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Energy Stocks

Real Talk about Energy

By Elliott H. Gue, on Feb. 9, 2015

We’re giving Big Picture readers a glimpse behind the paywall at Energy & Income Advisor, where serious individual and professional investors will find high-quality coverage and analysis of all things energy.

Each month, Roger Conrad and I host an exclusive Live Chat where we tackle any and all questions from subscribers—an invaluable resource in these uncertain times.

January’s Live Chat lasted more than seven hours, a testament to our dedication and the thorny issues on many investors’ minds. Here are some excerpts from the proceedings.

Q: What is your opinion of Transocean’s (NYSE: RIG) bonds and notes? A: Transocean’s bonds have held their value, by and large. That’s in no small part because Transocean has maintained its investment-grade thus far and, therefore, can be held by more than just junk-bond funds. But that could change, as Standard & Poor’s and Moody’s Investors Service have Transocean on negative watch. We’ve had a Sell rating on Transocean and other offshore contract drillers a sell for some time. We don’t think the company will go bankrupt, even if the agencies cut its credit rating. However, the downgrade would likely prompt a selloff in the bonds. At this stage, you’re better off sticking with the junk bonds we highlighted in the Dec. 18, 2014, issue of Energy & Income Advisor. Q: Hope you guys are staying warm. Please elaborate on Energy Transfer Partners LP’s (NYSE: ETP) acquisition of Regency Energy Partners LP (NYSE: RGP). The acquirer’s stock price took a sizable hit after the deal was announced. A: We issued an Alert on the deal the day it was announced. This acquisition, which the market has expected ever since Energy Transfer Equity LP (NYSE: ETE) acquired the general-partner interest in Regency Energy Partners back in 2010, marks the ongoing consolidation in the midstream space. We expect Energy Transfer Partners to remain active on this front, especially if one of the smaller master limited partnerships (MLP) cracks up because of its marginal asset base or counterparty risk on contracts. Investors have grown overly complacent about MLPs, focus entirely on yield and gloss over the risk embedded in some business models; such a shock could prompt a selloff in some of the best names, setting the stage for well-capitalized names such as Kinder Morgan (NYSE: KMI), Enterprise Products Partners LP (NYSE: EPD), Plains All American Pipeline LP (NYSE: PAA) and the Energy Transfer family of partnerships to step up acquisitions. Expect the acquirers to focus on assets that complement their existing systems, creating the opportunity for significant synergies and growth opportunities. As for Energy Transfer Partners’ purchase of Regency Energy Partners, the deal will be accretive because Energy Transfer Equity, the MLPs’ general partner, has agreed to reduce its incentive distribution rights for several years. But the deal’s primary appeal hinges on the scale that the combined company will gain in the Permian Basin and the integration of Regency Energy Partners’ gathering pipelines in the Marcellus Shale with Energy Transfer Partners’ Rover Pipeline. Energy Transfer Partners also boosted its distribution by $0.02 per unit, maintaining its run rate from the past year—a good sign for the deal. Much of the downdraft in Energy Transfer Partners’ unit price reflects concerns about dilution because of the deal’s equity component. Investors should regard this pullback as a buying opportunity. Q: We never hear anything about the Strategic Petroleum Reserve (SPR) these days. One would think that the SPR would be accumulating inventory while oil prices are so low. What, if anything, do you guys known about the SPR’s actions? Once again there is demand by speculators for floating oil storage (idle tankers). Does such storage amount to a drop in the bucket for oil demand or would it/does it have a measurable effect on oil prices, although perhaps only temporary? From past experience how does the unwinding of this speculative storage effect oil prices? A: The Dept of Energy publishes data on how much oil the US holds in its strategic petroleum reserve (SPR), which has held steady at about 700 million barrels. No major additions or subtractions lately. China has taken advantage of the decline in oil prices to add to its strategic reserves though data on how much oil they hold or their purchases isn’t as transparent. Regardless, I don’t think additions to strategic government reserves in the US, China or anywhere else will be large enough to turn the tide for the global oil market. There are reports of an increased amount of oil being held in floating storage on tanker ships. The last time we saw that happen was back in 2009. Storage is typically driven by a few fundamental factors, including the shape of the futures curve. Right now, for example, front month Brent is trading under $50 per barrel while Brent for delivery in December 2015 fetches about $57.50 per barrel—almost $10/bbl higher. This dynamic encourages traders to buy oil at cheap spot prices and store the crude, as they can sell December futures and lock in a price of $57.50 per barrel, realizing a riskless profit of almost $10 per barrel by the end of the year. As long as the oil market remains in contango, you’ll see more oil head into storage. Meanwhile, the glut of crude oil continues to build, which is why I think we’ll see downside to $30 per barrel in the first half. As for the US, keep an eye on inventories in Cushing, Oklahoma, where storage capacity is roughly half full. The price spread between Brent and West Texas Intermediate (WTI) crude oil is too narrow, which has increased imports on the Gulf Coast because it’s cheaper to import Brent that use domestically produced crude. Accordingly, inventories should continue to build at Cushing until the spread widens. Yes, a continued build in global oil inventories will remain an important signal that the oil market is oversupplied and will keep a lid on any rallies in oil in the first half of 2015. When we see this trade unwind–like we did back in late 2009–it will be a signal the oil market is rebalancing. We’re just not there yet. Q: You recommended American Airlines (NSDQ: AAL) several months ago. What is your present view of that stock? A: We still like American Airlines. The carrier doesn’t hedge its fuel costs, making the company one of the biggest beneficiaries from the drop in oil prices. In addition to the direct benefit of cheaper jet fuel, lower prices at the pump stimulate consumer spending and demand for air travel. If weakness in the broader market persists, investors could have an outstanding opportunity to buy American Airlines’ stock. Q: I’d like to pick your brains on commodity prices. I’ve read that many of the big oil speculation positions (futures) in are still held as long positions and that, until these are liquidated, oil prices have further downside. What’s your take? A: We concur that there’s more downside to come for oil prices.To reiterate, we expect crude oil to approach $30 per barrel in the first half of the year, followed by a gradual recovery. Historically, speculators are really bullish–heavily long oil futures–near the tops of the market and really bearish–heavily short–near important lows. My reading of the data from the Commitment of Traders report is that we’re not yet at levels that would be historically consistent with a major bottom. I am also paying attention to data on the futures commitment of energy companies (also published weekly in Commitment of Traders). So, this data is a very rough indication of what producers are doing in terms of hedging activity. Producers that have hedges in place appear to be resetting the positions appear to be cashing in their swaps and options and using the proceeds to hedge higher volumes at lower prices. This trend has two implications:

  • They’re preparing for a prolonged period of lower oil prices. If that weren’t the case, they’d probably just sit on the hedges they have in place and wait for oil to recover.
  • These new oil hedges may allow the producers to continue drilling for longer than would otherwise be the case, prolonging the weakness in oil prices. This is another factor that leads me to believe many investors expect oil prices to jump back more quickly than will likely be the case.

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