Energy Prospectus

We were on quite a roller coaster ride last week, but the Sweet 16 is up just 0.07% on the week. Trading on Friday, ahead of the Labor Day weekend, had something to do with that.

Crude oil prices are up more than $8/bbl in the last two weeks. The big response was primarily to the Department of Energy's admission that they have been overstating U.S. oil production since the beginning of the year. Had they been reporting production accurately, WTI probably would be much closer to $60/bbl.

The overall market has also been on the roller coaster. September and October always seem to be more volatile months.

The Sweet 16 is down 17.0% YTD, compared with the S&P 500 Index that is down 6.7% YTD. Two of the smaller companies in the Sweet 16 (BTE down 63.5% YTD and BCEI down 68.7% YTD) have put the most drag on the group. Both are trading more than 100% below my valuations and First Call's price targets are above my valuations for both of them. The smaller E&P companies always get hammered more in these oil price cycles. They are both in decent shape and should survive. I am looking at several companies that impressed me at EnerCom that may replace them. OAS is another one (down 33.1%) that may need to be replaced.

I am extremely bullish on the companies with big exposure to the SCOOP & STACK plays in Oklahoma: XEC, CLR, DVN and NFX. All four are in our Elite Eight.

I have finished updating the profiles and forecast models for all of the Sweet 16, you can download them from the website.

Analysts have now had plenty of time to adjust their forecasts and valuations for 2nd quarter results. Therefore, the First Call prices targets are worth comparing to my valuations. Keep in mind that a lot of Wall Street firms are using very conservative oil & gas price decks.
> Companies where First Call's price target is above my valuation: BTE, BCEI, CLR, FANG, MTDR, RRC.
> My valuations are more than 10% above the First Call price targets for: CRZO, DVN, GPOR, LPI, NFX, SM
If you look at the Sweet 16 spreadsheet on the website, you can see my updated valuation compared to First Call's price target for each company.

Oil Prices: At Friday's luncheon in Houston, I put up this chart: https://www.tradingview.com/chart/wBMe44ta/

Historically, oil price cycles last two years. The 1986 crash was the only one that lasted much longer because OPEC had more than 13 million barrels of excess production capacity back them.
A common theme in all of the cycles is that the oil price tested the low three times before climbing back to the long-term trend line. As you can see on the chart above, WTI has now completed the 3rd test of the low. It may retreat again, but I doubt we see sub $40/bbl again.
This cycle started in July, 2014, so we are now 14 months into it.
On average, it takes 12 months for oil prices to crawl back to the long-term trend line after the 3rd test of the low. Adjusted for the spike in the U.S. dollar, the long-term trend line is around $85/bbl.

A few things are different in this cycle:

1. OPEC has very little excess production capacity. Saudi Arabia may have another million bbls per day they could bring to market, but they are already pushing their big waterflood very hard and they risk "coning" if they pull too hard on the producers. All other OPEC members are producing at max rates, except for Iran due to the sanctions.

2. The Iranian Nuke Agreement, or more accurately the confusion surrounding the agreement, is a dark cloud hanging over the oil market. The key thing to remember is that signing of the agreement in October by President Obama does not lift the sanctions. The Iranians must meet 17 requirements before the sanctions are lifted. If all goes smoothly (very unlikely) the sanctions could be lifted in 6-8 months. Iran has some oil in storage they can bring to market quickly, but nowhere near the 30-40 million barrels I have seen is some reports. 2/3s of the oil they have in storage is heavy sour crap that no one wants. Iranian production will increase approximately 200,000 bbls per day shortly after sanctions are lifted, but it will take a lot of work and probably two years before Iranian production returns to pre-sanction levels.

3. U.S. production capacity is falling and the rate of decline will accelerate into year-end. EIA admitting that their production forecast models are flawed is the first step. This is what I believe will bring oil prices back to around $60/bbl by year-end. U.S. production peaked at 9.7 million barrels per day in March, was down to 9.3 million BOPD in June and is probably near 9.0 million BOPD now. My estimate is that U.S. crude oil production drops under 8.5 million BOPD by the end of Q1 2016, at which time the U.S. will once again be importing more than 50% of the crude oil it needs on a daily basis. U.S. crude oil imports averaged 7.7 million BOPD in August.

4. Non-OPEC and Non-United States oil production is also going to decline by approximately a million barrels per day YOY in 2016. I see very little mention of this in the press, but today's low oil prices are impacting capital programs all over the world.

We are entering a very interesting period of the oil price cycle. This is usually when we see a lot of M&A activity. Unless you think oil prices are going to stay down FOREVER, these stocks are grossly oversold.

Below is some good advice from Mitch Zacks. Fear and Greed drive the market. Today Fears is in control, driving share prices of some very good companies down to ridiculously low levels. Mitch gives us a good history lessen. I add that this oil prices cycle is acting very much like the last one (2008/2009). The price of oil bottomed a few months earlier in 2009 than it has in this cycle, but the overall pattern looks very similar to me. Back in 2009 EAI & IEA also grossly underestimated demand growth that results from lower fuel prices. They are doing it again. The 4th quarter of 2009 was one of the best quarters EVER for the Sweet 16 (up more than 50%). In 2010, the Sweet 16 gained over 54%, with four stocks going up more than 100%. Several of our favorite small caps went up over 500% in less than a year. - Dan

Market Volatility – Like 2008 or 2009? By Mitch Zacks \ Senior Portfolio Manager

If you’re nervous about where the market is headed (after enduring two eyebrow-raising weeks of pronounced volatility) then guess what - you’re normal. Human nature is to fear losses, and memory of the 2008 bear market still lingers. Nobel Prize-winning psychologist Daniel Kahneman discovered that investors dislike losses roughly twice as much as they enjoy gains. Frankly, I think losses are despised even more than that.

It makes sense then that the current volatility has many questioning the sustainability of this bull market. The knee-jerk reaction is to sell stocks and ride-out volatility from the sidelines. But, I think that’s the wrong move and I still see this current volatility as a short-term market correction, not a bear market. To me, this market is looking more and more like 1998 than 2008.

4 Reasons I Think This Market is More Like 1998 than 2008

Many investors won’t remember this, but in 1998 the market took a steep dive from mid-July to mid-October, falling slightly more than 19% in total.

But in 1998, the market did what it classically does in a correction – it falls quickly and steeply, posts a mini-recovery mid-way through (kind of what we’re seeing now), and then it falls quickly again until the correction finds its bottom. From there though, the market powers through to a very swift recovery, which in 1998 meant climbing some 28% from mid-October to the end of the year. Investors that got spooked out of the market given that volatility would have been majorly whip-sawed. My advice: don’t be that investor.

Indeed, I see a similar pattern forming today. I wouldn’t be surprised if the market continues bouncing higher after big down days, luring investors to believe the correction is over when in fact there is still more downside left. But that’s ok! We’re only about three weeks into this downside volatility, and corrections can last anywhere from a few weeks to a few months. Market Insights September 7, 2015


Investors should brace for continued volatility, but not fear it. I still think fundamentals point to more secular upside from here, and this downside volatility should be short-lived with a quick recovery in the wings – just like 1998.

Here are four similarities I see between 1998 and today:

1) Late Stage Bull Market – 1998 was the eighth year of a ten year long bull market, and 2015 marks the 6th year of our current bull market. A lot of folks think this is too long to be in a bull market, but that’s a false thought – bull markets since the Great Depression have lasted an average of 8 or so years, meaning for this one to last two more years would be quite normal.

2) Concerns over Asian and Emerging Market Currencies – at present, many are worried that the strengthening dollar is going to doom Emerging Markets [EM], especially if you tack-on lost revenues due to falling commodities prices (since many EM countries are energy and mineral exporters). A strengthening dollar also hurts EM countries because their debt is almost universally denominated in dollars, meaning that a strong dollar equates to more costly interest payments. All very true. Interestingly though, the same scenario occurred in 1997, when global markets rattled over the Asian currency crisis. Countries like Thailand, Indonesia, and South Korea rapidly saw their currencies fizzle in value, and experts predicted a complete collapse in the global markets. But it didn’t happen. The stock market corrected then and there was a carry-over into 1998, but it wasn’t enough to send equities into a prolonged downturn. The China economy concern (and currency devaluation) of today shouldn’t either.

3) Interest Rate Hikes Looming – as it turns out, 1998 was the precursor to a series of interest rate hikes by the Federal Reserve – just like 2015 seems to be. From 1999 – 2000, the Fed raised interest rates six times from 4.75% to 6.50%, but the market also annualized 5% over the same period! For everyone that fears interest rate hikes by the Fed, all they need is a history lesson: stocks have done remarkably well during the past three rate hike cycles.

4) Optimism Building, but Not Fully Developed – there’s no quantitative evidence to support this, but my general feeling is that investors aren’t entirely comfortable with this bull market. In my view, there has to be some level of unjustified optimism about stocks in order for me to believe they are overpriced. And I just don’t see that today. In my opinion, stocks thrive on skepticism – they love to climb that ‘wall of worry.’ And that wall very much exists today, especially now.

Bottom Line for Investors

Many are tempted to think that this market’s volatility is somehow unprecedented, and the media are quick to spin the downside. But that is simply the wrong way to think. The market has endured steep quick declines in the past (1998, 2011) and recovered briskly at a moment’s notice. I think the same applies to the current scenario, and that investors should hold their breath a bit and remain patient. Downside volatility is scary, but often times it’s just temporary. I think it is this time too.

-Best Regards,

Mitch

About Mitch Zacks

Mitch is a Senior Portfolio Manager at Zacks Investment Management. Mitch has been featured in various business media including the Chicago Tribune and CNBC. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A in Analytic Finance from the University of Chicago.

ZACKS INVESTMENT MANAGEMENT, INC.