By Dan Strumpf
The sharp fall in oil prices has wreaked havoc on shares of
energy companies, leaving investors to decide whether now is the
time to go bargain hunting.
U.S. crude prices have fallen by more than half since June,
trading at a six-year low of around $45 a barrel. For motorists
filling up their tanks with sub-$2 gasoline, that has been a cause
for celebration. But for investors in the energy sector, it has
been a calamity.
The S&P 500 Energy index, comprising the industry's largest
companies, lost more than a fifth of its value over the six months
through Thursday, the biggest decline of any of the 10 major
sectors, according to FactSet. The broader S&P 500, by
contrast, rose 4%.
The pain has been worse for shares of smaller producers, many of
which took on loads of debt to finance new drilling. A barometer of
small energy companies, the S&P SmallCap 600 Energy index, has
swooned 47% in the past six months.
Experts warn that the wild swings in energy stocks could
continue for some time. While blue-chip names like Exxon Mobil have
offered energy investors some insulation from volatile oil prices,
producers and service companies are more vulnerable to the
tumult--but have more to gain should oil prices stage a
rebound.
Investors essentially have two ways to play the energy market:
for stability and income, assuming the oil price stays at current
levels or even dips more, and for growth, assuming a price rebound
will come sooner rather than later.
Here's what you need to know.
Income and Stability
Investors thinking about getting into the sector should have a
stomach for volatility and an eye for the long run.
Experts agree that oil prices will rise out of their doldrums
eventually, but how long until a rebound takes place is a matter of
fierce debate. This month, analysts at Bank of America said they
expect U.S. oil prices to fall to $32 a barrel by the end of March
before climbing to $57 by the end of the year.
"You can't look at the sector and think you're going to be lucky
enough to time the bottom," says Russ Koesterich, chief investment
strategist at BlackRock, which manages $4.65 trillion. "You have to
be thinking about it for the longer term, realizing you may see the
stocks down 10% or 15% before they bottom."
The upheaval has sent many pros seeking shelter in integrated
oil companies--blue-chip energy firms that control the wells that
draw crude from the ground and the refineries that turn it into
fuel. They owe their stability to their diverse business mix and
rock-solid balance sheets.
Oil production is likely to keep growing, despite the decline in
prices, thanks to advances such as hydraulic fracturing, or
fracking. Earlier this month, the International Energy Agency said
it expects nearly one million barrels a day of extra oil to be
pumped around the world in 2015. Global economic growth, meanwhile,
remains sluggish, damping growth in demand.
Shares of Exxon Mobil are down just 10% in the past six months.
Fellow Dow Jones Industrial Average component Chevron is off
18%--no picnic, but better than many rivals.
"They are less of a pure play on oil," Mr. Koesterich says.
"Relative to the rest of the sector, the correlation between the
integrated [companies] and the oil price is much less."
Steady dividends are an added benefit. The oil industry has seen
downturns in the past, but neither Exxon nor Chevron, for example,
has cut its dividend in decades. In a cash pinch, both would have
plenty of room to curb share buybacks first, says Lysle Brinker,
director of equity research at consultancy IHS Energy.
The dividend is "the only reason, for some investors, why they
own these stocks," Mr. Brinker says.
Investors with an appetite for energy stocks, but not for
stock-picking, have plenty of options among exchange-traded funds
and actively managed mutual funds.
The biggest energy-focused ETF is the $11 billion Energy Select
Sector SPDR Fund, which tracks energy companies in the S&P 500.
The fund charges annual fees of 0.16%, or $16 per $10,000
invested.
Among mutual funds, the $10.1 billion Vanguard Energy Fund has
weathered the downturn in oil prices better than its competitors,
according to investment researcher Morningstar.
It has lost 25% in the past six months, compared with a 29% drop
among all energy funds. The fund charges annual fees of 0.38%.
The Vanguard fund's relatively heavy tilt toward integrated
energy companies and its lighter weighting of more beaten-down
corners of the sector has helped its performance, Morningstar
analyst Kevin McDevitt says.
"You're getting the commodity exposure, you're getting the
energy exposure, but you're not getting all the volatility that
comes with it," he says.
Another option: the $3.6 billion T. Rowe Price New Era Fund,
which invests in the energy industry as well as miners and other
resource producers. It weathered the crude downturn by boosting its
holdings of integrated oil companies beginning last summer, Mr.
McDevitt says.
Over the past six months, the fund has lost 19%, compared with a
22% slide for the broader category of natural-resources funds. It
charges an annual fee of 0.66%.
Master Limited Partnerships
Another popular energy bet for income-hungry investors has been
master limited partnerships, the pipeline and storage firms that
earn their keep transporting and storing oil and natural gas.
MLPs pay most of their earnings to shareholders, a draw for
income-starved buyers. And since they focus on storing and moving
products, MLPs are seen as more insulated from turbulent
prices.
The Alerian MLP index, a barometer of the industry, yields
6.16%, compared with less than 2% on 10-year government debt. But
the index has lost 14% of its value over the past six months,
making MLPs far from immune to oil's tumble.
"A lot of people have gone out and said [MLPs] are uncorrelated
to oil prices, but that's simply not true," says Richard Bernstein,
head of the $3.4 billion firm Richard Bernstein Advisors in New
York.
As long as U.S. energy demand holds up, oil will continue to
flow through the pipes and MLPs will remain a good investment, says
Simon Lack, founder of investment-advisory SL Advisors in
Westfield, N.J. Indeed, fuel demand is on the rise over the past
year, according to the Energy Information Administration.
"The biggest fear for MLP investors is demand destruction, and
we're in the complete antithesis of that," Mr. Lack says. "If
anything, lower energy prices are going to result in more demand,
not less."
But MLPs could see more pain if their oil-company customers
start demanding lower prices, Mr. Bernstein says.
Investors have an array of options when it comes to MLP funds,
including the $9.1 billion Alerian MLP ETF. Another popular option:
the $5.6 billion JPMorgan Alerian MLP Index exchange-traded note.
Both charge annual fees of 0.85%.
Investing for a Rebound
If giant oil companies and MLPs are partly insulated from oil's
tumble, they also are less likely to climb as quickly should crude
stage a big rebound, experts say.
With U.S. output still rising and the global economy in low
gear, that rally still could be a long way off.
But that doesn't mean prices will stay under $50 forever. When
and if they rebound, exploration-and-production, or E&P,
companies will likely be among the first to benefit.
To date, they have been among the hardest hit. A widely tracked
gauge of E&P stocks, the S&P 500 Oil & Gas E&P
index, has fallen 28% in the past six months.
"Nobody is making money at the $45-a-barrel level," says Norman
MacDonald, portfolio manager of the $991 million Invesco Energy
Fund.
But that means supply has to decline and prices will rebound
eventually. "It's a very self-correcting mechanism," he says.
The cost of producing oil varies widely from place to place,
even in North America, where wells are newer and production costs
typically higher. Among Mr. MacDonald's biggest holdings are Devon
Energy, Canadian Natural Resources and Ultra Petroleum. All are
producers concentrated in North America but with relatively lower
costs of production.
"If oil stays at $55, $60 a barrel, they will survive," he
says.
John Dowd, who runs the $2 billion Fidelity Select Energy
Portfolio, says he is paying closer attention to the quality of the
underlying company assets when deciding when to buy, instead of
focusing on traditional valuation metrics such as price/earnings
ratios--in large part because both prices and earnings are in such
upheaval, he says.
"You want to buy an energy stock when the outlook is dark and
dreary, and right now it's pouring," he says.
One temptation investors should avoid, experts say, is betting
on the price of oil directly, which can be done via oil futures
contracts or ETFs that invest in them, such as the $1.4 billion
United States Oil Fund, which charges annual expenses of 0.76%.
The concern: Oil-futures contracts expire monthly, requiring
investors to roll into the subsequent month's contract on a regular
basis. This process can take a big bite out of returns when the
longer-term contract is more expensive than the expiring contract,
as is the case now.
At current prices, that penalty amounts to a 12% erosion of
annual returns, according to John Gabriel, a strategist at
Morningstar.
"For an individual investor, I would never really recommend
getting involved with the commodity itself, because it's kind of
the Wild West," says David Kelly, chief global strategist at J.P.
Morgan Asset Management.
Playing the Field
An E&P-heavy bet can be played with the $1.4 billion SPDR
S&P Oil & Gas Exploration & Production ETF, which
charges an annual fee of 0.35%. Another option is the $445 million
iShares U.S. Oil & Gas Exploration & Production ETF, which
levies a 0.43% annual charge.
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When oil producers are feeling the pinch of cheaper crude, one
of the first things they do is cut their spending. That translates
to lean times for oil-field service providers such as Schlumberger,
Baker Hughes and Halliburton--the firms that lease the drills,
blast open the wells and service the equipment that makes the oil
flow.
The S&P 500 Oil & Gas Equipment & Services index has
plunged 32% over the past six months. Analysts at Barclays say
capital expenditures by energy companies are set to fall 9% this
year, the first spending drop in six years.
But like exploration-and-production firms, service companies
stand to gain from a rally in oil.
"A more aggressive investor that thinks there's going to be a
rebound would probably go with the service providers and the
equipment providers, because those guys have been hit the hardest
but stand to rebound the most," Morningstar's Mr. Gabriel says.
Mark Dawson, chief investment officer at Seattle-based Rainier
Investment Management, says he cut his holdings of energy stocks as
they rose and fell last year. Today, the percentage of investments
the $6.7 billion firm allocates to energy is in the mid- to
low-single digits, he says.
But one stock the firm has held on to is Schlumberger, because
of the service giant's global footprint and strong assets. "Any
stabilization in the energy market, this would be at the top of the
list to either add to or build back up," he says.
Fund investors can make a concentrated bet on oil services with
the $1 billion Market Vectors Oil Services ETF, which charges an
annual fee of 0.35%.
Write to Dan Strumpf at daniel.strumpf@wsj.com
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