With WTI (West Texas Intermediate) crude oil prices at or below $61/barrel, stuff is, as they say, getting real. Regular readers know that I have been writing bearishly about oil prices since the spring. Even after oil fell into a bear market in October, around $82/barrel (West Texas Intermediate), I wrote an article in October titled "Why I'm Not Buying The Dip In Domestic Energy Stocks."
This caution led me to sell almost all of my shares of Trinity Industries (NYSE:TRN) months ago at much higher prices, though in typical fashion I missed the blow-off top in the railcar manufacturers. I discussed this in May in "Trinity Industries: Another Beat And Raise; Is It Nearing A Top?," in which I ended with the following:
Conclusion: TRN is a hot stock with both price and earnings momentum. Nonetheless, counter-cyclical risks are growing. I remain long TRN, but I now find a number of other stocks more compelling and have therefore sold into the post-earnings rally.
TRN is far below its price at that time.
With oil prices in full retreat, this is now a very interesting time in the oil patch for investors and speculators (I'm in both categories). Let's look at the risks vs. rewards by first setting the stage as I see it. You may see it differently, of course.
The natural resource complex may be in the sort of epic, historic bust that occurred in the tech world beginning with the frantic 2000 peak, partly ended in 2002, and then ended for good in 2008-09. A more recent analogy is the recent financial wreck, which was foreshadowed when homebuilding stocks peaked in the summer of 2005. As in those busts, the market destroys poorly managed companies as well as those that simply guessed wrong, taking on leverage at the wrong time, or where force majeure-type issues did them in.
My guess is that the resources boom, which began with silver well under $5/ounce and gold at $253/ounce in 2001, lasted 10 years and is now in a major bust phase, similar to the 1970-80 period which was followed by marked declines in inflation rates. Thus it was that silver frantically rose near $50/ounce, only to collapse the moment that the U.S. announced that it had killed Osama bin Laden. Attendance at mining conferences peaked in 2010-11, as did the resources IPO boom. The boom was wild.
As an example, the Sprott Physical Silver Trust ETF (NYSEARCA:PSLV), which simply holds silver bullion and thus has operating expenses with no income and "should" trade at a discount to NAV, reached 18% above NAV, around which time I wrote a blog post urging readers interested in silver to avoid this vehicle. Mr. Market ignored me, bringing PSLV to a bizarre peak around 30% above NAV. This sort of thing is only seen during a mania that can mark a durable top. Of course, PSLV collapsed worse than silver bullion did.
The most recent and much more economically significant event was, of course, the U.S. shale boom. By now all readers are aware of the nonsense that was going on; the question is whether new money that has avoided getting hurt in the bust should play in this space now. A key to my view is that, on balance, the decline in oil prices comes from a supply shock rather than a demand shock. Thus, I look at it more favorably than not. Of course, it's important to remember the challenges that the global economy has. My view is that overly high oil prices have acted as a tax on the economies of oil-importing regions such as Japan, China, and most of Western Europe, and that their economic prospects have now been enhanced by the current trend in oil prices.
Trading considerations aside, powerful political forces are now negatives for hydrocarbon use, and this is an important intermediate-term and possibly long-term headwind for the sector. A related point is the potential of solar. Upon moving to Florida in 1985, we took advantage of a modest Federal subsidy and installed rooftop solar panels on our house. We were disappointed when the ongoing bust in oil prices led the Feds to remove the subsidy. Now that solar efficiency is making steady gains, I expect that it will be a permanent growth sector of the global economy, and that it will restrain price increases for fossil fuels -- and will be economically viable without subsidies.
Next I will summarize my thoughts on how to play, or not play, this impressive collapse in crude oil prices.
Discussion -- Big Oil
I view giants such as ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), Total (NYSE:TOT), BP (NYSE:BP), and the others as having no investment interest whatsoever here. While crude oil prices are at five-year lows, their stocks are in general 50% above their five-year lows. That's after paying out generous dividends, so compared to the scarce commodity that's getting scarcer (crude oil), their total return has risen far too much. I see lots of downside risk to their trading prices.
I even am uncertain if they will ever return 100 cents on the dollar in any reasonable length of time to stockholders at current stock prices. For all I know, they could go the way of auto manufacturers, weighed down by environmental issues, cut-throat competition, loss of ownership of the reserves they need, etc. Investors interested in Big Oil have several ETFs to choose from. A well-known diversified one with heavy representation of the oil majors is Energy Select Sector SPDR Fund ETF (NYSEARCA:XLE).
Of course, Big Oil has huge refining capacity and in general is now more in the refining and marketing business than the upstream business, but in this section I'm talking about the companies that do little or no producing of oil. These include Valero (NYSE:VLO), Tesoro (TSO), Marathon Petroleum (NYSE:MPC), HollyFrontier (NYSE:HFC), and others. These appear more interesting than the majors on a trading basis (though ultimately they tend to have similar total returns): They are direct beneficiaries of lower input costs. Some of them, such as Valero, market gasoline as well. Some have formed midstream subsidiaries.
This is a heterogeneous group that tends, over time, to move with the economy. VLO is expected to have sales over $100B in 2015, with a market cap of only $25B and a P/E well below 10x. While it is better to buy it at or below book value, which is around $20B, it is an interesting value purchase here. I'm mildly bullish on the refiners and do think they could be interesting plays for the January effect, as tax-loss selling is clearly coming into play here. I have bought toeholds in VLO and TSO very recently.
I expect some bankruptcies of the most leveraged players (though who knows, "extend and pretend" could come into play here in a big way). One of the worrying signs for this sector came a couple of years ago when they all, like lemmings I suspected, switched focus from natural gas to crude oil production. I don't want to name names I'm bearish on, especially because I'm a long-only investor. I'll just opine that this looks like a minefield.
There likely are extraordinary trading opportunities coming (or are here) to buy the dip this month, planning to sell the rip in January. The riskier the company and more depressed the stock or ETF, the better the rip will be. Any rip may, however, be very temporary -- and is not guaranteed to occur. Among the many leveraged producers that is likely seeing both a surge in short-selling and tax-loss selling is Ultra Petroleum Corp. (NASDAQ:UPL). A liquid vehicle (pun intended) for this sector is the SPDR S&P Oil & Gas Explor & Prodtn ETF (NYSEARCA:XOP). It is not a pure play, though. I do not own any producers.
Having begun investing in 1979, I have a soft spot for the drillers. Some of the hot names from that era are still around. This group includes Schlumberger (NYSE:SLB), Helmerich & Payne (NYSE:HP), and Rowan (NYSE:RDC). SLB and HP are great names with great finances that will be there for the next upturn, unless HP happens to get acquired.
HP is interesting because it is an almost debt-free mid-cap company (and therefore a possible takeover target) that helped power the fracking boom. In the late 1990s, it bet big on an oil boom powered by extracting oil and gas from shale. It therefore developed what is now the leading line of drilling rigs adapted for horizontal, unconventional drilling techniques: its FlexRigs line. I wrote about HP bullishly last year at reasonable stock prices and sold the last of my HP shares around $105. It has now come down to under $61 after peaking near $120. Published EPS estimates for 2015 and beyond can be ignored. The important fundamental point here is that it HP is going to end the 2014 calendar year with about a $47 book value, essentially all of which is tangible book. It manufactures its own rigs. It also has net working capital of about a billion dollars out of a market cap of $6.7B as of Dec. 10.
HP's trading history gives support to investors who buy the dip now. Going back to 2002, the only time it has ever traded below book value as of the end of its fiscal year (Sept. 30) was in 2008-09. Even so, each and every year it also traded well above its current ratio of market cap to book value. During the oil exploration bust years of 2003-04, when it operated only marginally profitably, it averaged a 50%-60% premium to book value. That ratio projects at least a $70 price even if profits nearly disappear -- which they might.
HP is my favorite oil and gas play here, and I have begun scaling back into this name, which also pays what now amounts to a dividend payout about 4% of the stock price. As a relevant aside, I believe that HP's management historically has been honest and shareholder friendly. I trust them to work diligently on behalf of all shareholders.
Companies that manufacture petrochemicals benefit from lower input costs and also benefit from the economic stimulus that lower oil prices provide. These include LyondellBasell Industries N.V. (NYSE:LYB) and a number of others. There has been some panicked selling here, and trailing and forward P/Es look reasonable here. I bought LYB on the dip and may buy more.
Other Related Stocks
TRN has a lawsuit relating to a small business line of highway guardrail manufacturing. While the company expects no adverse financial effect from a recent jury judgment against it, this plus the anticipated decline in shale drilling are weighing it down. I view TRN as the dominant railcar manufacturer. Over time, railroads are not really expected to carry large amounts of crude oil, and I think that its businesses will likely expand. I have added a little bit of TRN into this bust on a buy-and-hold basis, based in part on trust in management regarding the guardrail lawsuit. A loss will be material, but should not be devastating in my opinion.
I'm leery of airline stocks, which I have found to be poor ways to play drops in oil prices. All they do is compete the savings away. On the other hand, shopping malls really do benefit. Most shopping does not occur via the Internet, which is just another variation of the old mail-order business model. Retailers will benefit from cheaper gas, but in most cases, their stocks appear to discount this phenomenon. I went long Macy's (NYSE:M), which I view as well-run, last week and added to my holdings when it dropped early this week.
Note that all these positions that I have mentioned are very small, toeholds really. But with today's additional fall in oil prices and ominous warnings that crude could fall to or below $40/barrel, I am sensing that the short-term panic may be reaching maximal volume and that a rebound in oil prices could be coming soon -- even though if it occurs, it may well not be the final end of this already-historic bear market.
Basically, while I'm not an investment adviser, my personal view is that the oil and gas sector of the stock market is too much like a snake pit that most investors should not put new money into yet. That's just my opinion, not advice, though. What existing holders of stocks that have been marked down by Mr. Market should do is another matter. Overleveraged companies could see their stocks go to, or near, zero if the bust continues (my base case). However, strong companies with differentiated technologies such as SLB and HP, or producers with low production costs and strong finances, might be attractive stocks either on a trading or buy-and-hold basis -- though their trading prices could easily drop further for both fundamental and headline reasons.
Overall, I'm most bullish on beneficiaries of this rationalization of oil prices, which have finally caught down to U.S. natural gas prices, precious metals, etc. These beneficiaries are many and include fixed income and numerous sectors of the economy. It also includes numerous regions of the country that do not produce energy, such as the East Coast and most of the West Coast. The evolving collapse in oil prices is, in my view, a huge event that could be durable and that is now my macroeconomic event of this year, along with the associated global decline in interest rates to historic lows.
Thus, I believe that traders and investors who approach the current oil crash with flexibility may be able to reap rewards that exceed the risks -- which are numerous.
Disclaimer: Not investment advice. I am not an investment adviser.
Disclosure: The author is long HP, TRN, LYB, TSO, VLO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.