A Carnage Of Oil And Gas Shares

Energy was the worst performing sector on the S&P 500 index in 2014 as crude oil prices fell more than 50 per cent since last June.

The financial distress in global energy has begun as Saudi Arabia shows no inclination for an output cut and the economics of oil exploration means US shale output will not fall until well into 2016.

This means crude oil can stay in its current $45 to $60 trading range in the next year. Schlumberger has axed 9,000 jobs. Exxon Mobil has ended its Russian Arctic oil-drilling venture with Rosneft. Royal Dutch Shell has cancelled its $6 billion chemical plant in Qatar.

Leveraged shale oil producers in Texas or North Dakota can no longer borrow bank loans or issue debt in the high yield debt market. There is also a demand shock component in the meltdown in oil prices as China GDP growth falls to
a 25-year low and both the IMF and the World Bank cut global growth forecasts.

So what does the oil meltdown mean for energy shares on Wall Street in 2015? Energy is the ultimate capital intensive, global, long lead-time investment.

business. Profitability is volatile since oil and gas prices fluctuate wildly, as do drilling and exploration costs and companies with weak balance sheets get devastated when they are forced to produce below their marginal cost of production or shunned by the high yield debt markets.

This is the reason major US natural gas and shale oil companies have fallen 50 to 70 per cent from their June highs. This is not a correction in Wall Street energy stocks. It is a washout – a swift and savage bear market in a sector that contributes 12 per cent to the S&P 50 index’s earnings.

Oil service firms are also natural victims of a meltdown in energy shares. Energy capex and services could fall at least 25 per cent in 2015 and far more in sanctions hit oil provinces like Russia and Iran. Wall Street oil services shares have plummeted as the oil price fall accelerated.

Even global oil services firms such as Schlumberger and Halliburton will not be immune to a fall in earnings and operating margins. It is entirely possible that the US rig count falls from its current 1,670 level to 1,200 and global oil major capex could fall 20 per cent.

As interest rates fall, there are opportunities to bottom fish in the shares of pipeline or midstream asset master limited partnerships (MLPs).

With dividend yields as high as 6.5 per cent and distribution growth rate potential in the 5 to 6 per cent range, pipeline MLPs that can offer a total return of 12 per cent yet are relatively immune to commodity price risk.

Refining could be another strategic opportunity as the spread between West Texas and Brent crude can rise beyond its current $2 and a Republican Congress will allow US energy exports to the world.

Philips (PSX) has the unleveraged balance sheet and transport/pipeline infrastructure to benefit from the post- crash world of petroleum refining.

If US economic growth and job growth accelerates in 2015, demand for gasoline will rise. I am also bearish on the prospects for Philip’s joint venture with Chevron as crude’s fall devastates chemical margins. Pipeline construction could also suffer.

US large cap shares are at great risk at 17 times earnings. The 30-year US Treasury bond yield has fallen to generational lows at 2.52 per cent, clear evidence of deflation risk.

The strong dollar will pressure US multinational earnings, as will recession in Europe and a fall in oil-linked demand in the Middle East. Earnings risk has never been higher on Wall Street where pipeline and refining shares could be low beta, safe havens.

Russia’s sovereign credit downgrade to junk demonstrates the utter failure of Putin’s economic model. Sanctions will tighten as the war in Ukraine escalates and the oil crash guts Kremlin revenues. The worst-case scenario is a Russian sovereign debt default and global contagion, as in August 1998.