The 2014 decision by OPEC to rely on a market share strategy (rather than production cuts) also contributed to the current glut. Is there any opportunity to be found in this sector?
My team takes the longer-term view, so we believe the answer is yes. However, in the short term, investors need to be prepared for a few bumps. OPEC continues to battle some of its members regarding adherence with agreed-upon production cuts. At the same time, the two countries with quota exemptions (Libya and Nigeria) are producing hundreds of thousands of barrels more per day than expected. And of course, the US shale boom continues unabated. The Energy Information Administration estimates that US shale oil production will rise by more than 100,000 barrels per day in September for the sixth consecutive month.
Beaten-down sectors provide opportunity
The S&P 500 Index is up about 10% so far this year, but the energy sector is off over 19%.1 Yet, my team believes conditions are ripe for a turnaround in energy.
- Exploration, production and service company valuations are near historic lows based on our analysis, trading at a price-to-book (P/B) multiple of 0.55. This compares with an average P/B of 0.88 for the sector using data all the way back to 1952.2
- Many energy companies are currently what we call “under-earners.” In good times, these firms can be cash-generating machines, but the long stretch of low energy prices has resulted in layoffs, dividend cuts, fewer stock buybacks and expense reductions. Once prices rebound a bit and stick, these companies should be even better positioned for growth, in our view.
- The sector is clearly out of favor and has been for some time. We believe investors are always wise to consider sentiment, but should then dig a little deeper and analyze the trends and facts.
- After the long period of underperformance, many funds (understandably) lightened up on energy shares and are now underweight.3 At some point, this trend will reverse, and demand for these shares should increase. Also, many investors have taken short positions in energy stocks, and they will have to buy shares in order to settle these positions.
- Last, energy company capital expenditures (capex) are at historically unsustainable levels relative to cash flow.
This last point is important. Over time, we have observed that during normal market conditions, energy exploration and production (E&P) companies usually spend about 110% to 115% of cash flow. (This would be unusual in most industries but not in the E&P space.) However, today capex and other expenses are running about 140% of cash flow,4 which we believe is clearly unsustainable. We believe that as companies rein in this spending, production will ultimately slow, and the market will accelerate its rebalancing.
Where we see opportunity
Portfolio managers for both Invesco Growth and Income Fund and Invesco Equity and Income Fund have been actively seeking out energy sector companies that meet the criteria outlined in this blog. Following careful analysis, we have been pleased to add a number of energy companies to the funds, all at very attractive prices, in our view.
Specifically, we have recently bought or added to our positions in Occidental Petroleum and TechnipFMC. These companies equal 1.85% and 1.35% of Invesco Growth and Income Fund (respectively) and 1.08% and 0.91% of Invesco Equity and Income Fund (respectively) as of June 30, 2017.
TechnipFMC is an oil field service company that was formed by a merger back in January but had a very rocky start. As a result, it has suffered a low valuation and has low expectations — in our experience, this is often an ideal scenario to begin building a position, especially when combined with a fundamental catalyst such as an improving supply/demand balance for oil. OPEC today has very little excess capacity,5 so increased demand for oil should eventually translate into higher energy prices. We believe TechnipFMC is well-positioned to benefit from that.
1 Sources: Ycharts.com and Marketwatch.com, data as of Aug. 17, 2017
2 Source: Corporate Reports, Empirical Research Partners Analysis, data as of June 2017
3 Sources: Bloomberg L.P. and Standard & Poor’s, data as of Jan. 31, 2017
4 Source: Empirical Research Partners Analysis, data from 1952 through 2016, smoothed on a six-month trailing basis
5 Sources: International Energy Agency, RJ&A and Bloomberg L.P., for 1970 through 2016
Blog header image: Roberto Caucino/Shutterstock.com
Capital expenditures (capex) are funds used by a company to acquire or upgrade physical assets such as property, industrial buildings or equipment.
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
Businesses in the energy sector may be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply and demand for energy resources. Short-term volatility in energy prices may cause share price fluctuations.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The products listed are subject to certain other risks. Please see the current prospectus or offering document for more information regarding the risks associated with an investment in the fund.
The holdings listed are for educational purposes only and are not buy or sell recommendations.
The Energy Select Sector SPDR ETF (NYSE:XLE) was trading at $63.51 per share on Friday morning, up $0.54 (+0.86%). Year-to-date, XLE has declined -14.59%, versus a 11.95% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of Invesco.