doesn’t even have to be a deal. Not only would rumor be enough, but both HK and XCO have also taken such a severe hit in the last year that anything short of the worst possible news will cause a relief rally of sorts. One word of warning, though; while the potential rewards of a play like this are significant, so are the risks. Investment should be minimal, with only capital allocated for actual trading being deployed.
If that is not your style then you could adopt the same strategy with a couple of mid-sized companies that have avoided the worst selling pressure, based on the fact that when Shell went shopping they bought big. It would come as no surprise if Continental Resources (CLR) or Devon Energy (DVN), for example were talked of in terms of a takeover by the big boys. Now that Shell has moved, Exxon (XOM) and Chevron (CVX) won’t want to be left behind.
Once again, given the overall level of pessimism regarding earnings this season, even fairly bad news is likely to be shrugged off in all of these cases. Any positive results or outlook, on the other hand, will result in significant support. That, combined with the inevitable takeover chatter, makes an investment split between all four of the stocks above a tempting short term proposition.