INSIGHTS

On November 17, 2014

Patching Up the Oil Patch – 3 Big Developments Point Toward a Timely Opportunity

Over the past few weeks the price of oil has experienced a significant drop. Although cheaper oil may mean good things for consumers, it has signaled nothing but pain for energy-related stocks. Many wonder if the move in the price of oil signals a long and ugly future for drillers and producers in the U.S. oil patch. What is certain is that investors in the oil patch are voting with their feet. Many of the large-cap energy stocks are down by at least 20 percent with mid- and small-cap stocks down 30 or 40 percent. Is the slide over or is this just the beginning of something more severe? We think we may have three compelling signs that would cause us to rethink our allocation to the energy sector.

The U.S. energy renaissance has certainly been a boon for domestic energy production. Everyone from drillers and producers to pipelines has seen a number of really prosperous years. As for the United States in general, we are much less dependent on foreign supplies of crude than just a few years ago. As the world develops and grows, so does the demand for energy.

So, if the consensus is correct about world demand, why would the prices drop so dramatically? Many believe this reflects a global drop in demand for oil. Over the past few weeks we have seen Europe and Japan fall into recession, which would seem to support the thesis for a drop in demand. But does the current slowdown mean that energy demand will decrease over the long term? Global central banks remain resolute in maximum monetary stimulus. Stimulus is designed to lead to growth. Economic growth is generally correlated with energy demand.

Others believe that the drop in prices has to do with the over-supplied market. They argue that recent technical advances in drilling and completion procedures have brought more product to the market, overwhelming static demand. They note that the more over-levered, oil producing countries like Russia, Iran and Venezuela actually increase their production to try to make up for the revenue shortfall caused by falling prices. Saudi Arabia recently has been accused of unilaterally dropping prices to protect their share of the international oil market. Some say that they are intent to drive Russia and U.S. shale drillers out of business. The argument of over-production violations points out that OPEC efforts to regulate supply in order to control oil prices have failed. Members have been relegated to “self-help” measures to protect market share. Few believe that the upcoming OPEC summit on Thanksgiving Day will do much to stem oil prices.

As an investor, it is really difficult to listen to the noise surrounding the energy market and gain any highly confident insight. In truth, the slide in the price of oil and the values of energy companies is likely partially to blame on a number of these reasons. With the future of energy in question, how can an investor make a correct decision to allocate investments to energy?

Over the past few weeks we have seen three sets of events that lead us to believe that now could be the opportune time to go shopping in the oil patch. These events have clearly shown that participants in the energy complex are speaking with their wallets and not their mouths. We think this is the most relevant way to handicap the future. Are we calling for oil prices to rise? That is not what we are looking to do. Our observation is merely to spot value and to determine if there exists a reasonable basis to expect higher prices in the future. We think this opportunity is likely historic.

1. The first sign was that Harold Hamm, the billionaire CEO of Continental Resources (CLR) publicly announced that all of Continentals’ short oil hedges in the futures market had been covered. Not only did this book an enormous profit for Continental but it also meant that the company was now unprotected against further decreases in oil prices. Was this just a gutsy bet or does Mr. Hamm know something we don’t? Our bet is that if Hamm really saw demand dropping for oil domestically he would not have chosen to cash in his insurance policy. We take his actions as very bullish on the demand for oil and a vote of confidence in energy prices stabilizing or even rising.
2. The second sign we have noted is a sharp increase in insider buying for energy-related companies. Officers and directors who buy stock in the open market with their own funds can be a very telling sign as to how they perceive the business environment and the value of their equity as an investment. Insider buying is only significant to us if it is substantial, not option related and widespread. We have been blown away with the insider buying in the energy complex. The list of companies with significant insider buying is a long one. We see the buying broadly across the energy complex. Insiders tend to be early and be right. We think this is a significant indication that there is real value here to be had.
3. The final event that we have witnessed is the likely beginning of energy M&A (mergers and acquisitions) activity. Last week it was disclosed that the number two energy services giant, Halliburton (HAL), was in talks to scoop up its rival Baker Hughes (BHI). There can be a number of reasons for one industry leader to make a move to consolidate a competitor, but we think low stock prices had to be a significant part of their decision. Baker Hughes had seen their stock price decline transform them into an appetizing merger candidate. We think when market prices fall to the point to lure this kind of bid then the industry as a whole is likely underpriced.

The past few weeks have witnessed an historic nosedive in the oil patch. While many folks are trying to look for the cause of the drop, we would rather look for signs of an opportune entry point. We think that we have witnessed three compelling sets of events that would lead us to be a strong buyer of energy names. Events that include well-known oil magnates cancelling their hedging insurance, an opportune spate of insider buying in the complex and a headline M&A deal convince us we are in value territory. Since almost every economy is massively stimulating for economic growth, higher energy demand lies in the future. This opportunity might just allow many investors to own a piece of energy’s future at a nice entry point.

CRN: 2014-1104-4493 R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.