INSIGHTS

On April 13, 2015

AAM Viewpoints: Oil - Investment Opportunity or Falling Knife?

The Energy sector has been a bottom performer over the past two years and many investors are trying to determine if this presents opportunity or is a “falling knife.” I believe there are long-term opportunities, but investors need to have the appropriate risk tolerance and should expect more volatility to come. West Texas Intermediate (WTI) closed at $53.98 per barrel on April 7, off a low on March 17 of $43.46, which was the lowest level we’ve seen since early 2009, giving investors hope we had built in a bottom for the price of oil. However, oil has had difficulty sustaining a recovery as the supply glut continues to create worries about finding a bottom in the price of WTI. The Energy Information Administration (EIA) announced stockpiles of oil gained 10.95 million barrels in the week ended April 3, which was significantly higher than expectations of only 3.25 million, and the perceived “glut” has once again created downward price pressures in the oil markets.

The chart below illustrates the 50% slide in price-per-barrel since mid-2014 and it appears we are forming a bottom. With that being said, nervousness related to supply and demand continues to weigh on the price of oil. As Matt Lloyd mentioned in his blog in January (Oil’s Disconnect and Opportunity) this type of severe price drop has occurred three times in the past 30 years with an average correction of 61%.

We believe it is never a good idea to try to time the market, but experts are beginning to look closer at the sector for opportunities and some tend to believe we may be near an entry point, and I would agree. There are several compelling factors to consider and two are highlighted below:

1)      Mergers and Acquisitions (M&A)

M&A activity was relatively high last year as Halliburton agreed to acquire Baker Hughes for $34.6 billion, CorEnergy agreed to acquire MoGas Pipeline for $125 million, and Kinder Morgan announced a $71 billion buyout of three MLPs (Master Limited Partnerships). Although the M&A activity slowed at the end of the year as the price of oil continued to decline, we believe activity will likely pick up as companies with strong cash flows look to leverage opportunities to make strategic acquisitions in 2015. Most recently Royal Dutch Shell PLC announced it will buy BG Group PLC for $70 billion making it Europe’s largest oil company.

2)      Insider Buying

Insider buying of energy company stock has been increasing. Recent announcements of insider buying have been seen in Chesapeake Energy (CHK), NGL Energy Partners (NGL), Marathon Oil (MRO), Southwest Energy (SWN), Bill Barrett (BBG), WPX Energy (WPX), and Bonanza Creek Energy (BCEI) to name a few. As we’ve stated before, insiders tend to be early and right.

Supply and demand remains the top headline for the sector as the EIA also reported crude inventories climbed to 482.4 million barrels last week which is the most since they began compiling the data in 1982. However, the trends in demand show consumption increased by 900,000 barrels a day (b/d) in 2014 and averaged 92 million b/d for the year. EIA expects global consumption will rise by 1 million b/d in 2015 and by 1.1 million b/d in 2016 (see the World Liquid Fuels Production and Consumption Balance chart below). One consistent piece of the puzzle is demand growth from population increases and forecasts reflect global population rising by 2 billion to 9 billion over the next 25 years. Much of the growth in energy demand is likely to be driven by China and India. China’s biggest oil refiner (China Petroleum & Chemical Corp, or Sinopec) is signaling the nation is headed to its peak in diesel and gasoline consumption far sooner than most Western energy companies and analysts are forecasting. According to Sinopec Chairman Fu Chengyu, the peak in diesel fuel which tracks economic growth may only be two years away. Additionally, India is ranked as the world’s 4^th largest oil importer and has become the 2^nd Non-OECD (Organization for Economic Cooperation and Development) country to create emergency oil stockpiles. Current estimates call for India to stockpile roughly 40 million barrels this year with approximately 8 million barrels already acquired. The wildcard, which has been around since before the volatility picked up last week, is the possible removal of economic sanctions against Iran and the potential for Iranian oil to enter the market. If the sanctions are removed and we see pricing pressure on oil, the EIA still forecasts that “Brent Crude” oil prices will average $59 per barrel in 2015 and $75 per barrel in 2016.

We believe the price of oil will likely trend higher over the next few years and this presents an opportunity for patient energy investors. As stated earlier, there will likely continue to be volatility in the sector as the headlines contribute to the price swings and while we are not looking for WTI to reach its 10-year average of approximately $80 per barrel anytime soon, there is likely upside from here.

CRN:  2015-0410-4707 R

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