Are the equity markets running out of energy?

A number of things are working in our favor, including the continued strength of the U.S. economy and seasonality, as December is historically the best month to own stocks. As of last Friday’s close, the S&P 500 had a total return of 15.3% for the year. That is just above the top end of the 8% to 14% range we predicted at the beginning of 2014. We believe 2015 will also provide solid returns but on a more humble scale.
We are targeting a total return of 6% to 10% for the S&P 500 next year. The main reason for the slightly lower range is our view that price per earnings expansion will not help drive returns like it did this year. We do foresee opportunities for slightly better returns in small caps, selected international segments and, for the very patient — the energy sector.
(More: Time to strap in for the downsides of cheap oil, higher interest rates)
Energy seems to be on everyone’s mind given the dramatic fall in crude and gasoline prices and the even more dramatic fall in the prices of energy shares, especially the small-cap issues. Specifically,
• West Texas Intermediate (WTI) is off about 46% since hitting a near-term high on June 20
• Gasoline is off about 43% since hitting a near-term high on June 24
• The S&P 500 Energy Index (large cap) is off 26% since hitting a near-term high on June 23
• The S&P 600 Energy Index (small cap) is off 52% since hitting a near-term high on June 30
The huge hit to the small-cap shares clearly displays a concern from investors that the U.S. shale industry is at risk as the price of WTI continues to move down.
No industry can survive plummeting prices for its product forever, but we have to realize many factors are at work. In addition, WTI has had declines like this before and the energy sector has bounced back accordingly. As we look at the energy complex, we have to understand that not just supply and demand drives petroleum prices. We must also deal with entities like OPEC and their desire to be able to drive prices, and the concept that many oil-exporting countries need large oil revenues to balance their budgets. If prices go down, they need to make it up in volume.
Therein lies one of the problems: too much supply. Simply put, the world is awash in oil. U.S. production is at its highest level in 30 years and is up about 30% over the last four years. Across the globe, it is estimated that the current surplus is about 2 million barrels a day. It’s also estimated that about 1 trillion barrels have been discovered over the past five years, which alone represents about a 30-year global supply. Factor that in with tepid demand growth due to slowing economies overseas and more-efficient vehicles, and oil prices were bound to move lower.
(More: Small caps break record as rally broadens out)
Some may think they can drive U.S. shale producers from the market with lower prices, which in turn would help alleviate the daily surplus and allow prices to walk higher. That may work in the short term but in the long term we think shale production and cheaper oil is here to stay. The big reason is technology and experience and their effects on well productivity and costs.
Looking at one of the major Bakken shale producers, its current well cost is about 16% below the average cost in 2013. Even with improvements below this level, the effects will be huge for U.S. producers and the shale industry, making them more economically feasible every day. Bottom line: Five years from now, we will be reading more pertinent headlines about shale producers (especially U.S. shale producers) than OPEC’s actions.
So as we close out 2014, we wouldn’t spend a lot of time trying to predict where oil will finally bottom, but clearly we are getting close. Over the past 10 years, the WTI has gone as high as $145.29 (July 3, 2008) and as low as $33.87 (Dec. 19, 2008). It currently sits at about $55 and has averaged $81.65 over the past 10 years. In short, it has been highly cyclical, just like the energy sector’s weighting in the S&P 500, which has ranged from a low of about 5% to a high of about 16% over the last 25 years. Over this period, it has averaged 9.4% and sits at 8.1%.
This weighting will begin to move back toward average, and then to above average over the next couple of years. That should bode well for patient energy investors. There will clearly be some fallout like defaults and bankruptcies in energy, but there will also most certainly be an uptick in mergers and acquisitions, which should help support energy shares.
In the meantime, we can relish the fact that energy is in everything and that likely will bode well for almost every other industry. In addition, consumers will have more free cash, which should continue to provide some tail winds to the global economy and be another positive factor to keep the bull market for U.S. equities intact for 2015.
Mike Boyle is head of asset management at Advisors Asset Management.