Investors in the energy sector should be used to volatility, as prices for various fuels tend to jump around with each piece of bullish or bearish news. However, the second-quarter proved even more volatile — and ugly — than usual.
Let’s take a closer look at the energy space, and the best way to play it.
Trouble in Q2
Energy prices, as well as the equity-based Energy SPDR (XLE) each fell during the last three months, for two main reasons.
To start, concerns about global growth are once again creeping into view, sending investors fleeing to safe-haven assets — including cash. Unfortunately, when the dollar strengthens against other major currencies, the prices of commodities typically drop. When the value of the dollar weakens, the prices of commodities generally move higher. Since many commodities — especially in the energy space — are traded in American dollars, the strengthening currency has zapped them of gains.
At the same time, fear of stimulus tapering from the Fed – which would translate to higher rates — has sent investors away from risk. That means bailing out of commodities.
The result: International benchmark Brent crude fallen more than 7% so far this quarter, which represents the third straight quarterly loss … and the longest period of quarterly losses since the late 1990s.
Rising production from key producing regions such as the Bakken have also taken the wind out of West Texas Intermediate’s sails. The domestic crude benchmark has fallen about 2.2% — mostly due to slackening demand and some of the largest crude oil stockpiles seen in more than three decades.
Then there is natural gas to consider. As inventories continue build at above-average levels, front-month futures contracts have recently slid to a more than a three-month low, totaling a 4.3% decline for natural gas this quarter.
A Few Bright Spots
Of course, while pricing for various energy commodities have tanked, the sector did enjoy some bright spots. M&A activity, along with shareholder activism continue to drive stocks within the sector higher. Many hedge funds, pensions and institutional investors continue to target “undervalued” energy firms and have pushed for master limited partnership (MLP) spin-offs, special dividends, asset sales and complete board redesigns.
Investors in struggling SandRidge Energy (SD) recently got some good news when hedge fund TPG-Axon was finally able to oust troubled CEO and company founder Tom Ward. Likewise, a flurry of shareholder activism activity has hit fourth-largest energy producer Occidental Petroleum (OXY). Shareholders recently voted out chairman and former CEO Ray Irani after issues with his enormous pay package and relative stock underperformance. That’s prompted many to believe that OXY will be broken up and sold.
And if energy firms weren’t being subject to the whims of activist investors, they were breaking out their checkbooks or being bought up. Several deal highlights include General Electric’s (GE) purchase of Lufkin Industries as well as the $7 billion merger of Crestwood Midstream (CMLP) and Inergy (NRGY).
Finally, the energy sector continues to be buoyed by rising issuance of MLP subsidiaries. By placing pipeline, gathering and other refining assets into an MLP, the sponsoring firms are able to avoid taxes and receive back generous distribution payments. Three new MLPs came public during the quarter, while both Devon Energy (DVN) and Enbridge Energy Partners (EEP) announced new potential deals in the space.
Uncertainty in Q3
Despite M&A activity, activism and the potential for more MLPs — all things that will help drive the sector going forward — there is still a lot of uncertainty surrounding the global economy and the Fed’s tightening.
Global growth appears to be stalling, with several key data points drifting lower. That’s not a good sign for commodities since lower global growth equals lower demand. And given that there are already surpluses of both natural gas and oil — not to mention coal — it could mean even lower prices ahead for futures contracts … and subsequently a spat of lower earnings numbers from the various E&P firms in the sector.
Lower earnings are obviously not good for share prices. As investors are already dumping risk in spades, one small misstep could send energy sector equities tumbling downwards once again. Ask any natural gas-focused producer what happens when the price for your fuel craters.
On the flipside, lower growth could mean that the Fed won’t end its quantitative easing plans anytime soon. “QE infinity” could help continue to boost stocks run throughout the quarter. Already, the market has seemed to cheer recent downward revisions to GDP numbers for the U.S.
How to Play It
Perhaps the overall arching lesson for investors in the energy sector going into the third quarter is think long term. Any real down days could be used as a chance to pick-up some quality E&P firms — like Exxon (XOM) or Range Resources (RRC) — on the cheap.
After all, we never know exactly when the next geopolitical event will spike prices higher.
As of this writing, Aaron Levitt did not own a position in any of the aforementioned securities.