"A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years …We are profoundly worried that this could be a risky allocation over the next 10." - Sanford C. Bernstein & Company Analysts (January 2017)
“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria” - Sir John Templeton
“Life and investing are long ballgames.” - Julian Robertson
As a market historian and a professional investor for over two decades, I believe we reached important secular turning points in 2016, first with commodities, which bottomed early in 2016, then with sovereign interest rates, which bottomed in the middle of 2016.
Looking back, oil prices clearly had reached a turning point in 2016, yet it has been an extraordinarily painful, frustrating ride for those of bullish on energy equities, particularly the out-of-favor energy equities, including Chesapeake Energy (CHK), which I have written about publicly on SA recently.
Even more painful than the performance of out-of-favor energy equities in the energy sector has been the performance of oil service stocks, which have been decimated even as crude oil, natural gas liquids, and even natural gas prices, have risen firmly from their 2016 lows.
Why are oil service stocks lagging the rise in energy prices, specifically crude oil prices so much?
What does this mean going forward?
We will explore these questions below.
Oil service stocks are sending a positive signal that energy exploration and production companies are living within their cash flows, which should be a bullish sign for supply/demand energy fundamentals, and even a more bullish sign for E&P equities.
A Secular Bottom In Oil Prices
Oil prices peaked in 2008, and bottomed early in 2016, as the long-term chart shows below.
(Source: Author, Stockcharts.com)
Looking at the rise of oil prices from 2002 to 2008, which roughly aligned with prior economic expansion before the current one, it is striking how contained oil prices have been in the current economic expansion.
The impact of slowing global growth from 2011 to 2015 is clear on oil prices in the chart above, with a lagging impact, and this makes one wonder if the current expansion in global economic growth from 2016 onward will impact oil prices with the same lag effect?
Time will provide the answer. However, for our discussion purposes now, it is clear that oil prices bottomed in 2016 and have made a secondary low in late 2018/early 2019.
Oil Service Stocks Undercut Their 2016 Lows
In contrast to the price of crude oil itself, oil service stocks, as measured by the VanEck Vectors Oil Services ETF (OIH), actually undercut their 2016 lows in late 2018.
Adding to the narrative, the seven biggest components of the OIH, led by Schlumberger Ltd. (SLB) with a 19.3% weighting in the OIH, followed by Halliburton Co. (HAL) with a 14.8% weighting in the OIH, followed by FMC Technologies (FMC) with a 5.1% weighting in the OIH, followed by Baker Hughes (BHGE), with a 5.1% weighting in the OIH, followed by National Oilwell Varco (NOV), with a 4.9% weighting in the OIH, followed by Transocean (RIG) with a 4.8% weighting in the OIH, followed by Patterson-UTI Energy (PTEN), with a 4.8% weighting in the OIH, all undercut their 2016 lows with their 2018 price declines.
All of the largest market capitalization oil service equities have been negatively impacted, as shown above, and smaller oil service stocks like fracking sand provider U.S. Silica Holdings (SLCA), which has a 1.0% weighting in OIH, have been crushed, no pun intended.
With oil prices strongly up from their 2016 lows, and U.S. oil production reaching record highs, how could there be such universal pain in the oil service equities?
Looking For An Answer Yields A Clue
In reading through 10-Ks and 10-Qs of energy companies, including Exxon Mobil (XOM), Chevron (CVX), Occidental Petroleum (OXY), Anadarko (APC), Apache (APA), Hess Corp. (HES), Devon Energy (DVN), EnCana (ECA), Pioneer Resources (PXD), Concho Resources (CXO), Cenovus Energy (CVE), California Resources Corp. (CRC), and Chesapeake Energy (CHK), to name a few annual reports I have read recently, it is clear that there is a focus on spending within cash flows, especially among the non-major energy companies.
Collectively, these non-major energy companies, along with their smaller peers, were the beneficiaries of an ultra accommodating interest rate environment, which raised money from public and private investors, and which allowed these companies to spend beyond their operating cash flows, in the search for growth, and higher future energy prices.
However, there has been a paradigm shift, and spending within cash flows, and delivering free cash flow is the new buzzword in the energy sector.
Adding to the narrative, the major oil exploration and production companies, including XOM, CVX, BP (BP), Royal Dutch Shell (RDS.A), (RDS.B), and Total (TOT), collectively, these companies have been on the sidelines compared to their own past capital expenditures, though XOM and CVX are notably increasing their spending and production forecasts in the Permian basin.
Taken all together, it has been an epic bear market for oil service stocks. However, there is a silver lining, in that the dismal performance of oil service equities, notably on a relative basis, suggests that there has been ongoing fiscal discipline in the exploration and production companies, which should be very bullish for future supply/demand fundamentals in energy prices and in energy equities.
Oil prices bottomed in 2016, yet energy equities have generally lagged at best, and oil service stocks actually made new lows in 2018, even with oil prices much higher than their 2016 levels, with the top seven companies in the VanEck Vectors Oil Services ETF all undercutting their 2016 lows in 2018.
Energy stocks across the board were also hit very hard in 2018, and I believe this selling climax in 2018, even with much better underlying commodity prices, represented a true capitulation in energy equities.
If exploration and production companies keep exercising fiscal discipline, look for oil service stocks to continue to lag. However, this could be very bullish for energy prices, and energy equities, as demand growth outpaces constrained supply growth.
Ironically, constraints on supply growth this time could be self-enforced constraints, not pipeline bottlenecks, and this renewed fiscal discipline could be just the jump start that beleaguered, downtrodden energy equities need.
Do you agree? I am curious to read the discussion in the comment section.
Bigger picture, fundamentals still do matter, fundamentals were always the wrong scapegoat, and I still believe 2019 is going to be a banner year for value equities, as price discovery, after a decade of growth outperforming value is poised to return with a vengeance.
To close, even though it has been a very difficult almost decade-long stretch for value-oriented investors, with pockets of significant out-performance, including 2016, I think we are about to enter a golden age for active, value investors, who do the fundamental work, who can find the future free cash flow leading companies, and the most out-of-favor sectors and the most out-of-favor equities, including this recent public write-up, will be at the forefront of this opportunity.
Thank you for taking the time to read this article,
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Disclosure: I am/we are long CHK, CVE, ECA, RIG, DVN, XOM, CRC. 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.
Additional disclosure: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.