There’s blood in the street these days when it comes to the energy market, with some names down 40% or more.
In the old days, Baron Rothschild made a fortune investing in similar circumstances – it was he, in fact, who coined the famous phrase.
But there’s another expression on Wall Street that can also apply to these situations: Never catch a falling knife.
The question, therefore, is which investments are trading at a discount, and which ones are truly deadly?
Plenty of Uncertainty
A lot depends on oil prices in the short run. Unfortunately, there are too many contradictory indicators to tell exactly what will happen, but we can still analyze the situation.
First of all, demand has been soft in the United States and in Europe, but it hasn’t been collapsing by any means. Just look at the strong sale of SUVs in August, which portends a pent-up U.S. demand that exists at lower prices.
Secondly, the Saudis have been pushing to keep prices low enough to kill the threat of U.S. energy independence. In fact, as our own Karim Rahemtulla reported, Saudi Arabia is prepared to sell oil as low as $80 for two years in order to curb competition from the United States.
Meanwhile, the Obama administration is faced with a catch-22… it loves low oil prices, but hates the hydraulic fracturing that makes those prices possible.
Thus, it’s easy to see why the short-term outlook for oil is so unclear. My sense is that oil prices are within $10 or so of the bottom, but they won’t rebound significantly anytime soon. This is good for consumers, but very dangerous for frackers and investors in the sector.
In fact, that very danger could place a cap on prices for months, or even years, to come!
You see, when oil prices drop, many small producers can find themselves in a trap. They could be losing money on every barrel of oil they produce, but be unable to slow their production because their cash costs of lifting are still less than the oil price and they need the cash to flow to stay alive.
All of this oil flowing will keep prices low until demand rebounds – if it ever does. In turn, most domestic oil producers will be consigned to the ranks of the walking wounded, not going bankrupt but not growing their profits and, in most cases, unable to raise capital to buy the other walking wounded for when (if!) prices ever rebound. This would also hurt oil service providers, since the money won’t be there for new production oil developments.
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Given such a dreary outlook, is there anywhere for investors to turn in the energy market?
Opportunities Amid the Rubble
In fact, there’s one sector that can profit from the carnage: pipeline and storage companies.
These companies don’t work on commission. Instead, they charge by the barrel or they immediately hedge any product they do buy to ensure a stable margin.
Best of all, the barrels produced by wounded oil companies will have to end up at a refinery somewhere. Therefore, a company like Plains All-American Pipeline (PAA) will continue to collect the tolls on oil going to refineries. And since 70% of its revenue is fee-based, it has plenty of cash flow to cover the ample (4.7% yield) dividend.
Of course, MLPs have been volatile lately. But after some panic selling last week, Plains All-American’s MLP units are mostly back – though still well off their highs. And with PAA’s yield, investors can afford to be patient while the market looks for energy sector opportunities that won’t cause them pain while oil prices continue to struggle.
Finally, smaller operators like Holly Energy Partners (HEP) have some of their own risks, but can provide even greater opportunities. Holly yields 5.8%, is 100% fee-based, has a relationship with a refinery parent company, and may benefit from consolidation in the industry.
Bottom line: These toll-takers will continue to benefit from increased domestic production of oil even if prices fail to recover.