January 14, 2017
By Kirk Spano, MarketWatch |
Five years ago, in the article that landed me a role here at MarketWatch’s Trading Deck, I wrote there was “one general thing that changes everything for America.” That one thing was the rise in production of American oil.
Within a year of that article, once American companies started pumping oil in earnest, we saw a large runup in oil stocks XLE, +0.46% That bull market lasted until the recent oil price crash CLG7, +1.64% The oil crash, as we know, was caused by the Organization of the Petroleum Exporting Countries and Russia flooding the market with oil. Recently, they agreed to slow production to help finish the rebalancing of global oil markets.
Today, we are at the beginning of another large rally for oil stocks. There are several catalysts for this move.
The Trump administration is very pro-fossil fuel. The renewed focus on American oil will help drive oil prices higher in coming years and ease regulation on fracking.
The looming decline in global deepwater oil production, about 3 million barrels a day starting this year, will also put pressure on oil prices to rise. This production decline for the most part won’t be replaced with new deepwater megaprojects. Most projects are too expensive and have too long of a payback in an era when we eventually expect to have cheaper, longer-range electric vehicles.
On top of a gradual decline in deepwater oil production, there is a wild card that could drive oil prices toward $100 per barrel again: A very real possibility in the near future that the dollar will no longer be the lone global reserve currency.
As I discussed about a month ago in an article titled “Could Trump, China conflicts take the U.S. to recession?” it is very possible that China and Saudi Arabia make a deal to trade oil in yuan. If they do that, then the “petrodollar,” which is built on global oil being traded in dollars since the early 1970s, will be no more. At that point, the yuan USDCNY, -0.6724% becomes a co-reserve currency, and the dollarDXY, -1.16% depreciates.
If the dollar falls in value due to a such a shock, the price of oil will rally mightily. That of course would be very profitable for most of the surviving oil producers, including American shale.
There is a lot of incentive for China and Saudi Arabia to do such a deal. It would allow both to diversify away from the dollar and support their own long-term interests: a more diverse economy in Saudi Arabia and a bigger role for China in international trade. Most of OPEC could follow suit in such a yuan-for-oil arrangement.
There might even be a security component of a Saudi-China deal on oil and the yuan. Consider, then, what that could look like and what it means to oil prices. What if China deployed troops to Saudi’s border with Yemen, a country embroiled in civil war in which Saudi is supporting one side and Iran the other? Or took part in an Iraqi “peacekeeping” force that fights ISIS? There are quite a few scenarios that could add to the risk premium for oil.
There are many moving parts to the global oil, currency and trade markets. I cover many of those in a report titled “2017 — The Return of Volatility to Markets,” to be published the week of Jan. 16. Sign up at my investment newsletter to receive it.
The bottom line is that over the next few years, the price oil is likely to rise, or to rise a lot. That is a pretty good equation for oil-stock investors. Having extra exposure to the energy patch is again a good idea. Especially good are companies involved with American shale, as they have a lot of supporters in government now.
Two trades to consider
The survivors in the shale patch stand to do very well in a higher-priced oil environment. Those with better balance sheets will do better than those with heavier debt. Moreover, companies with significant natural-gas production will probably be safer long-term as oil use shrinks sometime in the next decade and natural gas use keeps on growing.
I recently discussed 4 stocks for oil’s final bull market. For those looking to build a better asset allocation, here are two funds that can give you greater exposure to higher-priced oil.
While many will focus on the oil explorers and producers to capture profits, there are many companies in that group that have so much debt that even higher oil prices won’t save them. I like the companies with better balance sheets and a mix of oil and gas production. Many such stocks can be found in the First Trust Natural Gas ETF. FCG, +0.15%
FCG focuses on companies with significant natural-gas production. While several components are pure play natural-gas producers, most also have significant oil production, such as Devon Energy Corp DVN, +0.60% a Permian basin leader and the ETF’s second-largest holding. There are also desirable midstream assets in FCG, such as Kinder Morgan KMI, +0.25% and Enbridge Energy Partners EEP, +0.47%that help add a solid dividend to the fund.
In my opinion, FCG is a buy at recent price levels.
Companies that provide equipment and services to the oil-and-gas industry also do very well whe oil prices rise. In fact, the equipment and service companies are usually more levered to rising oil prices than producers. The SPDR Oil & Gas Equipment & Services ETF XES, +0.09% is my selection here. I prefer it to other ETFs because of its non-market-cap weighted portfolio. I believe the midsize companies will do best in an extended bull market, so I don’t want to overweight the large companies. XES is a buy in my opinion at recent price levels.
Disclosure: Subscribers to Kirk’s investment letter Fundamental Trends have previously been recommended FCG & XES. Certain clients of Bluemound Asset Management own FCG & XES. No new recommendations or transactions are planned in the next three trading days for the discussed securities. Opinions subject to change at any time without notice. Follow me on Twitter @KirkSpano for a free stock pick of the month or Facebook for a free stock pick of the month with analysis. Sign-up for a free monthly piece of research at Fundamental Trends. January’s report is “2017 – The Return of Volatility to Markets”