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Portfolio > ETFs

Bleak Energy Picture to Brighten in 2016, but Volatility to Remain

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The despair in the energy sector as crude oil languishes around $45 per barrel has driven out investors who don’t see an upside anytime soon. However, two experts at the Morningstar ETF conference panel, Drilling for Opportunities in the Oil Patch, weren’t so dour, and in fact, see some upside in 2016. 

Kevin Baum, senior portfolio manager for commodity and alternative ETFs at Invesco Powershares Capital Management, and Edward Davis, portfolio manager for Fidelity Management & Research Co., both saw the dark cloud lifting from energy investments in the coming year. 

Since June 2014, crude oil prices have dropped 60% while natural gas fell 45%, and likewise, energy-related equities, especially exploration service companies that are leveraged the most, have fallen a commensurate amount in price, about 50%-60%, said Davis. “If you take a traditional measure, like price-to-book, energy equities today compared to any time in the last 100 years are cheap relative to the market…We are at a valuation extreme.” 

Key to the oversupply was the doubling of U.S. production after 25 years of decline, along with reduced demand by a slowing global economy, Davis added. Saudi Arabia, which had been holding back production, determined it had ceded too much share to the United States and turned on its spigot. These factors caused the price fallout, but Davis does see a bright light at the end of the tunnel. 

“The crude market itself is not as nearly oversupplied as it has been in the past with price crashes,” he said. “We consume 95 million bpd globally, overproducing about 2 million bpd…and there’s little spare capacity over and above that…about 3%-4%.” He compared those levels to 1986, when we had a 15% spare capacity, and in 1998, post-Asia crisis, a 7% oversupply. “So we’re not in as dire as environment as that. Crude is a depleted resource, and capital spending globally has been cut.”

Now, however, demand is growing faster with cheap gasoline, and even Chinese demand is up 13% year-over-year despite the market and economic issues there, he said.  

“The U.S. is producing 500,000 bpd less than a couple months ago, although the Middle East is pumping as much as it can. Still, I could paint a picture we’ll be back in balance next year,” Davis said. 

Baum agreed, stating “this is clearly a supply story…it is not a 9/11 scenario, not the global recession of 2008. This has been a U.S. shale story first and foremost. He expects to see drilling production cuts, “so we see a healthier, balanced market in 2016.” 

Both men saw prices rising to between $65-$85 per barrel in the second part of 2016 due to several fundamental factors, although volatility will still be in play. 

Davis noted there was a “dead cat bounce” in energy prices earlier this year, but since then prices have hit multi-year lows. “People don’t want to talk about it, but that’s where you find a bottom, when no one wants to dive in,” he said. 

Moderator John Gabriel, a strategist with Morningstar, pointed out what keynote speaker Jason C. Hsu had illustrated in his presentation that morning, that a market low was when to jump into an investment. So is this the time to come in? 

Baum agreed that would be a smart move, and now that energy is an out-of-favor asset, investors should look at it in a contrarian way. Davis agreed that energy ETFs would be good investments, adding that there are many parts of the production stream he looks at as a portfolio manager.

“If you’re looking for pure torque, and are convinced energy prices are going back to $70, buy the most undervalued exploration company in energy you can find because if oil goes up 50%, stock prices go up (much) more.” He added that the stocks of bigger companies, like Exxon and Chevron that produce oil and gas but have big downstream products, tend to go down less in big drops and up less in big rallies. Also, keep in mind the refining sector, which  “has been the best performer the last five to six years.” 

Davis also warned that due to hedging rolls going off next year, there could be a “another shoe to drop” in 2016. However, Baum thought if there were a surprise, it would be on downside of supplies, not upside. Therefore, he expects a healthier market although not in the next few months, which both speakers think will see continued softness in energy prices.  


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