| Wednesday, September 9, 2015 | |
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The End of Energy Sector Woes
 Energy stocks seem to be circling the drain.
It seems bottomless and vicious.
But we've had more than one energy sector collapse in the last 20 years. The industry, by nature, is prone to boom and bust cycles.
Don't forget: The energy sector has also been one of the most profitable over the last two decades.
The trick to success is not to try to catch the falling knife, but to be patient and pick spots. It's about not getting overly aggressive, but looking toward the future for signs of a bottom.
We look for signs of hope when everyone else just sees destruction. And one of the signs we look for is already underway, and has helped fuel rebounds in the collapses preceding this one...
In the second quarter of 2014, West Texas Intermediate (WTI) averaged $103.21 per barrel. In the third and fourth quarters of 2014, the price per barrel averaged $97.78 and $73.16, respectively.
The price of WTI averaged $57.85 in the second quarter and is currently averaging around $47 for the third quarter.
So, we're still down more than 51% year over year. The fourth quarter will get us a little closer to being able to compare apples to apples... but it'll likely be a large moat between the two average prices year over year.
The price of crude soared following the broad market collapse two weeks ago.
On August 24 and 25, the price of crude jumped nearly 10% and then bounced higher another 7% on August 28 to over $45.
This leap shot up shares of energy companies across the board...
But I tempered my expectations. The reality for WTI's huge price swing isn't that crude has turned a corner; it appears to be a tremendous amount of short covering.
Admittedly, we may have witnessed a near-bottom in oil prices at $38. But a surge back to the May 2015 peak of $62 doesn't seem realistic because fundamentals in the market can't support it... at least not yet.
But that doesn't mean there isn't hope for the energy sector. Companies have started slashing capital expenditures this year, already shelving $200 billion in projects.
And as we see from the chart below, the capital spending-to-cash flow ratio for the S&P 500 Energy Index is at its highest in 25 years...
Not surprisingly, the last two times the ratio was even close to being at this level was in 2009 and 2002... our last two market crashes. Though those were broad-based downturns where everyone believed the world was ending.
In reality, all you had to do was buy near the bottom and you came out sitting pretty.
We always want to attack when negativity is at its peak and be careful when optimism is overflowing.
Over the last 12 months, the energy sector's spending on acreage, machinery and other outlays has been 1.1 times the industry's cash flow.
The sector is slashing as much as it can from expenditures to protect its balance sheet, hoping to regain some profitability and be in a better position when crude begins to rise.
Here's what you need to know...
First, let's talk about our last two meltdowns. During the collapse in 2002, the average price per barrel of crude per month declined year over year for 14 straight months before we started seeing gains. This downtrend began in May 2001 and continued until June 2002.
Now, we can take a look at a supermajor and see how it performed as a guide. For example, shares of Exxon Mobil (NYSE: XOM) largely fell during that span, bottoming in July 2002 before heading higher.
And in 2009, the average price of crude per month declined year over year for 13 straight months before we started seeing a gain. The declines began in October 2008 and continued until October 2009.
Shares of Exxon didn't finally bottom out until July 2010.
So, basically, it took the sector little more than a year to begin to recover in the last two sector collapses.
But the bad news is, right now, we're already in our 14th straight month of year-over-year monthly price declines. And, as I mentioned above, the average price per barrel of crude was well over $70 in the third and fourth quarters of last year.
So, we're not likely to see any year-over-year gains there in the near future. The best hope could be December, as crude averaged just over $59 per barrel last December, or January 2016, since crude was at $47 per barrel in January of this year.
This is important because if prices are down year over year each month, revenue and earnings per share are going to be negative year over year in their quarterly results.
The only way to increase profitability is to slash and burn capital expenditures.
Prior to our last two collapses in 2009 and 2002, going back to the mid-1990s, the price of crude tumbled lower for 25 straight months. But don't worry, I don't think we'll have declines for that long.
Although we are entering winter maintenance and preparing to switch to winter-grade gasoline, which means lower demand for crude from refineries, those same stocks - refineries - are the safest bets in the near term. The margins on winter-grade gasoline are much better than those on the summer driving season blend.
We'll have another six months of sluggish crude prices, unless a hurricane plows through the Gulf of Mexico in the next couple of months. I know it's difficult, but right now it's all about stalking the companies you like and looking for the right moment to strike. And the end appears to be in sight.
Good investing,
Matthew
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