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Is Now A Good Time To Buy Energy Stocks?

It was only a month ago that I began advising investors to ease up on certain energy stocks, following 20 percent-30 percent gains since the beginning of the year. But a brutal May and a weak start to June have sent oil prices — and some energy companies — back into bear market territory.

The front-month West Texas Intermediate (WTI) crude contract ended May over 16 percent lower, which marked the first monthly loss of the year. What has happened, and is this now a buying opportunity for energy stocks?

What’s Driving Oil Price Down

There are two bearish factors weighing down oil prices. The first is that it is becoming apparent that the trade war with China will be lengthy. There are fears that this will impact oil demand there as well as here.

Add last Friday’s announcement by the Trump administration of plans to impose a 5 percent tax on all goods imported from Mexico unless “the illegal migration crisis is alleviated.” These tariffs would potentially rise to 25 percent by October. This sent a chill through the stock markets and the oil markets, with WTI losing more than 5 percent on the day.

The global oil demand picture has been mixed in recent months. The International Energy Agency (IEA) reported that oil demand numbers for the January-February period in China grew by 410,000 barrels per day (BPD) year-over-year. India’s demand grew by 300,000 BPD, and U.S. demand was close behind with 295,000 BPD of growth.

But oil prices impact demand, and they have risen sharply since January. This, along with the trade war, may explain more recent reports that overall oil demand in China had declined by 0.3 percent year-over-year in the first quarter.

That brings me to the second factor that I believe is impacting the oil markets. Every time demand in China slows down, there’s a rush to push the narrative that it’s because electric vehicles (EVs) are finally starting to take a bite out of oil demand.

This explanation promotes the fear that crude oil will soon end up like coal, which in turn helps push oil prices lower than they should be. Bloomberg recently projected that oil demand in China will peak in 2025 as a result of EVs.

Related: Is It Time For A Contrarian Bet On Oil?

Thus, there is a fear premium in that investors don’t want to be left holding a worthless commodity. I think such fears are premature. In fact, the current weakness in oil prices is totally out of sync with geopolitical factors in Venezuela and Iran.

Investment Outlook

Let’s consider a few things. First, Bloomberg also recently reported that energy stocks now account for only 5.02 percent of the S&P 500, which is less even than in early 1999. Notably, at that time oil prices had collapsed to $10/bbl and the tech bubble was depressing the share of all other sectors.

Consequently, a 5 percent energy share today is a significant historical disconnect. In other words, energy stocks are again undervalued relative to history (except those who believe we are now at the end of the oil age).

Second, we should consider the different segments of the energy sector. When oil prices fall, typically oil producers get hit the hardest. Pipeline companies usually take a milder hit, and refiners often benefit because their margins expand.

Related: Middle East Torpedo Attacks Send Oil Prices Soaring

That hasn’t been the case this time. At least not entirely. Two top oil producers, ConocoPhillips and EOG Resources saw declines in May of 3.8 percent and 8.2 percent. That’s especially modest considering the double-digit drop in oil prices.

Midstream companies held their ground. Enterprise Products Partners fell by 2.5 percent in May. Magellan Midstream Partners was one of the few energy companies that rose during the month (+1.1 percent).

The supermajors Chevron and ExxonMobil saw respective declines of 2.2 percent and 8.4 percent. Incidentally, this puts Chevron’s yield above 4 percent, which has historically nearly always been a good buy indicator.

But the big story is the refiners. The nation’s two biggest refiners, Marathon Petroleum Corp and Valero saw shares decline by 21.6 percent and 20.2 percent respectively. Valero’s yield has risen to a whopping 5.1 percent.

Refiners often trade out of sync with oil prices, but this time the concerns about overall demand, and higher-priced oil from Mexico as a result of tariffs, hit the refiners hard. Trade tariffs on Mexico could be a double-whammy if the country retaliates, because U.S. refiners send large volumes of finished products back to Mexico.

Bargains in the Refining Segment

Most segments of the energy sector are relatively more expensive than they were a month ago, considering the large drop in the price of oil. If the price remains in the current range for very long, oil producers and integrated oil companies will likely see larger declines.

The midstreams started the year undervalued, but after a large run-up many of them had reached fair value. Magellan Midstream was an exception, because it hadn’t gained as much as many of its peers. The stock was overdue; its May gain went against the rest of the energy sector.

All things considered, refiners are unlikely to suffer as much as the market fears. Further, lower oil prices will help lift gasoline demand, and that should help prop up margins. Refiners are the only sector that appear to have become bigger bargains following the oil price decline.

By Robert Rapier

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