Despite Oil Plunge, Energy Stocks Still Above August Lows

Last week was a tough one for the stock market, the worst since the August mini-meltdown.  Most major averages fell more than 3.5%.  The S&P 500 was down 3.8%.  The NASDAQ Composite dropped 4.1%.  The Russell 2000 lost 5.1%.

S&P 500, Dec. 11, 2015

Friday’s plunge took the S&P 500 to an intraday low of 2008.80, worse than its Nov. 16 intraday low of 2019.39.  This potentially sets up a new pattern of lower lows and lower highs that is characteristic of a downtrend.  The recent stepped up volatility and drop below the 50-day moving average suggest that caution is in order.

This week’s market drop was sparked allegedly by pessimism about the outlook for energy prices.  The price of oil plunged after OPEC decided to stick to its strategy of maintaining market share and not make any production cuts.  This, combined with warm winter weather to date in the northern hemisphere, has raised fears of a worsening supply glut.

WTI Crude Oil, Dec. 11, 2015

The decline in commodity prices generally and oil in particular has raised fears about a slowdown in the global economy.  The decline in commodity prices can be attributed in part to China, which is transitioning its economy away from exports and infrastructure spending and toward consumer-driven growth.  In addition, the price of oil is being pressured on the supply side by the return of Libya, Iraq and soon Iran to the world oil markets.  Futures markets currently anticipate that the price of a barrel of West Texas Intermediate crude oil will remain below $45 through 2016 and not move back above $50 until April 2018.

Besides the negative impact of falling oil and natural gas production on industrial production and GDP, the low prices are raising concerns about the financial viability of independent oil producers.  Oil & gas energy junk bond issues represent about 12% of the overall high yield market.  Year-to-date, these bonds have delivered a negative return of about 19%.  By comparison, the overall junk bond market is down just under 5%.  Meanwhile, the DJ US Exploration & Production Index, which consists entirely of the common stocks of independent producers, is down 23%; while the DJ US Total (Equity) Market Index is down about 3%.  Despite concerns this week about the suspension of distributions from the Third Avenue Focused Credit Fund, the performance of the high yield market appears to be very much in line with that of the equity market, including the energy sector.

Yet, this week’s performance of the oil & gas sector was not all that bad, given the plunge in the price of oil.  While WTIC crude set a new 6-year low, most oil & gas equities held above their late August lows, as shown in the chart of the Dow Jones US Exploration & Production Index ($DJUSOS) below:

Dow Jones US Exploration & Production Index, Energy Stocks

While the plunge in $DJUSOS over the past couple of weeks may be disheartening to investors who had bet that the sector had already completed a successful retest of its recent lows in September, there is still hope that a bottom has been put in, as long as the Index holds above that late August low of 587.68.  The same is true of the DJ US Integrated Oil & Gas Index ($DJUSOL) and the DJ US Oil & Equipment Services Index ($DJUSOI), but not the DJ US Pipelines Index ($DJUSPL), which has fallen to new lows following Kinder Morgan’s 75% dividend cut.

At Friday’s closing low of 600.63, $DJUSOS is only 2.2% above that late August low, so investors cannot be complacent.  Oil & gas stocks may still reach new lows if the market sell-off continues.  The upcoming week will likely be key for the sector.

S&P 500 Sector Performance (1 wk) Dec. 11, 2015

This week’s broad market sell-off was not especially unusual.  So-called “risk-on” sectors, like energy, financials, materials and technology, led the market lower; while the “risk-off” sectors, like utilities, consumer staples, health care and telecom services, held up best.  The recent step up in volatility is a concern, but we have seen similar volatility throughout the year.  So far, the market has bounced back each time.  Given the push by central bankers around the globe to keep their economies afloat through quantitative easing, the market’s bias will probably remain to the upside, unless and until the economic and geopolitical backdrop changes markedly for the worse for an extended period of time.

Against this backdrop, those investors willing to consider the oil & gas sector should focus on those companies with stronger balance sheets capable of riding through the storm.  Recently, the market has favored integrated producers for that very reason (and also their resolve to continue paying dividends).

Below investment grade-rated energy companies have greater upside potential, but only if oil prices do not remain at these low levels (or lower) for more than a year or perhaps two.  Oil & gas high yield bonds currently offer average yields above 14% and spreads over comparable maturity Treasurys of nearly 1300 basis points.  From a risk-reward perspective, relative to other high yield bonds, the sector looks very attractive, even though these bonds have not yet shown any clear signs of bottoming.

December 13, 2015

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, NJ  07036
(908) 448-2246

Charts courtesy of

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