In comparison to the extreme volatility it displayed during the final three months of 2014, the price of crude oil stabilized somewhat during the first quarter of 2015.
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After closing 2014 at $53.27 per barrel, the West Texas Intermediate (WTI) prompt month futures contract settled as low as $43.47 per barrel during mid-March, but then rebounded and finished the quarter at $47.60.
Natural gas followed a pattern similar to crude oil, with the prompt month futures contract finishing 2014 at $2.889 per million British thermal units (MMBTU), falling as low as $2.579 per MMBTU during the first week of February, and then closing out March at $2.640/MMBTU.
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Interestingly, the crude oil and natural gas prompt month futures contracts were down 11 and 9 percent, respectively, during the first quarter of 2015.
However, the the SPDR S&P Oil and Gas Exploration and Production ETF (XOP) was up 8 percent over the same period. This movement in energy prices in one direction and the E&P sector in the other is counter intuitive.
Prompt month energy futures contracts are notoriously volatile however, and can be significantly impacted by temporary, fleeting events, such as supply disruptions, or unusual weather.
But even when we look at a long dated strip of futures contracts, the same pattern held. At the end of 2014, the average price of crude oil futures contracts for delivery during 2016 to 2018 settled at $65.89/barrel.
At the end of the first quarter of 2015, this 3 year strip price had fallen to $60.54, an 8 percent decline.
Natural gas futures contracts for delivery from 2016 to 2018 dropped from $3.73 to $3.30, a 12 percent fall, during the first quarter of 2015. The overall equity market was up less than a half a percent over the same period.
If we look back to the entire month of December, the current valuation of the energy & production (E&P) sector looks even more expensive on a relative basis.
For the full month of December, the average price of crude oil and natural gas for delivery during 2016-2018 was $67.75/barrel and $3.93/MMBTU respectively, so crude has declined 11 percent from the December average, natural gas dropped 16 percent, and yet XOP is up 9 percent.
In my opinion, I think energy industry investors have the specter of the 2008-2009 financial crash, and subsequent six year stock market rally, in the back of their minds.
They are over eager to try to catch a rebound in energy prices, and less cautious about energy industry fundamentals and valuation.
Lessons from Coal
Although oil and gas producers are not facing the same kind of secular decline and existential crisis that the coal industry is going through, cautionary lessons can be gleaned from coal’s travails.
Just as inexpensive and cleaner burning natural gas has gradually displaced the demand for coal for electricity generation, disruptive renewable energy technology will have an increasing impact on the demand for fossil fuels.
In addition, just as coal producers who incurred low levels of debt have a better chance of riding out the current price swoon, oil and natural gas producers that followed a more conservative approach to debt issuance have a better chance of surviving an extended period of low energy prices.
In my opinion, valuations for the E&P sector are stretched here, and investors have “jumped the gun” a bit in anticipating an energy price bounce.
Clearly if oil prices can recover even half the losses they incurred during Dec 2014-Jan 2015, XOP will probably perform very well.
If prices remain where there are, however, I think XOP will struggle to maintain its current level.
I am not normally an advocate of owning energy-commodity ETFs due to their well-documented inability to match the performance of the commodities they are designed to track.
I may scale back into XOP when valuations become more attractive.
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The investments discussed are held in client accounts as of April 14, 2015. 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.
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