It’s hard to overstate the nature of what has happened in the oil markets since the beginning of the coronavirus (COVID-19) outbreak in early January. At that time, supply and demand looked reasonably balanced. OPEC and its partners (primarily Russia) were taking action to make sure that balance was maintained. I felt confident enough in the fundamentals to predict that oil prices wouldn’t fall below $50/bbl this year. But since then we have experienced the fastest and most dramatic change in oil market conditions that I have ever seen in my career. And when a market sell-off turns into panic, the market moves can become irrational.
As John Maynard Keynes once said, “The market can stay irrational longer than you can stay solvent.” Thus, it’s prudent to apply a great deal of caution in the current environment.
Sure, Energy Stocks Are Cheap
Oil is the most important commodity in the world. It’s still how our supply chains and critical services are moving around. But oil production has expanded so much in recent years, we suddenly found supply way in front of demand as people have stopped moving about. Oil prices — and the energy sector — were crushed in response (with a strong nudge from Russia and Saudi Arabia).
Energy stocks look extremely cheap — and they are. But it doesn’t mean they won’t get cheaper.
The challenge is that the fundamentals are changing so rapidly that we don’t even have a good handle on what those fundamentals currently are. When this sell-off began, I said that it could be 10 percent, 25 percent, or 50 percent — we just didn’t know because we are dealing with a moving target.
What seems undeniable is that we still have a period of bad news in front of us before conditions begin to improve.
Advice for Investors
The collapse of oil demand, the overall decline in the stock market, – and most importantly – the price war that Russia and Saudi Arabia have started have crushed the energy sector. Investors aren’t discriminating between good and bad companies (recognizing that at $20 oil, you would be hard-pressed to find good oil and gas companies). The entire sector is on sale.
With oil prices all the way down into the $20s, Russia may eventually decide that the pain is too great and come back to the table. But in the interim, many shale oil producers will probably be forced out of business.
What should investors do now? It may be instructive to review what happened in 2015 as oil prices collapsed. The hardest hit were shale oil producers, especially those with a lot of debt. There will likely be another wave of bankruptcies.
So, I would only invest new money into the energy sector with the utmost caution.
ConocoPhillips, which I have previously recommended, isn’t primarily a shale oil producer. The company has retooled to break even at $40 oil (although we are a long way from there now). ConocoPhillips can sustain low prices longer than other producers. COP will be one of the last pure oil companies standing, but its share price has taken a gut punch from the collapse in oil prices.
Pipeline companies, especially master limited partnerships (MLPs), were in a bubble in 2014. Their values collapsed along with oil prices, but the underlying fundamentals got stronger for those that weren’t highly leveraged.
MLPs like Enterprise Products Partners even increased their distributions throughout the oil price collapse. It will take a long bear market before the strongest MLPs have to think about cutting distributions. But some of the highly leveraged MLPs are already announcing distribution cuts.
Refiners fared well the last time oil prices collapsed. They make their money on the price differential between crude oil and finished products. They often make their biggest profits when oil prices are falling. That’s what we saw in 2015, when Valero returned 43 percent as other energy companies were plummeting. Conditions are different today with gasoline demand collapsing, but refiners should be in a better overall position than oil producers.
The large integrated companies have sufficiently deep pockets to survive the challenging times ahead. Many of the oil supermajors have gone decades without cutting dividends, despite enduring several challenging oil markets.
The bottom line, however, is that we just don’t know how bad this is going to get. The oil markets are certainly not alone in rapidly shedding market capitalization. The recent drop in the S&P 500 was the fastest since the 1987 market crash. That should have the full attention of investors.
If you have cash on the sidelines, I would be extremely cautious in chasing these energy stocks down. We can’t yet see the light at the end of the tunnel. When investing becomes more akin to gambling, it’s best to only invest money you can truly afford to lose.
By Robert Rapier
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