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Low oil prices & volatile stock markets: 10 things every energy investor needs to know

Low oil prices & volatile stock markets: 10 things every energy investor needs to know

2015 was undeniably a dismal year for energy investors. After "bottoming" in January, oil prices broke down again in March, then hit a 6 year low in August before finally declining to a lower low in mid-December. Although it's tempting for investors to "dip their toes" back into the energy sector, there are still lots of warning signs on the horizon. For those brave enough to pick up beaten down oil stocks, here are 10 important market correlations that all investors should be aware of.


Commodity prices are cyclical and correlated to the US dollar.

At the risk of sounding like a broken record, anyone invested in commodities should closely watch the US dollar. That's because all commodities are denominated in US dollars - therefore, as the dollar rises, commodity prices fall. Although the US dollar has climbed significantly this year, the greenback has stalled out for much of 2015, hovering between 94 and just below 100 on the US Dollar Index scale. And that has arrested the fall in commodity prices for the most part. But the dollar can't sit just below 100 forever. It will break out eventually (either up or down). If the US dollar breaks down, expect a bounce in all commodity prices. But if the dollar sharply jumps to the upside, commodities could take another huge leg down, and it could be really painful this time (think late 2008 or late 2014). So while you're trying to guess where oil prices are going, be sure to keep one eye on the US dollar.

 
WTI SPOT PRICE (BLACK) VERSUS US DOLLAR INDEX (GREEN) CHART COURTESY WWW.STOCKCHARTS.COM

WTI SPOT PRICE (BLACK) VERSUS US DOLLAR INDEX (GREEN)
CHART COURTESY WWW.STOCKCHARTS.COM

 

Plunging commodity prices are bad - not good - for the world's economies and usually warn of a global economic slowdown.

Contrary to popular belief, falling commodities are usually caused by weak demand, not oversupply. But wait, what about all those reports about record oil production out of the US, Russia and Saudi Arabia? True, oversupply doesn't help. But the oil markets were oversupplied long before oil prices came crashing down. Too much supply was forgivable 4 years ago, because we thought we had very strong demand from China, and we figured they'd all be driving SUVs by the end of this decade. But that didn't happen (thankfully!) and China's demand for many commodities has considerably weakened since 2008. That's bad for all commodities - including copper, gold, iron ore, steel, zinc, aluminum, gold, silver . . . even corn and soybeans, which have all been hitting multi-year lows. Falling commodity prices warn of weak global demand, and that's never a good thing. So the next time a newscaster tells you that cheap gas should help stimulate the world's economies, don't believe it.

 
2014 WORLD OIL CONSUMPTION PER CAPITA GRAPHIC COURTESY BP

2014 WORLD OIL CONSUMPTION PER CAPITA
GRAPHIC COURTESY BP

 

Prices tend to overshoot on the way up and overshoot on the way down.

Remember $140 oil? I hope you enjoyed it because $25 oil might be the payback. There was no reason for $140 oil, and there's no logic behind $20 oil. Don't try to rationalize it. Just accept it. Sub-$30 oil might just be the golden opportunity you've been waiting for to plow back into energy stocks.


We're a lot closer to the bottom than we are to the top.

In hindsight, you should have dumped all your fossil fuel stocks along with the Rockefeller's in late 2014 (they're billionaires for a good reason). But if you missed the boat, resist the temptation to dump all your oil stocks today. If you made it all the way here and wiped out half your portfolio in the process, you might as well ride it out to the bitter end. Market bottoms happen when everyone throws in the towel and gives up hope. We may not be there yet but we're getting pretty darned close.

THE $860 MILLION ROCKEFELLER BROTHERS FUND MANAGERS, HEIRS TO THE STANDARD OIL FORTUNE, DIVESTED THEIR FOSSIL FUEL HOLDINGS IN LATE 2014, CITING BOTH "MORAL AND ECONOMIC" REASONS.

PICTURED: STEPHEN HEINTZ, LEFT, WITH VALERIE AND STEVEN ROCKEFELLER. PHOTO COURTESY THE NY TIMES.


Beware of oil producers carrying US denominated debt.

Any Canadian oil producer who issued debt in US funds is in deep doo-doo right now. There's a good chance the Loonie will breaks below 70¢ in the first half of 2016. Rising US interest rates and ballooning federal deficits will adversely affect the Canadian dollar. Canadian oil companies holding US denominated debt will see their debt rise as the Canadian dollar falls, regardless of whether their facilities are cash flow positive. And it's not just Canadian oil companies. Just ask Brazil's Petrobras who owe over $100 billion in US denominated debt - an estimated $24 billion due over the next 24 months. Good luck with those payments!


Dividends in the energy patch are not sacred, unless you've got lots of cash in the bank.

Dividend-paying energy and pipeline stocks are tempting, with many large cap names paying out almost 10% annually. However, keep in mind that oil companies never traditionally paid a dividend in the old days. The energy sector is incredibly capital intensive. All available free cash flow was normally reinvested back into the business in order for the company to grow and survive. But that all changed a few years ago. Thanks to low interest rates, investors poured billions into dividend-paying stocks as an alternative to bonds and GICs. And energy companies joined the party, offering lucrative dividends as an incentive to buy their stock.

But dividends are certainly not sacred in the energy patch. They cut into the company's cash flow and few are willing to borrow to pay a dividend over the long haul. Unless you're Exxon, BP or Shell (with lots of cash in the bank), dividends will be slashed next year if low oil prices persist. So don't buy a stock just for its appealing dividend.


Mergers happen at the end of a commodity downturn, not the beginning.

Some have been asking why so few mergers have happened so far, with exception of Shell's takeover of BG Group and Suncor's takeover attempt of Canadian Oil Sands (which is really small peanuts in the grand scheme of things). There are 3 reasons why there haven't been many mergers yet:

  1. Interest rates are so low that companies are having little trouble paying their debt. Even companies with poor credit ratings have managed to borrow at low interest rates. That means they can still make their loan payments and are not desperate to sell out just yet.
  2. A lot of small companies were required to hedge their production in order to secure loans, locking in 2014 oil prices on forward sales. That has been helping smaller producers, particularly in the US, stay in the green and keep pumping oil through 2015. As those hedges come off in 2016, expect cash flow to plummet. The better players will get taken over. The less attractive ones will likely declare bankruptcies. And that will hopefully take some oil production offline, which would certainly help prevent oil prices from falling too much further.
  3. Mergers happen after several years of low commodities prices, when producers have already cut costs, de-staffed employees and sold any assets not bolted down to the floor. We're not there yet, and we may not be there for a few more years.
 
A BRIEF HISTORY OF MEGA-MERGERS IN THE ENERGY PATCH AFTER THE COLLAPSE OF OIL PRICES IN 1986

A BRIEF HISTORY OF MEGA-MERGERS IN THE ENERGY PATCH AFTER THE COLLAPSE OF OIL PRICES IN 1986

 

Know the difference between "Risk On" and "Risk Off" markets.

When oil prices first began falling in late 2014, the overall markets didn't really care (outside of energy stocks, of course). It's called the "Risk On" trade, with money flowing into almost all sectors, the hallmark of strong bull market. But that all changed in 2015. In the latter half of the year, falling energy prices began to drag down the whole market, in what's known as the "Risk Off" trade, when investors flee to safer assets such as treasuries and currencies. Since 2008, global stock markets have been highly correlated to energy prices. So it's very unlikely that markets can recover when oil prices are still trying to find a bottom. We need to find a solid floor in commodity prices before the overall stock market can power to new highs. 


Know the difference between "High Beta" and "Low Beta" energy stocks.

High beta energy stocks are the most leveraged to oil prices. Think Canadian Natural Resources, Baytex, Cenovus, Canadian Oil Sands and the countless small energy service providers. When oil prices go up, these stocks stand to benefit the most. Beaten down high-beta stocks can pop 20% in one day when oil prices catch a bounce. But if oil prices continue to go down, holders of high beta stocks will get decimated. For those investing for the long haul, low beta stocks are a safer bet, such as ExxonMobil, BP and Shell. These companies are humongous and well diversified across the energy landscape. They likely won't fall as badly when oil prices go down, but also won't climb as fast when prices recover. Low beta stocks are not good for that "quick flip" trade, but a worthwhile investment if you've got a 10+ year horizon.


Watch the banking stocks. They'll tell you how the oil producers are really doing.

Saggy energy prices have actually dragged down banking stocks, particularly in Canada. That's because banks made a lot of money lending cash to the energy sector and the millions of people that benefited from lofty oil prices. But this stream of revenue is shrinking, and not just in Alberta. Alberta's riches have buoyed every corner of Canada and indirectly benefited many other industries, far beyond those houses in Kelowna, Air Canada flights to the Maritimes and the brand new F150s sold from the dealers' lots. Those banks who think they're not exposed to falling oil prices are deluding themselves. Banking sector performance is reflective of the overall economy. And they will suffer just as Canada suffers. So if you're wondering how Alberta's energy sector is doing, don't forget to keep an eye on the banking stocks. It's very likely they will bottom when oil prices finally find a floor. And that would be a great time to add some Canadian banking stocks to your investment portfolio.

 
CANADIAN ENERGY VERSUS FINANCIAL INDEX CHART COURTESY WWW.STOCKCHARTS.COM

CANADIAN ENERGY VERSUS FINANCIAL INDEX
CHART COURTESY WWW.STOCKCHARTS.COM

 

Happy trading!

Enbridge's Line 7 gets hit by protestors again

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How much for that heavy oil?

How much for that heavy oil?

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