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Five Ways to Play the Rebound in Energy

by | published October 28th, 2014

Typically, most oil and gas investors pile into shares of production companies when the market begins to bounce after a sell-off.

When you think about it, that makes sense – on the surface at least.

After all, these “upstream’ outfits are at the top of the sequence. It’s only later that the market shifts gears down the chain to the traditional beginning of the downstream segment – refining.

And it’s even later when refined products move down to the wholesalers and retailers that move it on to the ultimate end-user, otherwise known as the consumer.

So the conventional approach is to buy the upside move in the companies that are the earliest in this process. The simple reasoning runs, you can’t refine a product that isn’t available.

Yet, as recent experiences have proved, that’s not always the case.

In fact, the best performers after a plunge are found elsewhere…

Why It’s Different This Time

Now, it does bear to reason that after a more than 7% decline in the S&P 500, that the shares of producers would pop. Not surprisingly, that has happened.

But the move so far has been uneven. The rising tide hasn’t lifted all of the boats the same this time.

That follows with something I have noted on several occasions: We are moving into a period in which not all producers will behave the same exact way.

Part of this has to do with the price of oil.

And until the supply-demand dynamic changes, we are looking at a range of about $81-$88 a barrel in New York (the West Texas Intermediate, or WTI, benchmark), and a few dollars more in London (the Brent benchmark crude rate).

That will translate into some companies having a better market advantage over their peers.

For example, when the price moves below $90 a barrel, producers begin to reconsider some of the more expensive deeper, fracked, and horizontal drilling projects. And if the price of oil declines to $80, it can turn into project delays.

On the other hand, a falling price move actually favors companies that are drilling shallow, vertical, conventional oil wells, since those wells are inexpensive. So their cheaper drilling costs translate into a premium in market share.

This is not simply an issue of crude oil prices. It’s about who can bring the oil to market (where there is still demand) at a margin that is both profitable and at a cost to refineries that allows them to maintain their own sufficient margins.

But even in this case, while some operators do fare better than others, the major profit moves in oil are now elsewhere.

The Best Way to Play Oil (After the Plunge)

In fact, two areas to consider in today’s markets are selected oil field service (OFS) providers and midstream partnerships.

OFS is an even earlier link in the profit chain. These crucial services occur before the oil and gas flows and extends from initial geological surveys, through seismic shooting and analysis, to well drilling and completions, work-overs, and in unconventional projects everything from fluid management to water disposal.

The companies that provide either a broad array of services or meet special niche needs with little effective competition are the preferred moves here.

The first draws our attention to the big boys – Schlumberger Limited (NYSE:SLB) and Halliburton Co. (NYSE:HAL); the second points toward smaller, focused providers like Newpark Resources Inc. (NYSE:NR), a well site preparation company that also has a big interest in fluid management and water disposal. Both of these two things are essential in the fracking process.

Then there are the midstream providers. In this part of the sequence, there are several midstream companies that offer the best of both worlds: income and share price appreciation. And today, there are some interesting developments in this segment involving new arrangements of pipeline, terminal, storage, and related assets.

This has introduced a range of midstream limited partnerships (MLPs) that are able to combine separate profit centers all under one roof.

A perfect example would be Plains All American Pipeline LP (NYSE:PAA), which is moving its traditional midstream operations into downstream applications. PAA provides pipeline and related services for natural gas liquids and crude oil, as well as the marketing of the volume downstream. As an added bonus, the company also provides a very nice 4.7% annualized dividend.

Of course, MLPs have long been a major component in the midstream sector. These holdings center about midstream assets, which until recently included only pipelines, and pass through all of their profits to their partners, bypassing taxes at the corporate level.

When an MLP decides to float stock to retail investors, it is also floating a percentage of the asset ownership. That usually translates into a higher dividend payment, well above the market average.

The best way to move on all of these structures is still the JPMorgan Alerian MLP Index ETN (NYSEArca:AMJ). This is an exchange traded note, similar to an exchange traded fund (ETF), that emphasizes the interest proceeds of the constituent MLPs that comprise the tracking index.

Since June 2009, AMJ is up 129% and carries a nice 4.35% dividend.

This portion of the sector is certainly going to see some major changes ahead, as new holding patterns emerge, and merger and acquisition (M&A) moves change the landscape.

However, there is one caveat to remember. MLPs cannot issue debt. That means to fund expansion, they must acquire additional assets. Sometimes they get larger than the underlying asset can justify.

The much publicized decision by Kinder Morgan Inc. (NYSE:KMI) to end what was the industry’s largest MLP and move back to a more traditional corporate structure is a signal that further revisions in MLP design will have to come in other ways.

Nonetheless, one thing is clear.

The price of crude oil is only a starting point in assessing where to make money in the energy sector.

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  1. Bob
    October 28th, 2014 at 21:32 | #1

    The polls are predicting a Republican Senate majority. If so, expect fast track approvals for:

    Keystone pipeline, lifting of crude export ban, LNG export applications, increased drilling on E. Coast & Gulf, ANWR, curbing EPA climate regs, increased coal-powered generation and exports, never-ending sanctions on Iran/Russia.

  2. Ed Daniels
    November 1st, 2014 at 14:03 | #2

    Please comment on KMI—I have shares in KNP and 3 choices
    after the merger into KMI.
    Any advice for shareholders such as myaelf

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