Opportunity Lurks in the Energy Sector as Oil's Rout Continues

Opportunity Lurks in the Energy Sector as Oil's Rout Continues

Oil prices are heading south in reaction to OPEC's failure to pull back on production, as West Texas Intermediate crude oil tumbled below $36 per barrel, scoring a fresh seven-year low.

OPEC's decision to keep pumping oil at near record levels, despite weak global demand, means there is no end in sight to the glut of oil on the world market and could mean lower crude oil prices for a longer period of time.

"The dirty secret was that everyone was overproducing," says Stewart Glickman, equity analyst at New York-based S&P Capital IQ. At the current low level of crude oil prices, "if you are trying to prop up your cash flow, the only way to do it is by volume," he says.

Global markets are oversupplied by about 2 million barrels per day this year. "The biggest takeaway is that OPEC is essentially broken as a cartel," says Charles Sizemore, chief investment officer at Dallas-based Sizemore Capital Management. "They do not work as a collective. It's a case of every man for himself at this point."

Looming over the global oil markets is the prospect of even more supply with the return of Iranian oil next year once international sanctions are lifted. "Iran was OPEC's second-largest producer before sanctions and will battle now to regain that position. Further, despite the price plunge, U.S. production has not fallen as much as analysts expected earlier," says Neena Mishra, director of ETF Research at Chicago-based Zacks Investment Research. "I believe that oil prices are going to stay lower for longer."

A bullish case for oil? It is hard to make a strong bullish case for the current supply/demand equation for crude oil, but some analysts expect modest recovery into 2016. "We have near-record global output at a time when no major economy in the world is showing robust growth, meaning demand for energy is tepid. Plus, efforts to be greener, with alternative energy and efficiency drives, have further crimped demand. However, there is a lot of bad news already baked into current oil prices. I do see crude finding a bottom sometime in the first half of next year," Sizemore says.

Glickman says Denver-based Bentek Energy's forecast for $50 oil in 2016 "implies up, but not a meaningful recovery. Even at $50, a lot of producers will still feel some pain. Not that many U.S. shale plays are profitable at $40 per barrel, but at $60, there is a lot more to do," Glickman says.

Even though OPEC didn't do any favors for the price of crude oil in the near term, investment opportunity may still be lurking in the battered energy sector. Investors need to be choosy, but bullish analysts do see buying opportunities.

In the current environment, larger oil companies may be better positioned to weather the storm of lower oil prices. "If I look at my 'buy' list, they are mostly large companies. I'm looking to see if they are able to generate positive free cash flow," Glickman says.

He says EOG Resources Inc. (ticker: EOG) is an example of an upstream energy and production company that is expected to generate positive free cash flow in 2016. "They have spent a fair amount of money and time innovating in the oil field. Even as oil prices have fallen, they are able to still make money," he says. Glickman rates EOG Resources as a "buy" with a 12-month target at $99.

The low price of oil has boosted the revenues and stock prices of oil and gas refining and marketing companies, or those that take crude oil and turn it into products such as gasoline, diesel and heating oil. The plunge in oil prices means their input costs are lower and translates into the potential for higher profits. "Refiners seem to be the only bright spot in the energy space in this environment," Mishra says.

S&P Capital IQ rates Valery Energy Corp. (VLO), a downstream refining company that converts crude oil into products consumers use, as a "strong buy" with a 12-month target at $82. "They have an awful lot of capacity in the Gulf Coast, which is the nerve center for U.S. refining operations," Glickman says.

How to invest in oil with ETFs. Investors looking to play the refining space through an exchange-traded fund can consider Market Vectors Oil Refiners ETF (CRAK). "This is the first and the only U.S.-listed ETF to provide pure-play exposure to global oil refiners. However, with more than half of its assets invested in non-U.S. companies, the product has foreign exchange risk," Mishra says .

Another option for investors who may be skittish about the risks of an individual energy name could consider the Guggenheim S&P 500 Pure Value ETF (RPV), Glickman says. Valero is the largest holding in RPV, but this ETF is not a pure energy play. "It includes names that are seen as undervalued, and we have an overweight ranking on this ETF," he says.

For contrarian investors willing to step against the trend, Sizemore suggests Kinder Morgan (KMI) as a top pick for 2016. The company owns and operates a key pipeline network to transport natural gas and crude oil. "The stock is down more than 60 percent, and considering that this is a premier infrastructure company with vital gas lines that can't be replaced, it's hard to see much downside here. At these prices, this stock is priced to double within a year or two," Sizemore says.

Investing in beaten-down master limited partnerships is another option for contrarian energy investors. Most MLPs are involved in the processing and transportation of energy commodities under long-term contracts.

"They have relatively consistent and predictable cash flows, less correlated with commodity prices," Mishra says. "Their high yields have been the main attraction for investors, but investors need to be aware that a prolonged downturn in oil prices would put pressure on distributions." Investors looking for broad exposure to the major MLPs can consider JP Morgan Alerian MLP ETN (AMJ).