Taking the Contrarian View on Energy

WASHINGTON -- Be careful. The energy tape may shock you.

As crude oil, gasoline and natural gas inventories grow, exploration and production stocks are on the skids. Now, threats of price caps and additional re-regulation have power companies on the blink. The energy-service stocks -- the drillers and equipment providers -- never really got out of the starting blocks in January.

Jim Cramer best summed it up Wednesday evening: Momentum has left the sector.

In a matter of just weeks, energy has gone from managers' must-have list to the must-halve list, with investors quickly whittling positions across the board. "The squeal factor is increasing quickly among energy investors," says Dan Pickering, director of research at Simmons & Co., a Houston energy investment firm, and a member of the TSC Energy Roundtable.

Pickering thinks new money may avoid the sector, at least in the short run. "Nobody wants to catch a falling knife right now," he says. "A lot of investors are willing to miss an opportunity that the sector might make a small move to the upside on the chance there is another 5% to 10% on the downside."

Politics and Prices: The Worries Continue

Among the stocks hardest hit in the recent selloff are the independent power producers, the companies that supply electricity to California and other states to keep the lights on. With the Federal Energy Regulatory Commission recently restricting prices for power sold to Western markets and congressional rhetoric threatening re-regulation of all power markets, investors are squeamish about the future growth of companies like Calpine (CPN), AES (AES) and Dynegy (DYN). The smaller-cap names with less liquidity, such as Orion Power (ORN) and Aquila (ILA), have felt even greater trading pressures.

With both oil and natural gas storage levels increasing at an unexpectedly quick pace, commodity prices have felt pressure, which in turn has dampened enthusiasm for the exploration-and-production and energy-service stocks. Want to see ugly? Just look at the charts of such companies as Apache (APA), Anadarko (APC) or Burlington Resources (BR) in the E&P space or Halliburton (HAL), Smith International (SII) or Rowan (RDS) among the energy-service carnage.

The recent action is a clear pattern. As Doug Kass pointed out a few weeks ago, energy has been a crowded trade. When perceptions began to change, the momentum shifted and negativity spread. "Energy stocks are seeing multiple compression, not earnings reductions," opined Pickering. "Stocks are going down, and they look cheaper. That makes investors ask themselves what are they missing and are earnings really going to be what they appear to be. That just feeds on itself."

Fundamentals to the Rescue?

Can a return to a fundamental focus help pull energy stocks out of the doldrums? In the near term, that will be tough. However, in the coming weeks and months, keep your eyes on the following data for some evidence of life in the sector:

• Second-quarter earnings. Unlike the first quarter, when no surprise was good enough to propel the stocks higher, second-quarter results could fuel a relief rally. The sentiment shift has been remarkable. Most companies should modestly beat consensus estimates. Listen carefully to the conference calls: The outlook will be important. Especially focus on what E&P and energy-service companies cite as their benchmark price for crude and natural gas. I'm betting estimates are still based on below-market prices, even with the recent commodity selloff. That would provide good earnings visibility ahead.

• Storage and inventory data. Both crude and natural gas storage growth have been much greater than expected. That has pressured commodity prices and hence stock prices, especially of E&P companies. I still believe that natural gas prices will rise noticeably as power consumption increases this summer. Remember, this is only June. Just like investors and commodities traders quickly forgot about the gas shortage in March, they too will quickly forget about the excess supply once withdrawals begin.

• Rig utilization. Drilling rigs in use continue to push capacity. As summer drilling activity picks up, watch the rig-count number. If it heads higher, that means demand will push supply, prices will rise and new and refurbished rigs will come to market. That is a fundamental positive for energy-services stocks.

• Corporate combinations. This is a real wild card, but after the Barrett-Williams combination, there is still talk of more mergers, especially in the natural gas space. A deal between a major integrated oil company such as ExxonMobil (XOM) or Shell (RD) and a large E&P company could help reassure investors that the large players think the natural gas price story is sustainable. Such a move should provide at least short-term support for the stocks. As E&P prices have come off their highs, murmurs about possible deals are beginning to surface once again.

• Moderation in political rhetoric. This is both a wild card and the hardest of the indicators to measure. However, congressional hearings typically give way to congressional inaction. Eventually, California Gov. Gray Davis' rhetoric will become stale and receive only back-page coverage. As they say, out of sight, out of mind. (I don't look for this to happen anytime soon.)

• Economic wild card. The other wild card is the economy. The energy recovery scenario assumes a stable economy. The economy doesn't have to grow at breakneck speed, but signs of a prolonged or deeper slowdown are bad for energy. Says Pickering: "If the economy really slows from here, energy demand will follow. That wouldn't be good for the stocks."

• Middle East wild card. I don't think you have real worries here. OPEC is committed to the $28 target and the $25-$31 price band, and that looks like it will hold. That provides good support for current earnings estimates. Iraq continues to be an annoyance, but that's about it. While the West Bank and Gaza violence is troubling, other Arab nations are yet to show any interest at all in Palestinian affairs this time around.

Cramer is right: This kind of pain is no fun for anyone. It may very well get worse before it gets better. However, if you key on these indicators, you'll have a good chance to spot the turn.

Pickering says if you can stand the pain, now might be the time to start nibbling. "We are locked into a trading range -- we have been for a year," he says. "We are at the bottom of the range. Unless you think we are headed for an economic meltdown, you have to buy the stocks when nobody else wants to. That is the only way to make absolute returns in this kind of market."

He may be contrarian, but like Kass' suggestion that energy was a crowded trade, many times that's a good way to make money. "We could see another 5% to the downside, but I refuse to get too negative because that is what everyone is doing now," Pickering says. "And, you generally make money in energy by being contrarian on a trading basis."

Why should this time be any different?

>To order reprints of this article, click here: Reprints