With energy stocks having stabilized so far in 2015, it’s time to question whether the worst performers in the group — offshore drillers and oil services names — are a value opportunity or a value trap.
Stocks in this segment seem to offer attractive valuations, and the charts are beginning to form what appears to be a base. Unfortunately, the risks remain too high to justify moving into this group just yet.
The problem with trying to bottom-fish in energy stocks, especially offshore drillers, is that there’s no sign that a trough in fundamentals is in the offing anytime soon.
This week, Barron’s reported that Cowen & Company expects that lower oil prices and an oversupply of rigs will cause unfavorable business condition to persist into 2016. This view was also expressed in a Financial Times article last week, which reported that the industry downturn could last for another two years.
These stocks should represent an opportunity at some point, but not yet. A two-year interval until a recovery begins means that it’s still too early for investors to “look across the valley.” Put another way, what’s the motivation to buy into a late-2016/early-2017 story now?
Avoiding the temptation to buy too early is important with any stock that’s under pressure, but it’s particularly crucial with offshore energy stocks since their underlying business tends to move in such long cycles.
The likely result is that, while offshore drillers and services companies will certainly be fertile ground for trading — and will likely provide their share of short-term rallies in the coming year — a more lasting turnaround is still a year or more away.
This brings us to the charts. A sizable group of energy stocks have traded sideways in a range since December, among them the drilling companies Transocean (NYSE:RIG), Seadrill (NYSE:SDRL) Diamond Offshore (NYSE:DO), Ensco (NYSE:ESV) and Rowan Cos. (NYSE:RDC). The equipment and services providers Oil States International (NYSE:OIS), Dril-Quip (DRQ), and Tidewater (NYSE:TDW) have similar charts, as well.
Still, the duration of this sideways move is too short to create the type of base which would indicate that longer-term stability is in the cards. It should also be noted that both Ensco and Tidewater have edged below their previous lows, which may be a preview for the rest of this sector.
The danger of trying to bottom-pick in stocks linked to weak underlying commodity prices is evident in the performance of gold and coal mining stocks during their long slide.
Consider the chart of the Market Vectors Gold Miners ETF (NYSEARCA:GDX), which has been unable to hold prior lows time and time again over a multi-year period. If you believed the sideways performance signaled that the pain was nearing an end, you’ve been disappointed repeatedly in the past three years.
Investors in coal miners have had it even worse than those who have owned gold stocks. A look at the chart of the Market Vectors-Coal ETF (NYSEARCA:KOL) shows a similar pattern of short-term channels being resolved by moves to the downside, rather than recoveries:
This isn’t to say that drillers will necessarily face the same difficulties as coal miners, many of which are destined for bankruptcy. Instead, the lesson is that when stocks are experiencing fundamental difficulties and seeing earnings estimates slashed (not to mention facing the headwind of being tied to weak commodity prices), the risk-reward equation doesn’t favor buyers.
This is especially true when earnings estimates are falling as rapidly as they are for offshore-related energy stocks. The table below shows the extent to which earnings estimates have declined in the past three months.
These numbers reflect analysts’ efforts to recalibrate their expectations to account for last year’s sharp downturn in oil prices. At the same time, it isn’t reasonable to expect that the risk-reward equation will improve until estimates at least show some evidence of stabilizing.
It should also be noted that the past few weeks have brought the full range of bad news for RIG: a dividend cut, analyst downgrades of both its debt and equity, and the departure of its CEO.
Often, this sort of flurry of negative headlines indicates the realization of investors’ worst fears, which brings about a relief rally on the idea that conditions can only get better. Instead, RIG shares have languished — indicating that investors still haven’t capitulated despite the stock’s one-year return of -58%.
With this as background, it’s evident that while offshore energy stocks have performed better in recent months, this is no time to be complacent. On the contrary, the odds of further weakness are high enough to make this group a “no-touch.”
For now, the best bet is look for opportunities to fade any rallies and avoid the temptation to position for a longer-term energy stocks recovery. You’ll need to wait at least another six months. The road map for smaller offshore energy stocks has already been established by the coal and gold mining sectors, and investors would be wise to follow it until the fundamentals indicate otherwise.
As of this writing, Daniel Putnam did not hold an interest in any of the aforementioned securities.