Eroding Hopes for Some Energy Stocks in Tough Environment

Stuck in a long-term bear market, money managers are warning of more pain ahead for energy stocks. In fact, fundamentals – as in ample stockpiles, plentiful refined products and rising production in Iraq and Saudi Arabia – suggest that the odds are firmly stacked against a sustained rally and point toward ‘lower for longer' commodity price expectation.

After several industry biggies came out with abysmal quarterly results, some sector observers feel that the door is open for one more retest of the multi-year lows that oil and natural gas fell to in the first quarter.

With no guarantees that things will improve in the near-to-medium term, investors would be better off ignoring the following set of stocks.

Challenging Refining Backdrop Weighs on Downstream Operators

Till recently, U.S. downstream (refining and marketing) stocks were seen notching up healthy gains and earnings beats. This is because the companies use oil as an input from which they derive refined petroleum products like gasoline, the prime transportation fuel in the U.S. Hence, lower the oil price, higher will be their profits.

But with the cost of gasoline, heating oil, and other refined products catching up on the beaten down crude price, crack spreads (or refining margins) are under pressure. This is expected to impact the refiners' near-term profitability.

As per the U.S. Energy Department, the existing stock of gasoline is significantly higher than the year-earlier level and is comfortably above the upper half of the average range. This refers to low demand for the most widely used petroleum product and has cast a deep shadow over the performance of refiners

As a result of these bearish factors, the tendency for a downward estimate revision has been more obvious in recent times. Companies like HollyFrontier Corp. (HFC), Valero Energy Corp. (VLO) and Phillips 66 PSX look to be in most trouble.

E&P Cuts Hurting Oilfield Equipment Suppliers

With new competitors entering the market and shrinkage of capital expenditure spending by the drilling contractors, oilfield machineries and equipment suppliers have seen their pricing fall drastically. In particular, the companies' margins have been hit hard by the ongoing North American drilling slump. The situation – characterized by tepid demand and weak pricing – is not expected to normalize anytime soon.

While firms catering to North American land drillers have been the worst affected, lack of new deepwater drilling orders are starting to haunt the subsea part of the industry. As it is, the commodity price rout has made a number of deepwater drilling projects uneconomical. With contract backlog down, most of the players are facing continued pressure on revenues, earnings and cash flows.

In particular, we suggest avoiding exposure to Dril-Quip Inc. (DRQ), Weatherford International plc (WFT) and Natural Gas Services Group Inc. (NGS).

Depressing Prices Make It Difficult for Gas-Weighted Companies

Natural gas has rebounded strongly (by around 60%) since hitting 17-year lows of around $1.6 per million Btu (MMBtu) in the first quarter. The phenomenal run up notwithstanding, the commodity is struggling to reach the psychologically important $3 per MMBtu level. And with expectations of surging supplies in North America amid tepid demand, there appears no reason to believe that the supply glut will subside and natural gas will be out of the dumpster in 2016.

Consequently, natural gas-weighted exploration and production companies like WPX Energy Inc. (WPX), Rice Energy Inc. (RICE), Chesapeake Energy Corp. (CHK) are in for a tough time. Gas-focused partnerships like Williams Partners L.P. (WPZ) and ONEOK Partners L.P. (OKS) tend to suffer too, from falling sales for their natural gas liquids NGL processing.

Check out our latest Oil & Gas Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy.

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