Photographer: Akos Stiller/Bloomberg

Oil Stocks Unfazed by Commodity’s Plunge Seen Increasingly Risky

  • More downside than upside to holding energy shares: TriVest
  • FirstEnergy Capital sees company valuations as ‘pretty full’

Energy investors appear to be getting ahead of themselves, judging by the premium energy stocks are demanding over the price of oil.

While U.S. crude is down by more than 10 percent from its highest close this year on June 8, the S&P 500 Energy Index is off less than 1 percent since, and the S&P/TSX Energy Index of Canadian producers has gained 3.8 percent. The disconnect implies that, unless oil prices are set to rise sharply, equities are overpriced.

“Oil prices are telling you it’s not good and yet equity investors are finding all kinds of different reasons to stay in the stocks,” Martin Pelletier, managing director and fund manager at TriVest Wealth Counsel in Calgary, said in a phone interview. His firm closed its energy fund a month ago after the spring oil rally and has taken its clients’ individual energy holdings almost to zero, he said. “The upside is less than the downside risk.”

Crude has fluctuated on mixed signals since declining more than 20 percent into a bear market and closing below $40 a barrel in the first week of August. A rise in drilling rigs in the U.S., heading into a period of seasonal demand weakness, is fomenting negative sentiment that a supply glut will persist, while indications Saudi Arabia is prepared to discuss stabilizing markets are supporting prices.

The two-year rout in crude has eroded cash flow for producers globally, forcing them to shelve drilling, cut workers and squeeze costs to survive. The earnings picture has yet to improve. The most recent quarterly results for North American energy companies shows 84 percent had lower revenues than a year ago and 78 percent had worse earnings, according to data compiled by Bloomberg.

As West Texas Intermediate crude hovers around $45, the stocks of large oil and natural gas producers are implying $65, and smaller companies are pricing in oil above $55, according to Robert Fitzmartyn, an analyst at FirstEnergy Capital Corp. in Calgary. That disparity can be typical, as energy stocks don’t always track down or up in line with oil and trailed behind the commodity during this year’s spring rally, he said.

“For the most part, we’d probably say a lot of these stocks are pretty full right now,” as investors are focused on longer-term expectations for an oil price recovery, Fitzmartyn said in a phone interview.

Gas Producers

Year to date, the S&P/TSX Energy Index is up 23 percent, in line with the rise in U.S. crude prices, while the S&P 500 Energy Index has risen 14 percent. The best performers have been gas stocks, reflecting a 19 percent gain for the power-plant fuel since the start of May as summer heat in the U.S. increased the use of air conditioning. Southwestern Energy Co., a gas-focused producer based in Spring, Texas, has roughly doubled in value this year, while Calgary-based Birchcliff Energy Ltd. has risen more than 120 percent.

Analysts have so far avoided cutting their price targets for stocks on the S&P/TSX Energy Index amid oil’s recent weakness, unlike in the past. The recommendations are at their highest point this year, according to data compiled by Bloomberg. That may be because the prevailing view is that oil prices will rise.

WTI is poised to average $45 and $48.10 in the third and fourth quarters, respectively, followed by an average of $54.25 in 2017 and $61 in 2018, according to the median of analysts’ estimates compiled by Bloomberg.

Investors buying energy stocks think there’s still room for the shares to rise if oil indeed rebounds, said Laura Lau, senior vice-president and senior portfolio manager at Brompton Group in Toronto. Lau is adding energy holdings to her resource fund, she said, counting herself among those who see oil’s current weakness reflecting lower seasonal demand and betting prices will be higher toward the end of the year.

“They saw in the beginning of the year what happens when you’re underweight and these stocks explode. You wanna be there,” Lau said. “It’s not a bad idea to start adding some torque to the portfolio.”

That’s a bet Pelletier isn’t willing to make.

“Investors are saying, well, the rally off the lows is so strong and it’s got some legs to it, why would I give it up now?” Pelletier said. “If oil stays at its current level, in a month, energy stocks are going lower.”