How to Find Energy Company Value<br /> in a Schizophrenic Market
As we wind up the week, the market remains highly volatile today. But the reason for that chaos seems to be shifting from U.S. debt concerns back to the condition of credit in Europe.
Debt contagion in Western Europe has been the primary reason for market dives this week. The focus is now the condition of European banks – a disquieting shift when you remember the cause of the market slide beginning in late 2008…
Then, the credit crunch was enveloping economies worldwide. Banks could not get overnight funds from other banks, so access to business loans dried up, and the prospects of deep recession (or worse) led the worries in the U.S. and Europe.
At least the banking system is much better off this time around (even though financial institutions continue to withhold trillions of dollars from the flow of credit).
Now comes word that French banks may have the same endemic problems already identified in their counterparts elsewhere in Western Europe. If the trouble is real – and actions by Asian banks overnight yesterday do render credence to it – that will guarantee further turbulence in trading markets.
So much for Standard & Poor's example of France as the model for setting the U.S. debt house in order.
Actually, why anybody still lends any credence to these fiscal alchemists on sovereign debt matters is beyond me. The sub-prime collateral mortgage obligation catastrophe indicates they are not so hot on the private issuance side, either. Ultimately, whether the debt bubble is buried in commercial bank ledgers or in the public budget does not change the issue. It will have the same net effect when it bursts – disaster.
We should demand some accountability for rating agencies to understand what they are reviewing and forecasting. Otherwise, I would be about as successful with a Ouija Board.
One other matter before I stop kicking this dead horse…
This Time, Not All Boats Will Rise Together
Even getting the causal sequence right in explaining how we reached this point says little about what comes next.
European banks are already leveraged to a much greater extent than their American equivalents and have a wider exposure to investments in the private sector. Any banking sector – but especially the European one – relies upon the interbank lending mechanisms. When the flow of money freezes up, so does the sector as a whole (as we saw in 2008).
Of course, the turbulence is now likely to go either up or down, as evidenced by the wide gyrations of the last week. But we can hardly base an investment strategy on the roll of dice. Rather, it needs to consider the following.
The U.S. equity market is beginning to insulate itself from the widening debt problems in Europe.
Such insulation is partial at best, but it does augur a more sector-specific view of expected stock performance. There are certainly still American-only economic weaknesses to consider. Yet, there is little there that is not already out on the table.
This is going to be one recovery that does not raise all boats equally.
Which (finally) brings me to the subject for today's column…
Investing in a Volatile Energy Sector
Lately the energy sector has been exhibiting an almost schizophrenic personality.
First, commodities – crude oil and processed products, like gasoline and diesel (along with other so-called distillates) – are experiencing pressure to rise in price. However, the overall dynamics of the market, auguring a fear over decreasing demand, have been restraining that move.
Until yesterday, the commodity outlet for price rises has been gold. But that now seems to be leveling off. And with it, we should see some return of funds to oil futures.
As I've said before, the oil demand concerns are overdone. The global picture remains one of increasing requirements, whether that is reflected short term in U.S. and Western European usage or not.
And that leads me to the second part of the schizophrenia.
While yesterday's market showed some improving prices, it remains to be seen how much of the upward volume is simply a result of short covering.
The prevailing trend for the past week has been decidedly negative.
This has offset some encouraging signs from individual companies in the energy sector. In fact, we have already seen a bottoming out in a number of shares that represent broad differences in the market – from oil field services (OFS) through producers, midstream supply, storage and transport, to fuel distributors and wholesalers.
Clearly the problem is overall market sentiment and direction.
The huge daily losses we've witnessed in three of the last six sessions result, among other things, from massive withdrawals of cash, automated trading, and significant short plays.
All of these tend to overshadow individual company performance, unless a quarterly report much better than Street estimates happens to hit.
On the other hand, woe to any company reporting results that fall a bit short in this environment. They simply get hammered.
But there is some good news.
Volatility Cannot Be Sustained at These Levels
Markets will find equilibrium – although the balance resulting will be less secure and subject to more rapid spikes in instability.
Until the sector finds its feet, this means selecting individual companies to invest in.
Most of the shares on both my tracking list and “Trigger List” are showing, on average, a price 22% below what I consider fair market value. But in such an extremely troubled market, that does not mean they will be moving consistently up from here.
We need to take a closer look at these companies.
In the middle of a volatility cycle, I use four considerations to value a company:
- Its place in the upstream-downstream sequences, from production to use;
- Its leverage from available cash on hand;
- Its positioning in the specific sub-sector (for example, OFS, production, storage and transport, refining, wholesale distribution, power generation, technology, equipment); and
- The overall focus of management (whether the company sticks to what it can do best and most efficiently).
Based on those considerations, three initial areas of interest are already present.
First are oil and gas producers from existing low-cost fields with infrastructure and storage/transmission already in place.
Second are the midstream providers of gathering, processing, storage, and transmission in both oil and gas.
Third, we have companies that provide particular fuels (propane, lubricants, natural gas liquids, for example) and have control over both processing and sale.
[Editor's Note: Kent's Energy Advantage portfolio is well-stocked with companies like these. To learn more, click here.]
Each of these areas will be providing share moves that run significantly higher than any improvement in the market as a whole.
And that's just what we're looking for.