Earnings Season Proves How Smart We Are And Suggests A Long Term Investment

If you need proof that you, as an energy investor, are a smart cookie, it seems you need look no further than this season's US corporate earnings that have unfolded over the last month. According to Factset.com, 82% of US companies in the energy sector that have reported Q1 2014 earnings have beaten estimates. In that month, the Vanguard Energy sector ETF (VDE) is up nearly 7% and has gained over 15% in the last three months. That is pretty impressive and explains why we are all, as people who see potential in the energy business, feeling pretty good about ourselves.

Before you pull a neck muscle reaching back that far to pat yourself on the back, though, consider two other facts from that same report. Energy companies are also reporting the largest average decline in Year on Year earnings of any sector at -4.1%, and overall revenues are flat on the same basis. This seeming disconnect is easily explained; analysts, in their wisdom, have overestimated the decline in the industry but still, "not sinking as fast as we thought" is hardly a resounding endorsement of the US energy industry.

So, which is it? Are we all geniuses for being interested in a booming market, or mugs for being sucked into a bubble based on perception rather than reality? Despite that year on year decline, energy is still a very profitable industry, the most profitable in the world, in fact, according to this Sageworks study. As a traditionalist who believes that profit counts, then, I prefer the former description, but, as one of the aforementioned energy investors, I may be a little biased.

Bias aside, there are sound reasons to believe that what we are witnessing is a fundamental shift in the world's energy market and, as with any fundamental shift, there are disruptions along the way. The main disruptive effect is perceived to be from alternative energy. At some point there may be validity to that view. The climate change deniers can say what they want, but as evidence mounts, electorates in the developed world are increasingly certain that fossil fuels are having a negative effect on the environment.  In those countries, efforts are underway to cut consumption of fossil fuels and encourage alternatives.

Those efforts, however, don't mean that the basic investment thesis for energy, and in particular for oil and gas, isn't intact. The world's population is still growing, and, despite environmentally driven efforts to the contrary, so is the demand for oil. At some point, if the political will continues, alternative energy sources will one day meet that demand. Given that cost is and always will be a factor and that so many alternative energy companies are dependent on some form of government largesse to remain competitive, however, that day looks too far away to influence my investment decisions.

Undoubtedly, some traditional areas of the energy industry are already feeling the pain. I cannot get enthusiastic about any coal business, for example. This bearishness is borne out by that same Factset report which shows that coal and consumables led declines in revenue this quarter among energy sub-sectors, dropping 15%.

US oil and gas exploration and production companies also disappointed on the revenue front with a 10% decline, but there the future is brighter. The shale boom is still in its early stages and many of the companies exploiting it are having to reposition themselves in order to do so. Some borrowed heavily to buy mineral rights that turned out to be hit and miss and continued to work much less profitable conventional fields.

As these companies mature they are throwing less money around and concentrating on operating well run businesses. Boring things like return on equity, debt to equity ratios and gross margins are more important than how much acreage they have contracted.

In many of these cases analysts' estimates for revenue and profit have, understandably considering the disruption of that change, stayed pessimistic, leaving room for price appreciation.  Abraxas Petroleum (AXAS) would be a case in point.

Abraxas was at one time heavily indebted and seemed to lack any focus as a business. Now, after a trying couple of years during which the firm sold off non-core assets and used the proceeds to pay down debt, analysts' estimates seem incapable of keeping up with the profit and revenue growth. AXAS reported on Thursday; they showed growth on both the top and bottom lines and beat expectations all around. They have a gross profit margin of over 42% and return on equity of 57.85%, significantly higher than the industry average. Despite Thursday's gains on those results, AXAS looks like a solid long term investment to me.

It is companies such as this that are driving the earnings beats by the energy sector this quarter. They have refined their business and are beginning to make serious money. That is, after all, what a company is supposed to do. Buying into companies and sectors that are already profitable and set to become more so is about as far from chasing bubbles as you can get; it's just investing 101 and a smart thing to do. Hey, you never know, maybe my fascination with the energy market makes me a genius after all, despite what my wife and kids tell me every day!