Energy stocks sell-off is a buying opportunity

Oil prices have broken through most of the technical support levels on the way to the mid-$70s, per-barrel price range in recent weeks.

This has put more money in the pockets of consumers but has driven stock prices down on most energy and production (E&P) companies, even to a larger degree than the drop in oil prices would warrant in my opinion.

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Energy bounce-back?

Most companies that are producers have hedges in place for a large percentage of their production. For the next few quarters the price drop should not affect earnings dramatically in my opinion.

However if prices remain this low for an extended period of time, it will affect profits and will eventually slow drilling.

In my opinion, oil prices should not stay at these levels for an extended period of time. Foreign governments that rely on oil production to balance their budgets cannot tolerate these lower prices for more than about six months of time.

Some of the price decline can be attributed to the rise in the value of the U.S. dollar. Since commodities are priced in dollars, as the dollar rises, it takes fewer of them to buy them.

The prices of gold, platinum, palladium, copper, and nickel have all fallen this year.

As other economies improve, their currencies may possibly appreciate against the dollar allowing prices on all commodities to increase.

Production outlook

U.S. refineries have been in their semi-annual shut down mode in order to perform routine maintenance and to switch from summer blends to the winter blends.

At this time they also modify their process to produce more diesel fuel (heating oil) than gasoline. They are just about finished with this changeover.

The fall and winter production cycle for refined products will consume more oil than the summer season, which should help to stabilize prices.

With the surge in hydrocarbon production, there has been a very large increase in the production of Natural Gas Liquids (NGLs).

Ethane prices have fallen dramatically over the last few years giving chemical producers a large cost advantage over their foreign competitors. This is the primary reason for the dramatic increase in plant construction projects along the Gulf Coast.

These facilities are now beginning to come online allowing our chemical companies to increase sales and margins.

Ethane crackers, condensate toppers and refineries are dramatically increasing production and exports.

Smart plays

Westlake Chemicals (WLK) and LyondellBasell (LYB) are still our favorites in this sector. Their planned expansions are coming online now through mid-2017.

This will lower their cost even more and enable them to take better advantage of the abundance of NGL production.

Westlake, in its third quarter presentation, stated it had been able to raise prices on its products and increase sales. In the third quarter, the company posted all-time record revenue and profits.

Several mid-stream companies we follow are also building capacity to take advantage of this expansion in production and demand in the NGL space.

One of these is Enterprise Products Partners (EPD). Volumes through their fee-based pipelines, processing plants, NGL fractionators, and condensate processors are running at all time highs.

EPD has plans to spend billions of dollars on new capacity. This expansion of capacity and its low cost of capital should enable EPD to possibly increase its annual distributions by approximately 6% each year for the next several years in my opinion.

EPD just announced its 41st consecutive quarterly increase in distributions.

We continue to see increased output from producers in the Bakken, Eagle Ford Permian shale basins.

As companies learn more about the geological structures they are drilling in, they have modified their methods by adding an increased amount of sand per foot in the fracturing process.

This is increasing the initial flow rate and lessening the decline rate of production. These developments also increase profit per well.

This is good news for the E&P companies we follow and view the pullback in energy stock price as a potential buying opportunity.

Several names we view favorably include Continental Resources (CLR), EOG Resources (EOG), Oasis Petroleum (OAS),  Whiting Petroleum (WLL) and SM Energy Company (SM).

Large cap industrials are starting to show their strength again after the late quarter swoon. With lower energy cost, when demand returns, they should maintain good profits in my opinion.

Emerson Electric (EMR), Honeywell International (HON) and United Technology (UTX) have recently pulled back from their highs. If their earnings remain strong, which we anticipate they will, this should give us a very good entry point in the near future.

 Photo credit: Peter Markham via Flickr Creative Commons

DISCLAIMER: The investments discussed are held in client accounts as of October 31, 2014. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.