Deep Earth Publishing Newsletter, March 31st

By Martin Tillier

Picking the Best and Worst of Breed in A Depressed Energy Market

As I write, markets are experiencing unprecedented levels of volatility. Still, the criteria for picking stocks in volatile markets is the same whether daily movements in the Dow are being measured in the hundreds of points or the thousands. One of the things to consider is that outperformance on further declines is as important as outperformance in a recovery. So, with stocks flying around on a daily basis, investors should be asking themselves not just what to buy, but also what to avoid.

After a decade of underperformance and with some companies already struggling before the coronavirus pandemic, that is especially true when it comes to energy.

So, what should you be looking to pick up at bargain prices, and what should you avoid?

The Two Ds

During periods of extreme volatility, you can pretty much ignore technical analysis when it comes to predicting the next move. Charts can be useful for setting levels to stop out, and maybe for finding approximate entry points, but when it comes to deciding what to buy, they are no use at all. That all depends on fundamentals, the actual performance of companies and the strength of their balance sheet, for example.

Right now in the energy sector, the most important fundamental factors are the “two Ds” … Debt and Dividends.

The Exaggerated Importance of Debt in Energy…

Whenever there is a sudden shock to the markets and the economy, debt matters. In times of growth, servicing even a big debt load is not too much of a problem as interest payments represent a declining percentage of revenue. When growth halts, or even reverses, that changes very quickly.

For most companies, even in that situation, refinancing and restructuring are possible in an era of ultra-low interest rates. That makes debt more manageable generally than it has been in past economic shocks and recessions, but that doesn’t apply to heavily indebted energy companies.

They have a unique additional problem.

Their debt is secured by their assets, which are almost exclusively oil and gas reserves. Those assets are worth a lot less now than they were a short time ago, so the ability of those companies to refinance is severely limited. That makes the risk for highly leveraged energy companies not just about reduced profits. There is a very real risk of bankruptcy in some cases.

Debt ratios matter more than ever when looking for energy stocks to avoid on a big market drop.

…And of Dividends

Just as debt has exaggerated impact on the negative side of the equation following or during a collapse, so dividends are more important on the positive side.

Energy stocks traditionally owe part of their appeal to dividends that represent a decent yield for income seekers. The in-vogue monetary response to threats to economic stability, cutting even already low interest rates, makes the yield offered by some energy stocks even more attractive.

The events of 2008-9 and the response of the monetary and fiscal authorities to them have been studied and written about extensively in the ensuing decade, and there is a general consensus that that crisis was so deep in part because the responses were slower and less drastic than they needed to be.

That is why, once it became clear how disruptive the efforts to contain the coronavirus would be to the economy, the Fed didn’t hesitate to cut short-term interest rates to zero. The merits of that reaction are up for debate, but one thing is for certain…it made yield an even scarcer commodity than it was before.

There will always be those that need income from their investments, but most of us tend to think of that only in terms of individuals. We shouldn’t forget, however, that some big pension and insurance funds are also required to produce income from a portion of their portfolios and if they start buying, they can really move the market.

Percentage yields in the mid to upper teens, such as those offered by some European multinational integrated energy firms as oil and the stock market collapsed in early March, can justify a lot of risk. A good yield in a bearish market isn’t just about future payments, it also limits the downside somewhat and increases the chance of outperformance, even if stocks in general continue to head lower.

What to Buy and What to Avoid

The importance of the two Ds makes for a pretty clear picture of which energy stocks can be considered “best in breed” in a depressed market. Picks should have a strong balance sheet and cash position, manageable debt levels, and should, with some adjustments to outgoings, be able to maintain their dividend.

That, in turn, suggests that during turbulence, the big, diversified multinational oil companies such as Exxon Mobil (XOM), Chevron (CVX), Royal Dutch Shell (RDS.A), BP (BP) or Total (TOT) are your best bet. Those companies have the additional advantage of having refining operations, whose margins increase in times of falling oil prices. Total revenue will obviously still fall, but that can help to maintain cash flow.

Of those mentioned, I prefer CVX among the U.S. domestics, as they went into the downturn a bit less stretched than XOM, and RDS.A, who quickly took steps to protect a dividend that at the low point for the stock reached over sixteen percent, among the overseas based firms.

In general, I would avoid smaller E&P stocks in times of distress. Many of them operate at a high rate of leverage, which is great during the good times but can come back to haunt them when things get tough. If, however, the potential for big returns on a bounce back determined to take the risk of owning something in that space, there are a couple of other things to consider.

Give preference to companies that maintained positive free cash flow in the early stages of a drop, so take an Apache (APA), with positive free cash flow of over $1 billion, over an Occidental (OXY), with negative $1.12 billion, for example.

Things to avoid completely are companies who had liquidity issues going in. As massive as the potential gains are should something like Chesapeake Energy (CHK) survive, the downside to that trade is a total loss should they declare bankruptcy, something which as I write in late March of 2020 looks distinctly possible.

Risking everything in a trade goes against everything I was ever taught about position management, and if it is a risk that professional risk-takers are wary of, it shouldn’t even be considered by independent traders and investors.

Conclusions

Big market declines are times of big opportunity, but that doesn’t mean that buying indiscriminately at such times is a good idea. Buying into volatility is inherently a high risk/high reward strategy, so your decisions as to what to buy should be about minimizing the single-stock risk in that context. That means big, reliable firms that have the resources and experience to survive the down times should be a priority.

Chevron, for example grew out of Standard Oil, that was founded in 1879, and Royal Dutch Shell began operations in 1907. These companies have survived and thrived through two world wars, the great depression in the 1930s, the oil shocks of the 70s and 80s, the tech wreck of 2000-2001 and the great recession in 2008/9.

It could be that a virus will be the thing that ultimately brings them down, but I wouldn’t bet on it.

On the other side of the coin, companies that were having problems before this drop may offer a lot of upside but buying them means adding to an already high level of risk. There can be short-term trading opportunities in stocks like CHK and OXY, but they aren’t things to buy for the long-term when energy stocks in general are available at a discount.

CVX and RDS.A may not be sexy or exciting picks, but there is enough excitement around at the moment without adding to it, and in an environment of ultra-low bond yields, double-digit dividend yields look pretty sexy to me!

Cheers,

M

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