Despite Cheap Oil, Energy Sector Provides Opportunities

The energy sector has been dominating the headlines due to the dramatic drop in the price of crude oil in the later months of 2014, as global supply currently is exceeding demand. As is often the case in the short term, the market did not necessarily decipher quality, and stocks across the energy value chain were affected. As of February, the energy sector is the cheapest sector in the S&P 500.

While the recent volatility within the energy space has been challenging, we believe the current market provides opportunity for long-term investors across the energy value chain. Three ways to play the energy sector in the current oil price environment include:

Upstream: high-quality oil and natural gas producers;
Midstream: energy infrastructure pipeline operators; and
Downstream: refiners and petrochemical companies.

High-quality oil and natural gas producers
Prices notwithstanding, North American crude oil production is expected to grow in 2015, averaging an estimated 9.3 MMbbl/d. However, the pace of that production likely will change. Many oil and gas producers have trimmed their capital expenditure plans for 2015, with the majority planning year-over-year capital expenditure cuts ranging between 20-50 percent, even as they have indicated they still expect production growth year over year resulting from the carryover of aggressive 2014 drilling programs.
We expect drilling activity will be focused on the lower-cost oil basins, such as the Eagle Ford shale and the Permian Basin, where producers likely will focus on the core areas. In the current environment, we believe oil prices should remain high enough to support production in these key basins. Oil producers with low-cost drilling locations, strong balance sheets and experienced management teams are likely to perform better against their peers in the current environment.

Natural gas production also has remained robust, in 2014 setting the highest monthly production average on record, and is expected to grow by an estimated annual rate of 3.1 percent in 2015. The Marcellus is becoming the predominant U.S. basin in this low-price environment. Natural gas producers with core acreage there should continue to benefit as the Marcellus shale continues to increase its market share of total U.S. natural gas production.

Energy infrastructure pipeline operators
Energy infrastructure companies, specifically pipeline operators, typically are good investment opportunities in volatile commodity price environments. These midstream companies are attractive to investors because they typically provide current income plus growth to the investor. They generally earn a fee to transport oil and natural gas from the producer to the end user. Therefore, their cash flows tend to be less volatile, as they are not directly tied to an underlying commodity price. Should low oil prices persist, volumes may eventually decrease, which could affect crude oil pipelines. However, refined products pipelines stand to benefit from lower prices, due to increased consumer demand driven by lower prices at the pump. The new sources of crude oil and natural gas in the U.S. have created opportunities for energy infrastructure companies to build additional pipelines to transport rising volumes. Despite lower oil prices, the project backlog continues to be robust, with an estimated approximate $135 billion in projects through 2017. The visible growth from these projects underway provides clarity to cash flows and potential in 2015 and 2016. We believe new natural gas projects will continue at a fairly constant pace, but new crude oil-related projects will continue at a slower clip if prices remain low.

Refiners and petrochemical companies
The crude oil and natural gas production outlined earlier has benefited some companies within the downstream, and for some, lower commodity prices can be beneficial. Petrochemical companies should benefit from low-cost feedstocks and the ability to export, as demand for their consumer products increases as a result of growing gross domestic product. Low oil prices often spur economic growth around the world. In addition, refiners should benefit from increasing refined product (gasoline and diesel) demand. Data from the Energy Information Administration suggest demand for gasoline and diesel was higher in January of this year compared to the same period last year. As we move into the traditional summer driving season, we expect demand to continue to grow for U.S. producers of gasoline and diesel, which should boost U.S. refiners.

Despite recent volatility, North America remains a major, relevant, global energy player, enabling the U.S. to better control its national security, with significant production potential for generations to come. The overarching reality is that although currently there is a global oil supply/demand imbalance, the laws of economics ultimately should prevail. Lower prices may discourage short-term production growth but may also spur demand. We anticipate this will drive prices in the other direction, and the cycle will continue. We think that over the long term, prices will return to a range that is economical for production to continue broadly.