Stand Clear of Energy Issues
By: Tim McPartland,
As always we continue to research and read information relative to crude oil and natural gas and we can’t find even a hint of a reason for energy prices to move higher from here.
We also know that many investors–even those that call themselves ‘conservative income investors’ are trying to pick bottoms in either the preferred shares of energy issues or in MLP’s so they can make a play. In our opinion we are likely months away from a bottom in crude oil prices–and maybe even further than that depending on how a few events play out. Those buying the preferreds or the energy issues themselves (mostly MLP’s) will likely take a beating or worse–a potential wipeout.
Let’s look at what we think we know about the energy market now. We know on a global basis there is an oversupply of around 1-1.5 million barrels of crude oil a day–about 1-1/2% of daily usage. At first blush one would think that this tiny amount of oversupply could be taken offline relatively quickly. A month ago we thought that no later than April-May production would come into balance with demand. This seemed reasonable given the decline rates of new horizontal wells (up to 50% in year 1). We also thought that rig counts in North America would drop by about 3% a week–we have been right on in this thought (although Canadian rig counts are very volatile). Initially we thought we would see a production drop in North America within a month or 2–but now with no drop of any sort we have to believe it will be summer before any drop comes to be realized and later in summer before the supply/demand situation comes into balance. Recall that just last week the U.S. had a 5 million barrel build in inventories of crude.
NOW–what we don’t know nor do we have any super reliable data on is the international energy markets. It would seem that no OPEC nation is going to be cutting production anytime soon so there will be no help there. Additionally, we see big production coming on line in places like Iraq where they announced record production of 4 million barrels per day-and they are looking at further production increases of up to 500,000 barrels/day by year end. Iraq has stated that the production increase makes up for the sharp fall in pricing and helps them fulfill government budget targets (90% of the budget comes from oil). We also note that Chevron has had a couple new major finds in the Gulf of Mexico–whether these come on line anytime soon is unknown–but the potential hangs over the market. The same goes for ExxonMobil which has hit some major finds recently in the Artic.
So it seems to us that investors wading into this market at this point in time are way too early. We have to remember that we will never be oil experts (nor do we want to be) and our goals and ambitions are to make a fair portfolio return–NOT speculate on when a beat up sector will turn and head higher. On the other hand we know that there are energy preferred stocks out there that will likely give super returns to those that can ‘buy them right’ and we would not mind participating when that time arrives.
We believe before the end of the year most of the upstream MLP’s will eliminate their distributions completely. Some have already cut them by 50% and more will follow shortly. The last portion of the distribution cut will come in the 2nd half of the year after lender ‘redeterminations’ make cuts to revolver lines of credit highly likely. We do not see preferred distributions being cut at this point in time–but we will watch closely.
To summarize. At this point in time there is no available information that indicates crude oil prices will head higher soon–in fact available information would indicate more downside is to come. MLP prices continue to fall after a bounceback a week ago. Some MLP’s have cut distributions by 50% and the balance will follow shortly. Some lender ‘redeterminations’ will start as early as February and by the end of April most ‘redeterminations’ will be complete and MLP’s will be forced to cut distributions shortly thereafter. Only after these cuts will the preferred shares take major hits–there will be no ‘margin of safety’ left. We think supply/demand will come into balance in August/September. This would indicate that we may be able to tiptoe into a preferred by June or July. It is unlikely that any MLP common unit will become buyable for us.