With the slump in oil prices since the second half of 2014, several industries related to the energy sector have witnessed challenging times. In 2015, oil bottomed out at $45 per barrel in January 2015 and trended higher to $65 per barrel on the Brent over the next few months. The rally provided some relief to offshore drilling companies.
However, oil has again trended lower to $56 per barrel and this has translated into renewed pain for the broad industry. In this article, I will discuss the reasons to be bearish on oil in the near-term. Further, I will discuss the likely trend for offshore drillers and the good stocks to accumulate.
There are two important reasons to believe that oil will remain sideways to lower in the near-term. While I am still bullish on oil for the long-term, these reasons make me cautious in the near-term.
The first reason can be best explained from the chart below that gives the world production and world consumption outlook as of June 2015.
It is clear from the chart that global production growth is meaningfully higher than global consumption and there has been a significant change in forecast as compared to March 2015. The increase in production by OPEC has been the primary reason for increased oil glut globally, and relatively sluggish economic growth is also not helping oil prices.
Considering this production and consumption gap, I expect oil prices to remain sideways in the foreseeable future. This gap might close in the coming quarters as production growth flattens out on sustained lower oil price.
However, the second factor might offset the decline or flattening out in production growth. The deal with Iran has been reached and Iran can flood the market with more out in the next 6-12 months. This can be another trigger for oil prices trending lower or sideways.
In my view, Iran will gradually increase production, but there can be a case of conflict within the OPEC as Iran tries to increase its lost market share. In any case, oil supply will remain abundant and prices can move sideways.
With these two important points in consideration, I believe that investors need to be cautious on exposure to the energy industry in the near-term. However, gradual exposure can be considered for the long-term in oil and gas stock and offshore drilling companies.
Among offshore drilling companies, I like Atwood Oceanics (ATW, Financial) for the following reasons –
- First, the company has a modern fleet of rigs that have high contract coverage for 2015 and decent contract coverage for 2016, providing continued cash flow visibility.
- Second, the company has two rigs for delivery in 2016 and 2017. Financing these rigs can be done from internal cash flows and an available $500 million credit facility.
- Third, the company has among the best net income margin in the industry due to a modern fleet and the company also has a sustainable dividend of $1 per share.
With a healthy balance sheet as compared to peers such as Seadrill (SDRL, Financial) and Transocean (RIG), I believe that Atwood Oceanics is worth accumulating gradually on every decline. However, the investment horizon needs to be for 3-5 years for robust returns.
It is important to mention here that offshore drillers like Seadrill and Atwood have already stated in their recent conference call that an industry recovery is unlikely before 2017. Considering this point, I will avoid Seadrill because the company still has a strong pipeline of new rig deliveries and that is likely to increase the company’s leverage further. In particular, if industry conditions remain weak for the remainder of 2015 and 2016, day rates will slump and the company’s operating cash flow will decline meaningfully as compared to FY14 and the first quarter of FY15.
From a long-term investment perspective, I like the Vanguard Energy ETF (VDE, Financial) considering the fact that the ETF provides diversified exposure to the energy sector.
As of June 2015, the ETF had 36% exposure to integrated oil & gas companies, 26.9% exposure to oil & gas exploration & production, 15.9% exposure to oil & gas equipment service, 10.5% exposure to oil & gas storage & transportation and 8.4% exposure to oil & gas refining & marketing. With a SEC yield of 2.76%, the ETF is worth considering for the long-term and I would advice gradual accumulation for the next 3-6 months.
In conclusion, energy prices might have more negative surprise in store. However, I see this more as a long-term value buying opportunity and when global economic growth ticks higher (especially emerging Asia), energy prices will surge.
