Review & Outlook

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As Oil Prices Drop, Some Investment Opportunities Emerge

31 October, 2014 by Matthew O'Brien, Ph.D. in Commentary

Companies mentioned: EOG Resources (NYSE: EOG), Spirit Airlines (NASDAQ: SAVE), Tortoise Energy Infrastructure (NYSE: TYG)

One of the biggest developments in financial markets recently has been the precipitous slide in oil prices.  Since this summer, oil prices have declined more than 20 percent from their highs of above $100 per barrel.  Here is the price of oil versus the S&P 500:

oil prices

Chart: WSJ.com

The price gap between the international oil benchmark (Brent) and U.S. crude (West Texas Intermediate) has also narrowed to its closest range in the last few years.  Cheaper oil both helps and hurts the U.S. economy, which is to say that the U.S. economy isn’t monolithic, but really is a collection of many different economies.  Ordinary consumers get a windfall from lower oil prices as the decline translates into cheaper gas at the pump.  With extra cash to spare, companies in the consumer discretionary sector may stand to benefit.  Oil producers, however, get hit as their product immediately becomes less profitable.  Market commentators are wondering whether the decline in oil prices will slow or even halt the revolution in domestic energy production that has swept shale-rich regions of the country (North Dakota, Texas, Pennsylvania, etc.) over the past few years.  Generally speaking, shale oil and the unconventional methods used to extract it are expensive relative to conventional oil, so the question is: how high do oil prices need to be in order to sustain the surge in U.S. production?

The OPEC cartel hopes that the price is high, and that its member states can weather lower prices better than the U.S shale producers can.  At O’Brien Greene, we’ve traditionally avoided investing in pure oil and gas production plays, preferring instead integrated energy companies like Exxon and Chevron.  Last year, however, we liked a shale oil and gas producer enough to start buying it for our large-cap portfolios.

(1) EOG Resources (NYSE: EOG): we’ve written about EOG on our blog before.  EOG was up 40% for the year back at the end of June, after which there has been a steep sell-off as shorter-term speculators have fled the stock in response to the drop in oil prices.  The price is about $95 today, down from a high of about $117 per share.  Lower oil prices are no doubt bad for EOG, but we nevertheless like the company’s longer-term prospects.  EOG has an excellent management team that has proven to be very adept in managing the company’s variable emphasis on either oil or natural gas.  Furthermore, EOG keeps costs and debt low.  As Bloomberg has reported, one under-appreciated feature of the boom in shale energy production is the great extent to which it has been debt-driven.  In a down market, heavily indebted companies will be pressured and some may be forced to sell assets or go bankrupt.  A down market could help EOG in the long term by winnowing the herd of competitors who can’t match its strong fundamentals.

  EOG Resources U.S. Oil & Gas Producers Average
Pre-tax Margin 24.2% 8.2%
Net Margin 15.5% 1.0%
Long-term Debt/Capital 27.3% 37.5%
Return on Equity 17.4% 10.3%
Return on Assets 8.7% 4.5%
Return on Capital 12.7% 6.3%

Data from Zacks Research Service

In spite of its strengths, EOG isn’t expensive relative to other U.S. oil and gas producers.

EOG PE

Source: Zacks Research Service

EOG trades with a trailing and forward price-to-earnings ratio of 18.4 and 17, respectively, while the industry average is 19.5 and 18.8.

(2) Spirit Airlines (NASDAQ: SAVE): another company that we particularly like in the present environment is the small-cap stock of the discount airline Spirit.  We bought Spirit for our partners in the O’Brien Greene Small-Cap Stock Fund, L.P at the beginning of this year.  It is our best performing small-cap stock year-to-date, up 61% at today’s close.  Spirit just posted strong earnings, boosted by the drop in fuel prices, which is the single biggest cost for airlines; as Bloomberg Businessweek reported the other day, “Cheap Oil Lifts All Airlines, but Spirit Gets to Fly Highest” (Oct. 29):

The crude oil bear market represents a strong financial tailwind for airlines, which will likely fatten their profit margins over the winter. When jet fuel is cheaper, of course, more money flows “straight to the bottom line,” as American Airlines (AALPresident Scott Kirby put it last week. Yet a decline in crude oil expense doesn’t help every airline equally. A carrier’s nonfuel spending plays an important role in how much profitability cheaper jet fuel will offer.

Nowhere is that financial shift more pronounced than at Spirit Airlines (SAVE), which just reported a record pretax profit margin of 21.3 percent in the third quarter. Spirit executives cheered analysts by suggesting they can hit an operating profit margin of about 20 percent in 2015—the same year the Florida-based airline is planning a major growth spurt and hiring 250 new pilots.

Behind the profitability boom are Spirit’s nonfuel costs, which are about the lowest in the industry.

With Spirit’s non-fuel costs already low, the company benefits disproportionately from fuel price drops, as conventional airlines struggle to contain other operating costs.  Spirit now trades at a substantial premium to the airline industry generally, and its zero reported debt is misleading, since it does, like other airlines, carry significant debt, just not on its balance sheet.  Nevertheless, unlike other previously hot sectors like biotech and internet retailing, airlines continue to perform strongly as they benefit from sustained levels of travel and more fuel efficient jets.  The fuel price drop only supports this trend.

(3) Tortoise Energy Infrastructure (NYSE: TYG): one consequence of low interest rates, which have been artificially suppressed by central banks across the developed world, is the “search for yield” that has driven investors into new asset classes that offer higher yields but may be poorly understood.  One of the best performing asset classes in this regard has been master-limited partnerships (MLPs).  MLPs are tax-privileged corporate structures that payout most of their profits to investors (i.e. limited partners) in the form of distributions.  Typically, MLPs own “midstream” pipeline assets that have a toll-road like business model, transporting oil and gas from producers to refiners and consumers.  Tortoise Energy Infrastructure is a closed-end mutual fund of MLPs that we have owned for many of our income-oriented clients for a number of years.  We chose to own MLPs through a closed-end fund instead of directly for a number of complicated tax reasons.

Lots of investors have bought MLPs and MLP funds simply because they’re relatively high-yielding.  Many MLP owners seem to know vaguely that MLPs are involved in the energy industry, so when oil prices began to tank, they began to sell MLPs and MLP funds.  MLPs are primarily involved in midstream oil and gas transport, however, not production.  They are therefore relatively insulated from commodity price swings compared to the production companies.  The MLP sell-off was misdirected, we think, and largely driven by retail investors misreading the implication of lower oil prices.  The sell-off created arbitrage opportunities, however, because closed-end funds like TYG tended to be hit harder than the MLPs themselves.  (A closed-end fund buys a fixed set of assets and trades on the stock exchange like an ordinary stock, so there can be discrepancies between is price on the exchange and the net asset value of the underlying MLPs it owns.)

TYG historically tends to trade at a premium to its net asset value.  As oil prices were dropping recently, however, TYG’s price declined to the point where a few weeks ago it was trading at a 17% discount to its net asset value.  Given that TYG was yielding about 5% annually, this price discount relative to the net asset value made a particularly attractive arbitrage opportunity.  As of the close on October 14, TYG traded at $40.75 and at the close today $45.89.  TYG’s discount has narrowed now to 9.9%, but is still attractive.

The big risk with MLPs and MLP funds like TYG (which use leverage) is a rise in interest rates.  MLPs rely on borrowing to grow, since they  are obligated to pay out their profits as distributions.  Even if interest rates do rise, however, long-term investors who are willing to ride out the turmoil — while collecting their distributions all the while — can still do well.

 

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