Where To Look For Value Within Energy Next Year

As 2016 comes to a close investors need to consider two important issues: (1) what to do with the stocks they held this year, and (2) how to position themselves for next year. 2016 as a whole was a good year for energy stocks. The group is still nowhere near the highs of a few years ago, but oil seems to have decisively bottomed and most energy stocks are now rebounding strongly.

Against that backdrop, investors should consider locking in gains and losses on stocks based on their personal tax situation. The typical advice of financial advisors is that investors should sell stocks where they have losses so that they can use those losses to offset realized gains and minimize their tax bill.

The picture is a little more complicated this year though given that the new administration may lower capital gains tax rates next year. As a result, investors need to give more consideration to their window dressing operations than they normally would.

Much as the strategy for dealing with existing holdings is complicated by political considerations this year, the choice of industries for next year is similarly tricky. The chart below illustrates performance of different industries in the energy sector this year.

(Click to enlarge)

While storage and transportation in the energy space had a very strong year, many other industries in the space were slower to rally. O&G drilling in particular had a poor year until the surprise OPEC production cut agreement in November bolstered fortunes across the industry.

Overall, investors in the energy sector in 2017 may want to consider a barbell approach – buying the biggest winners and the biggest losers from 2016. In this case, that means buying the refineries (2016 losers) and pipelines (2016 winners).

For 2017, E&P firms are going to remain dependent on strong oil prices, but pipelines are probably going to be better insulated. In particular, it is highly likely that new pipeline projects will find a much more receptive administration after January 20, 2017. While local authorities may still mount costly challenges to specific projects like the DAPL, the general costs of new development should fall. Moreover, it is unlikely that the pipelines will be hit with new regulatory costs as they were under the Obama administration, and bipartisan interest in creating a stable set of rules around drone use could lead to lower costs for pipeline inspection in 2017.

Additionally, one subsector of the pipeline industry could do particularly well if Republicans are able to carry out comprehensive tax reform – MLPs. MLPs have been under some pressure among certain quarters in recent years, in part because they pay out high dividends which can create large tax liabilities for investors. To the extent that President Trump and Congressional Republicans cut taxes, those stocks could become much more attractive overnight. If dividends go from generally being treated as ordinary income to instead being treated more like capital gains (due to corporate tax rates being lowered to say 20 percent), then the stocks should rocket higher.

Notably, the biggest underperformer in the energy sector remains the refining group. That may change in 2017, and if it does investors buying in now could win big.

Refineries are facing both potential headwinds and tailwinds in 2017. While the controversial and much discussed RINs issue may be mitigated next year (especially with the recent announcement of Carl Icahn acting as an unofficial advisor to the President), border adjustment tariffs could create new costs for importers who rely on imported oil. Investors should be looking for firms that source most of their inputs domestically while also having potential to benefit from a change in the current RIN rules.

For investors that want to avoid the difficulty of choosing specific stocks, there are plenty of great ETFs across the energy space that cover all of the industries within the sector.