Time For The Contrary Investor

|
Includes: DBE, EPD, IXC, MPC, UGA, UNG, USO, XOM
by: Andre Weisbrod

Summary

The old adage is “buy low, sell high.” It is hard to refute. The exceptions occur when what goes low ends up out of business.

Buy low and sell high can work either on a short-term basis or a long-term basis. We are more long-term oriented.

So, what can we find that is truly cheap, yet holds intrinsic value that is likely to increase in value significantly over the next five years?

It’s hard to avoid looking at the energy sector.

The key is to find the right companies, ETFs and/or mutual funds.

Oil Oil and related energy is the most obvious category where the price is hugely down yet the intrinsic value should hold. The price of a barrel of oil recently retreated below $27. It was only about eight years ago (2008) when a barrel of oil topped out at over $140. That is a decline of over 80%! Whooda thunk it? No one I know of.

The current pricing of oil reflects increased production in recent years and a current oversupply. It is exacerbated by geopolitical forces that are manipulating the situation. Saudi Arabia and OPEC have not reduced production to stabilize prices as they have done in the past. It appears that as the USA made great strides toward energy independence, the motivation of some countries has been to try and retard that growth and put some energy companies out of business while delaying the U.S.'s independence. Other countries and many companies need to keep production up even at a loss just to stay in business, hopefully long enough to see prices rise again.

Indeed, many companies in the energy sector are in serious trouble. The cost to produce a barrel of oil varies from under $10 per barrel (Saudi Arabia) to $49 (Brazil) and $52.50 (Great Britain). (Source: CNN Money Nov. 24, 2015)

The essential math is relatively simple. If it costs a company $35 to produce a barrel of oil, it loses $5 a barrel at a $30 price. If you lose $5 per barrel, how long can you stay in business? It depends on your financial condition. If you have low debt, have sufficient cash reserves and are able to cut some costs, you have a good opportunity to outlast the current dip. But if you have higher debt, low cash, and cannot rein in costs, watch out.

Primary assumptions: 1. The demand for oil and gas will continue to increase. 2. The intrinsic value of the commodity is clearly present. 3. The oil and gas industries will not go out of business any time soon.

A reasonably sound expectation is for oil and gas prices to eventually increase from current levels. The question is: when and how much? We think it is reasonable, and possibly conservative, to assume a barrel of oil will cost $50 a barrel within three years and $60-$65 in five years. That would be a 100% plus return potential for investments that are directly related to the price of oil. A return to $100 oil at some point in the future is not inconceivable.

Many countries, as well as businesses, will need the price of oil to increase sooner than later. One statistic is called the "breakeven price" of oil. That is the price at which an oil revenue dependent government's spending commitments are funded by the country's oil revenues. For a country like Russia that estimated breakeven is $105 per barrel. Other countries depending on oil revenues may have break even prices as high as $180 (Libya). (Source: IMF, Deutsche Bank) It is a bit of a conundrum politically and practically. Clearly, policies and actions to bring the price of oil up are in those countries' best interests. Most prognosticators are estimating oil prices to reach the $40-$45 mark by summer of 2016. However, these same sources were wrong last year, when oil was $40 and they thought prices would end 2015 in the $60 range.

We were also wrong in 2015 when we agreed with our sources and thought oil should be nearing a low point at $40 a barrel. We did some buying and, of course, wish we had waited. Hindsight is such a tyrant. This time, however, the probability is better that the sources are right and oil prices will be going higher within 6-12 months. Even if it takes longer, the probability is that oil prices will increase over the next few years barring a global recession. They could go down a bit further than $27 first, but even if that wasn't the exact bottom, a five-year horizon is likely to prove the current opportunity to be sound.

Will $27 prove to be the nadir? If so, then this is the time to be buying. Now the question is what to buy. We see three ways to best assure long-term profits if energy prices do in fact rise.

1. Identify and buy the "best of breed" companies in the energy sector. These are companies that have relatively low debt, good efficiency and are most likely to outlast competition and take advantage as prices rise. Company choice is critical, because even if oil prices rise precipitously, some companies might still go under or have a long road back to profitability.

One alternative is to pick among the giant diversified energy companies that are best positioned to weather the downturn yet maintain or increase market share. Such a company is Exxon (NYSE:XOM), though it might not have the upside potential of others that have had a bigger beat-down. Or consider companies that are more involved in the refining and distributing side and might not have as much risk as the pure driller/producer companies. Marathon Petroleum (NYSE:MPC) and Enterprise Products (NYSE:EPD) are two examples.

2. Invest in the commodity side using such vehicles as ETFs that own/track commodities. Examples are United States Oil Fund (NYSEARCA:USO) DB Energy Fund (NYSEARCA:DBE), United States Gasoline Fund (NYSEARCA:UGA), and United States Natural Gas Fund (NYSEARCA:UNG).

3. Buy well-managed energy mutual funds or broad-based energy ETFs such as Energy Select Sector ETF (IXE) or iShares S&P Global Energy Sector ETF (NYSEARCA:IXC).

(Disclosures: At the time this was written, the author and/or clients owned shares of XOM, MPC, EPD, and IXC)

Disclosure: I am/we are long IXC, EPD, MPC, XOM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.