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With Oil Stocks Beaten Down, Is Now the Time to Buy?

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Jonathan Waghorn, portfolio manager of the Guinness Atkinson Global Energy fund, is bracing himself for further volatility in oil prices this year.

Energy stocks in general were among the worst performers last year, following one of the sharpest declines ever in global prices, and Waghorn believes oil—currently priced at around $48 a barrel—has the potential to drop further this year.

When and by how much, though, is hard to say, “and if you talk to eight different people, you’ll get eight different viewpoints,” he says.

Ditto for whether or not this is a good time for buying those beaten-up energy stocks: “Among those eight people, some will say this is an excellent opportunity to buy and others would say it’s best to avoid energy,” Waghorn says.

Waghorn and his team, though, believe that forthcoming energy market dynamics are likely to play out in a similar fashion to market dynamics in 1986 and 1987. Back then, the massive 65% drop in the price of oil was also caused by the same kind of supply/demand imbalance that’s happening today, he says. But as energy supply and demand began to realign, oil prices rose significantly over a 12-month period, leading to a 40% outperformance of the MSCI Energy Index over the S&P 500.

“If history were to repeat itself, we would see the oil price bottoming out at $35 to $40 a barrel before recovering to $70 or $80 a barrel,” he says. Considering the likelihood of that happening, he argues, there is a case for accumulating energy equities in the near term.

Guinness has a “shopping list of good ideas,” Waghorn says, for when oil supply and demand become more closely aligned and for when the price-per-barrel of crude rises. Topping that list are North American exploration and production (E&P) companies.

These are already important holdings in the Guinness Atkinson Global Energy Fund—which is broken into 30 positions each with a 3.3% weighting—based on the overall favorable growth outlook for the U.S. energy industry in the long term. E&P companies, “which live hand-to-mouth by converting one year’s cashflow into the next year’s capital spending,” are just starting to feel the pinch of lower oil prices, Waghorn says, and cutting back on their capex budgets.

That means that the production of North American oil will eventually fall (Guinness Atkinson estimates the 2015 growth rate to be at around 0.7 million barrels a day compared to growth of 1.6 million barrels a day in 2014), and could fall even further into 2016 if capex doesn’t pick up. “If these companies can’t spend money, then they don’t run the rigs and production starts to slow down,” Waghorn says.

Eventually, though, the drop in production will lead to a correction in the oil supply/demand imbalance, where continued demand, largely from emerging economies, and decreased supply would push oil prices up, and that in turn bodes well for E&P companies.

“Over the long term, we’re sitting with our base estimate of oil at $100 per barrel, so on that basis and once there’s a correction in the supply/demand imbalance, there is a clear upside in the sector,” Waghorn says.

The question, he argues, “is the timing,” and while “we haven’t yet upped the beta in our portfolio, we will do because we believe that energy will perform in the same way it did in the 1986 period.”

That said, though, supply and demand are not the only forces at play in the global energy markets today. There are a number of variables that can exert their influence, Waghorn says, including Russia, where sanctions are biting harder and harder as time passes and starting to stagnate the oil industry, and the tensions in Iraq, where the presence of the Islamic State has raised some serious questions about the country’s future production.

Political instability in Nigeria, another major oil producer, is also an issue. And of course, there’s OPEC itself.

“We don’t know what OPEC will do, we can’t predict their actions,” Waghorn says.

In the best-case scenario, he says, should U.S. and Russian production growth fall, then Saudi Arabia, Kuwait and the United Arab Emirates may take action to turn the oil price around, perhaps restoring it to the level that naturally produces a balance in world oil demand growth and non-OPEC supply growth.

However, Waghorn warns that there is no certainty that scenario will occur.


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