If you tread at all into the energy sector, tread lightly

It has become the ultimate stock-pickers market

Despite its size, Royal Dutch Shell’s $70 billion acquisition of natural gas giant BG Group is far from a green light for investors to jump headlong into energy, even as some M&A experts forecast a wave of mergers in the industry.
As entry points go, energy is very much a stock-pickers market, which is not to suggest that money cannot be made investing in the category right now.
Exhibit A is the recent performance of energy sector mutual funds, as tracked by Morningstar Inc. The painful ripple effects of oil’s six-month nose dive have produced a 12-month average decline for the fund category of 16.6%, including a range from barely negative to down 45.9%.
Meanwhile, the S&P 500 is up 14.8% over the past 12 months, but just 1.4% from the start of the year.
Trying times
“Minus the last 60 days, the last 18 months have been difficult for the energy sector, and active managers in the space have been beaten down,” said Steven Wruble, chief investment officer at FolioMetrix. “Energy stocks have been like the baby and the bath water, because everybody focuses on the price of oil, and it seems like that price is still signaling that it will go lower. I think energy is one of the first areas of this market where fundamentals are starting to matter again, and the good portfolio managers are being rewarded.”
Mr. Wruble touches on a basic truth about the overall energy sector: that one has to separate the commodity from the companies doing business involving it.
Crude oil, which is now trading above $50 a barrel, has recovered from a $45 trough at the start of the year. But the price is still down almost 55% from its June 2013 peak of more than $113.
“The commodity has gotten clobbered, and with it almost all the companies in the sector,” said Edward Deicke, a financial adviser with JHS Capital Advisors.
“We think there’s value in some of those companies, and that’s what the Shell deal is about,” he added. “That deal is the tip of the iceberg, because there will be more consolidation.”
On Wednesday, Royal Dutch Shell PLC agreed to pay $70 billion in stock and cash to acquire BG Group PLC in a deal that would create the world’s largest independent natural gas producer.
For investors, in terms of gaining exposure to either future consolidation or a rebound in the price of oil, the tricky part can involve both timing and access.
“We went long on the energy service sector toward the end of last year and that turned out to be a little early and caused some pain, but that trade is starting to look better and better,” said Paul Schatz, president of Heritage Capital. “At this point, I’d say the entry point for new money is still 3% to 5% lower from here, with a potential upside of between 15% and 20%.”
Mr. Schatz, who is investing in the sector through the Rydex Energy Services Fund (RYVIX) and Market Vectors Oil Services ETF (OIH), might see the category pull back to his entry-point level as first-quarter earnings start to roll in.
Consensus estimates have earnings for the sector coming in at 63.4% below the same quarter a year ago. The sector is such a negative outlier that it’s dragging the consensus for the entire S&P down to a 3% year-over-year earnings decline.
Mr. Schatz knows he is stepping out on a limb by playing the energy market through oil services companies, but he is among those who believe the price of oil is on the upswing.
“The energy and oil services sector is the most leveraged to the price of oil,” he said. “If you think oil is going to make a move that’s the most aggressive play, but if you’re wrong it can be tough.”
While Mr. Schatz sees oil gradually climbing to the $60 a barrel range, a lot of investors are ready to take the other side of that trade, which further makes the case for just riding out energy-indexed exposure.
“I think oil is higher right now on faulty ideas, because there is more oil in the pipeline than they can use, which is why it’s going lower,” said Theodore Feight, owner of Creative Financial Design. “I would guess we are in the first year of a three-to-five year down cycle before oil comes back, and that’s why I’m not buying yet.”
More deals likely
In terms of energy-related companies, Mr. Feight believes the fallout has only just begun.
“It’s kind of like real estate investors the way some companies thought this energy boom would last forever, so they just leveraged up,” he said. “There will be more deals like the Shell acquisition because the price of crude oil and what they can sell gas at is going lower. That makes some energy companies cheaper and creates opportunities for the big companies to buy them.”
If ever there were a case for allocating to a skilled stock picker over broad index exposure, it’s energy. Simply put, too many variables are in play right now for the overall sector to muscle out any kind of meaningful turnaround any time soon.