Drilling into potential of Oil Services, E&P companies

Ivy Energy Fund
11.13.18

Volatility continues to be a key factor in the world oil market and the stocks of energy companies. We think the oil market still is at an early-recovery stage and the fundamentals of supply and demand remain solid. In analyzing potential opportunities, we have identified several key factors at play that may affect the Oil & Gas Equipment & Services (Services) and Exploration & Production (E&P) industry segments.

The industry does not have the excess capacity it enjoyed as recently as 20 years ago. A major oil supply shock can’t be met by tapping excess capacity or oil reserves. The U.S. has been the main supplier of new capacity over the last five years, with the growth in shale oil output driving down prices because of the relative ease in bringing that oil online when compared to deepwater oil rigs.

Oil and gas equipment and services and oil and gas exploration and production

Source: Global Industry Classification Standard (GICS),
September 2018

Iran sanctions, if fully imposed, could take 1.8 million barrels per day (bpd) out of production. The U.S. is able, at best, to make up about 1.5 million bpd. We conservatively estimate that 1 million bpd will be needed to cover global growth in demand. These factors indicate the need for more spending to bring more oil to market — a scenario that can benefit both E&P and Services companies. Supply growth is slowing because of a lack of investment, primarily internationally, based on the cost versus U.S. shale.

Pipelines in the U.S. are getting full. Two new pipelines are under construction and expected to be in service in mid- to late 2019. E&P companies, which supply the pipelines, will need about six months to ramp up drilling activity, which requires the hiring of oil service companies. Capacity will be limited until that time and many producers may not be able to get their oil to market.

Oil prices have taken a winding path during volatile market year
OIL PRICES HAVE TAKEN A WINDING PATH DURING VOLATILE MARKET YEAR
OIL PRICES HAVE TAKEN A WINDING PATH DURING VOLATILE MARKET YEAR

Risk/Reward scenarios

We also have reviewed key factors in the risk/reward scenarios for Services and E&P stocks now:

  • The crude oil price historically has explained about 90% of the price of Services stocks. Those stocks now are well below the price of West Texas Intermediate (WTI) crude oil, the U.S. benchmark grade. That suggests to us that the risk/reward for investing in Services companies now is relatively favorable, compared to the last 20 years.
  • This relationship has happened only twice in the last 20 years and resulted each time in significant rebounds in the Services stocks toward the price of crude oil over the next 12 months.
  • Fundamentals in those stocks suggest there may be a bit more downside until capital deployment begins to grow and profitability bottoms. Because of too much capital allocation by U.S. companies into shale oil projects only, with little to no capital deployment to international projects, Services companies are near a bottom for return on capital and profitability.
  • As for E&P companies, price explanatory power has come from rig counts. As the price of deepwater production has come down relative to shale oil projects, we think there is potential for more capital expenditures in deepwater projects and an increase in U.S. activity, which will increase rig count. We note, however, that the E&P companies have not reached the level of stock price dislocation of the Services companies.

Disconnect in oil and equities prices

Over the past year, oil prices in general are up about 8% but the related equities are down over 12%. We think Services company equity valuations now are priced based on oil at less than $40 per barrel. By comparison, Brent crude oil is trading at about $71 and WTI at about $61 per barrel. In our view, this makes for a strong risk/reward environment for the equities.

Fundamental outlying risks are always present in energy, but we think one of the biggest risks now is the opportunity cost of buying too early — meaning before the stock prices capitulate and revert to their mean or at least to more normalized cyclical levels.


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Past performance is no guarantee of future results. The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through November 2018, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification. Investing in the energy sector can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments, and the cost assumed by energy companies in complying with environmental safety regulations. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.