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Over the last 20 years there has only been one meltdown in the oil market as violent as the one occurring today.
That was in 2008, when oil prices fell 75% from a record-high $147 in a matter of months.
This time, oil has fallen 50%, from $110 to $55. The fall hasn’t (yet) been as swift as the 2008 crash. But then again, the run to $110 wasn’t nearly as swift as the run to $150 either.
No corner of the energy market has been immune to the fall. In fact, last week was the sixth-worst week in history for Master Limited Partnerships (MLPs). Because of their defensive characteristics and high yields, MLPs tend to be among the most stable energy investments.
But their 9.6% fall last week was the sixth-worst in history. And according to Credit Suisse (NYSE:CS), MLPs are on pace for their third-worst monthly performance ever in December. Since the end of August, the Alerian MLP Index is down 18%.
While MLPs have been hard-hit, the energy exploration and production stocks have really taken it on the chin. The SPDR Oil & Gas Exploration & Production ETF (NYSE:XOP) is down 45% since the end of August.
With the price of oil and oil-related stocks so beaten up the question now is what, if anything, should investors do.
There is little doubt that valuations in the sector are cheap. After all, the yield on the Alerian MLP index is 6.43%, while the U.S. 10-Year bond yield is 2.08%.
That means the spread – the difference between the two yields – is 4.35%. That’s a large spread, and it suggests that MLPs will do very well over the coming months. Data from Credit Suisse suggests that when the yield spread is this large, MLPs average a 25.1% return over the ensuing 12 months.
In order for that yield spread to close, the price of MLPs needs to rise (which would bring down their yield) or the yield on the 10-year needs to rise. A third possibility is that MLPs cut their dividends. This would also bring the yield (and hence the spread) down. But at this stage I think it’s too early for MLPs to engage in widespread dividend cuts.
The punchline is that, based on this one historical measure, MLPs look attractive to investors that have the patience to stick to their guns. A couple of best-in-class names to consider include Kinder Morgan (NYSE:KMI) and Williams Companies (NYSE:WMB).
Investment in the oil producers is a little more complicated. One of the factors that drove oil prices down is the abundance of supply. In overly simplistic terms, a supply cut has to come from the major players – i.e. either from the U.S. or OPEC (or both) – to bring the market back to equilibrium.
Naturally, price plays a role as well since at a certain depressed price producers will cut back anyway since it will no longer be profitable to produce.
The most defensive oil producer investments are therefore European and U.S. majors that have the lowest production costs. Total (NYSE:TOT) and Chevron (NYSE:CVX) are in this group.
A more aggressive option is the pure-play U.S. producers that have the best acreage. With production costs lower than the competition, these companies have a chance to not only generate cash flow, but also to acquire beaten-up competitors. And the latter scenario is one which I think will play out early in 2015. The pickings are just too attractive to pass on for companies with stellar balance sheets.
Again, patience here will be critical as oil isn’t likely to rebound as quickly as it fell. That means investors should stick with the best-of-breed names that they have confidence in to ride out this bear market in energy.
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