Shaping a Portfolio for 2016: dealing with oil

Energy stocks now make up about 7% of the market capitalization of the S&P 500.  That’s not much.  They make up about 14% of the junk bond universe, however.  And they’re a huge chunk of emerging markets.  To my mind, it’s the spillover effect from these latter two areas where the price of energy may have an effect on the stock market.

forecasting earnings

I think it’s impossible to know what the earnings of oil and gas stocks will be for 2016.

If an exploration company spends $10 million to find 1 million barrels of oil, oil and gas accounting rules call for it to expense $10 of finding costs every time it produces a barrel.  On top of that, it expenses the out of pocket costs of extraction.

A complication:  suppose the extraction costs exceed the selling price of the oil.  If so, the oil company won’t produce any.  It won’t have revenue, but it won’t have a loss on its income statement, either.

If, however, the oil company decides the field is permanently impaired, it could write part of all of the cost of the field off at the end of this year.  That would allow it to show an accounting profit on output from that field in 2016.

This kind of housecleaning has already begun with Royal Dutch Shell, which has written off a number of high cost projects.

To the extent that the industry as a whole has large, non-recurring writeoffs this December, 2016 earnings will look better than we now think.  We won’t know this for a while, however.

reported earnings probably don’t matter that much

It seems to me that the stocks are no longer trading on reported earnings, but on the spot price of oil and gas instead.

It strikes me, too, that we’re now entering some sort of capitulation phase with oil and gas stocks, where panicky investors tend to throw the baby out with the bathwater.  This phase could last a considerable amount of time, especially if energy prices continue to slide during what is supposed to be the strongest season for demand.  So there’s plenty of scope for near-term bad news.

We’ll know that the capitulation is over only when the stocks stop reacting negatively to oil/gas price declines.

the energy sector is now a small part of the S&P 500

At today’s size, it would take a 15% fall in the Energy sector to clip one percentage point off the return on the S&P 500.  One could argue that in this sense, oil and gas no longer have a large bearing on the fate of the index.

one worry

It seems very clear to me that the current decline in energy prices is similar to what happened during 1982-86.  That is, a period of very high prices leads to the creation of supply overcapacity that causes the price to subsequently plunge.

I don’t think there are wider macroeconomic implications.   It’s all about the microeconomics of benefit to oil consumers and hurt to oil producers.  For the S&P 500, that ends up being a net plus.  For emerging markets, especially for OPEC, it’s a net minus.

I find it hard to follow the logic of the argument that if very high oil prices are bad for the world economy, then low ones are also bad.  Yet that’s what I’m beginning to read and hear in the financial media.  It’s taking the form of a claim that the price decline is not being caused by oversupply–which it clearly is–but by a recessionary falloff in demand.  The low oil price, these commentators say, is the first evidence that the world is entering a business cycle decline.

If investors in general begin to believe this, we could talk ourselves into a period of stock market weakness.

For long-term investors, this shouldn’t have any effect on investment strategy.  For more trading oriented, a stock market selloff based on false premises could provide a buying opportunity.  When?  My guess is as we enter the seasonal energy lull early next year.

 

 

 

 

 

 

 

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