The Bull Market in Energy Remains Intact

By  OCT 30, 2012 3:15 PM

Prices will likely to be all over the map in coming months, however, particularly as investors worry about a crash.


Oil prices have remained stable despite Hurricane Sandy. But the price of black gold on the New York Mercantile Exchange is still down roughly 15% in a little more than a month–and even further below where it began the year.

The price of oil is critical for energy producers. We’ve already seen considerable weakness this autumn in stocks that pay dividends tied to oil prices, and we could well see more in the coming weeks.

Royalty trusts such as the relatively new SandRidge Mississippian Trust (NYSE:SDT) pay distributions that are tied to the price of energy commodities produced from their land. Consequently, price and yield will fluctuate depending on the price of energy.

Since its April 2011 initial public offering (IPO), SandRidge’s first five distributions were: $1.07, $0.82, $0.79, $0.79, and $0.73, with the latest paid to unitholders of record on Aug. 14. These distributions are consistent with the price volatility of the oil and gas it produces.

Judging from the performance of SandRidge’s units since its IPO, however, at least some investors haven’t fully understood the variability of distributions. Units of the trust were first issued at $21, then shot up to $25 in a matter of days, and eventually hit $30 in early August 2011.

Two months later, the unit price slipped to a low of $18.76 amid market anxiety over the Debt Ceiling Crisis. It then nearly doubled to a high of $36.97 on Feb. 8, 2012, before beginning a jagged decline to its current price of less than $20, some 5% below the IPO price–action that deviated sharply from the actual movement in energy prices and by extension the distribution.

Similar misunderstanding seems to influence the trading of other royalty trusts, including SandRidge’s sister entity SandRidge Mississippian Trust II (NYSE: SDR). Since its IPO in April 2012, SDR has traded as high as $23.91 a couple weeks after issuance to as low as $17.37 in late June. And it now trades about 5% below its IPO price. That’s despite the fact that the only distribution action by the company was an 84.1% increase in late July.

Many investors in master limited partnerships (MLP) that produce energy seem to have belatedly realized that their holdings are indeed affected by energy prices. Nevertheless, the actual trading in these securities remains largely devoid of rhyme or reason.

For example, the price of relatively new MLP Mid-Con Energy Partners (NSDQ:MCEP) has been all over the map this year, and is actually only barely above its secondary offering price despite announcing a 2.1% distribution increase this month. By contrast, Vanguard Natural Resources (NYSE:VNR)–which now pays a monthly dividend–has been steadily moving higher since late May and is back within shouting distance of its all-time high.

The same incongruence can be found among the former Canadian trusts that produce energy. ARC Resources (TSE:ARX), for example, has been steadier than many pipeline stocks this year, despite wild fluctuations in prices for oil, natural gas liquids and natural gas (66% of output). So has Peyto Exploration and Development (TSE:PEY), which is again within reach of its all-time high despite the ups and downs of natural gas, which accounts for more than 90% of its output.

By contrast, fellow ex-trust Penn West Petroleum (NYSE:PWE) shares have dropped more than 34% this year. That’s despite the fact that management is executing strategy at the oil-focused producer better than it has in many years.

Even super oils have had wildly divergent years. ExxonMobil (NYSE:XOM) is a couple of good trading days from taking out the all-time high set in mid-2008, when oil prices were roughly 80% higher and natural gas was several times its current level.

Meanwhile, Total SA (NYSE:TOT) is actually underwater for the year and sells for little more than half its 2008 high. Management boosted its divided by 3.5% in July, and the stock now yields more than 6% , which is more than twice the yield of ExxonMobil. Although there might be fundamental reasons why some energy stocks outperform others, none of the obvious ones in these cases have anything to do with what should ultimately drive their value: the ability to increase production and reserves.

Rather, prices seem to be dictated by perceptions based on emotion. Selling has begotten more selling, which has sent some stocks tumbling. And buying has triggered more buying, which has pushed other stocks higher regardless of the strength of the underlying business.

That’s what I call the triumph of momentum over value. The resulting distortions never last long. But they can create havoc and cause those who get caught up in them to make very bad investment decisions.

The current weakness in energy prices is mainly driven by worries about global economic growth, and specifically concern that demand in China will continue dropping in the coming months. Additionally, the US energy rig count has dropped to its lowest level in 18 months after declining five months in a row, as US oil production has hit a 17-year high on productivity gains and inventories have surged. 

Some have gone so far as to proclaim the end of the bull market for energy that began in 1998, when oil traded under $10 a barrel and natural gas sold for less than $1 per million British thermal units (MMBtu). Forgotten is the fact that should oil fall below $50, the unconventional production responsible for current output levels would no longer be economic and would, therefore, be virtually shut down. That’s what happened to natural gas, whose prolonged retreat below $5 per MMBtu has caused producers to suspend new drilling for that fuel.

Finally, US demand–largely counted out since the 2008-09 Great Recession–has been recovering in recent quarters. And if today’s report of surprisingly strong growth in gross domestic product (GDP) signifies a trend, it could start surprising a lot of people very quickly.

The bottom line is energy prices are likely to be all over the map in the coming months, particularly as investors continue to worry about a reprise of the 2008 crash. But at its core, oil is still well, and so are stocks of solid producers, be they MLP, trust, super oil or former Canadian trust.

In fact, these stocks remain an essential part of any income-oriented portfolio. The best energy companies are not just growing enterprises that are boosting dividends and shareholder value over time. They also offer the best possible hedge against any resurgence of inflation, since energy would be a core component of any future inflation.

The key to successfully investing in dividend-paying energy stocks is to follow the value. As long as a company is increasing reserves and output consistently over time, any setback is a buying opportunity.

This article by Roger Conrad was originally published on Investing Daily.

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