Get ready for a sale on energy stocks

The current quarter has continued to highlight the sector's challenges and its long-term potential.

By InvestorPlace Sep 28, 2012 8:36AM

iplogo

oil rigBy Aaron Levitt

 

With autumn upon us and the air starting to feel crisp, we know the end of the third quarter is close by -- which means it's time to look back and see how the energy patch fared during the past three months.

 

It was a doozy of a quarter.

 

While there weren't any blowout earnings announcements or upside surprises -- in fact, it was quite the contrary -- there was plenty of activity in the sector. From hurricanes to major asset sales and acquisitions, the energy sector was abuzz with activity.

 

Overall, the oil patch was mixed as slowing global economic growth and falling futures prices for both natural gas and oil continued to have their way will firm's bottom lines. Yet, broad energy sector measures -- like the Select Sector Energy SPDR (XLE) -- saw prices rise as the fed unleashed a third round of quantitative easing, providing comfort to investors despite the sector's lower guidance.

 

The latest quarter continued to highlight the challenges as well as the long-term potential facing the energy sector:

 

Falling prices = lower earnings

Spilling over from the second quarter, stalling global growth continues to have its way with energy commodity pricing across the board. While there have been some recent price spikes -- such as the flare-ups across the Middle East -- prices for a range of fuels have drifted lower during the third quarter on excess supplies amid dwindling demand.

 

China's declining production and the eurozone's drop in manufacturing caused much of the price decrease, while speculation the U.S. and world would fall into a recession didn't help either.

 

Overall, crude oil slipped to just $77.69 a barrel in June and natural gas is more than 70% below its all time high reached in 2008. The main energy commodities slumped as supply increases -- due to the hydraulic fracturing boom making it easier to extract them -- outpaced global consumption.

 

Those overall lower prices during the quarter have wrecked havoc on E&P earnings. A wide variety of firms, such as Occidental Petroleum (OXY) and Devon Energy (DVN), have reported generally lower earnings as these lower prices have taken hold.

 

Analysts now think income from the oil & gas sector will fall 24% for the three months ending in September. That decline would be the biggest decrease in three years, according to data compiled by Bloomberg. Earnings for the oil patch fell 17% between April and June after dropping 3.8% for the first three months of 2012. With prices for various natural gas liquids now declining, it could be a rough earnings season ahead.

 

Acquisitions continue to rule the roost

As legacy wells dry up, the continued need to boost dwindling production drove another trend during the third quarter -- acquisitions. We saw a host of blockbuster deals as many firms dove headfirst and snatched up quality fields at bargain prices.

 

The quarter started with a bang, as China's biggest offshore oil and gas explorer, CNOOC (CEO), agreed to pay roughly $15.1 billion for Canadian energy firm Nexen (NXY). The deal -- which is the latest in a long string of many for China -- was deemed necessary to help turn the tide of the Asian Dragon's growing long-term energy demand. Analysts estimate that China will continue to come back to North America to do its energy shopping for some time to come.

 

It'll certainly have plenty of opportunities as beleaguered firms like BP (BP) and Chesapeake (CHK) continue divesting assets.

Capping off the quarter was another forward-looking purchase from Exxon Mobil (XOM). In its largest deal since buying XTO back in 2010, the energy major agreed to buy nearly 196,000 acres from Denbury Resources (DNR) in North oil-rich Bakken shale. The deal, valued at $2 billion, will go a long way to help boost the world's largest publicly traded energy company's output of crude oil.

 

While it remains to be seen just how successful all of these deals will be, one thing is for certain -- their sheer number and size are increasing.

 

Downstream surges forward

We've written about the harsh reality that has been the downstream or refining sector before here at InvestorPlace. The refining sector looked pretty grim earlier this year when higher crude oil prices put severe pressures on the refiners' margins. Well, for the past few quarters -- and continuing into the third -- things have gotten pretty good for refiners and marketers of crude oil products.

 

Refiners are realizing a huge boost to their bottom lines not only from lower crude oil prices, but from exporting record amounts of gasoline. For the first time since 1949, the U.S. exported more gasoline, heating oil and diesel fuel than it imported.

 

Basically, U.S. refiners are using their low-cost advantage over foreign downstream operators to export record amounts of gasoline and profit from the spread. That advantage is leading to rising earnings from firms like Valero (VLO), Tesoro (TSO) and HollyFrontier (HFC), and could signal the start of a new golden age for the refining sector.

 

A positive outlook for the fourth quarter

Looking forward, things might be picking up for the energy sector. While average prices for crude oil and natural gas were at lows throughout Q3, already we've seen some increases across the board. Crude has surged roughly 20% to reach $93 a barrel since its nine-month low in June. Likewise, natural gas has risen 60% since hitting a 10-year low back in April.

 

All in all, analysts estimate that these rising prices should help producers see a slight increase in profits for the fourth quarter, then an 8.8% profit gain in 2013.

 

Additionally, lower prices in the third quarter could (and should) signal lower capital spending budgets and force drilling activity levels lower -- something we've already seen occurring in the natural gas space. That'll help boost prices even more for the next couple of quarters to the so-called "sweet spot," where producers still make money without crippling demand.

 

For investors, all of this means it finally could be time to buy the energy sector as the earnings reports roll in. Remember, these reports deal with lower third-quarter issues -- not the current pricing environment we are in. Odds are shares of the E&P firms will drop on the "bad" news, resulting in plenty of bargains.

 

By and large, it just goes to show how looking back can lead to future opportunities.

 

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

 

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1Comment
Sep 28, 2012 12:16PM
avatar
Yes and as soon as the recovery hype starts after the election and holidays we'll see gas and oil skyrocket so there back to highs right before Spring Break and Summer vacations. It's all so predictable.  Buy STO and get a 4.4% dividend next May.
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