Undermining Energy

Has the bull market in energy stocks come to an end?

After rallying early in the year, oil and gas company stocks have slipped precipitously in recent weeks. In fact, in the past two weeks, while the S&P 500 has lost about 2%, the Natural Gas Index, or XNG, and the Oil Services Index, or OSX, have lost nearly 8% of their value. Even the Oil Index, or XOI -- which has support from the large, integrated oil companies -- has underperformed the broader market. And, as the chart below indicates, while energy has outperformed the broader market since January, the gap between the S&P 500 and energy stocks has narrowed significantly in the past several weeks.

Losing Ground While energy has outperformed the broader market, the gap between the S&P 500 and energy stock has narrowed

The recent weakness in oil and gas stocks is creating concern over the long-term trend for the sector.

"You have an energy stock market that is spooked and commodity prices that are a bit spooked as well," says Dan Pickering, director of research at Simmons & Company and a member of the TSC Energy Roundtable. "The jitters in energy stocks are clearly a function of big picture fears, especially uncertainty about the economy."

Energy demand suggests the economy is slowing. Both oil and gas storage data paint a picture of a reduced demand and increased inventories. Natural gas "storage withdrawals have been less than expected and we've seen a big build in crude oil inventories as well," Pickering says. "Part of the reduction in withdrawals earlier in the year was price-driven but now that prices are moderating, you would expect to see price-sensitive demand return. We haven't seen that happen."

Until the economic uncertainty is removed, energy investors should experience a heavy market that trades in a fairly tight range. Pickering sees the natural gas index trading between 215-250 and the oil services index between 100-120 with a bias to the downside. "Until there is something that puts an end to the uncertainty, the stocks will have a hard time making a big move to the upside."

Uncertainty in the markets has led to multiple compression. Investors remember all too well the impact of the 1997-98 global economic jitters and the impact on energy stocks. The "Asian Contagion" helped push the OSX to 45 and the XNG down to 100. With the "tech wreck" fresh in their minds, energy investors don't want to get caught in a similar downdraft.

"That's why it's tough to be aggressive and pound the table on the group," Pickering says. "You know the downside is significant if the economy and earnings roll over."

Short-Term Caution, Long-Term Optimism

There simply aren't many positive catalysts to move energy stocks higher in the short term. The economy isn't on the side of robust energy demand; it is entering the traditional, seasonally weak period for commodity prices, and investors expect energy companies to beat earnings expectations. The only earnings surprises likely to have investment impact are those companies that don't exceed expectations.

Still, the long-term energy story is intact, especially for natural gas. While relatively moderate temperatures toward the end of winter kept natural gas supplies above the critical 500 billion cubic feet level (storage will likely end this month at about 650 bcf), this is the first year of significant demand for summer natural gas to fuel new gas-fired power generation.

That should keep gas prices firm this summer and push prices even higher next winter. "With the withdrawal season winding down and no significant catalysts driving the market, the next few days should see gas trade in the $5 to $5.50 range," says Dain Rauscher Wessels' analyst Mark Easterbrook. "In the long term, we continue to believe that there will not be enough natural gas injections this summer to reach normal storage levels for the next season, causing prices to increase and experience volatility."

Pickering agrees. "I still think gas is the place to be," he says. "You look to gas-focused names, you look for attractive valuation relative to peer companies and you stick with relatively decent size market caps."

That pushes him toward the convergence names, companies that leverage natural gas to produce electricity and enhance their portfolios through trading and marketing.

He suggests investors look at companies like Dynegy (DYN Quote - Cramer on DYN - Stock Picks) and El Paso Energy (EPG Quote - Cramer on EPG - Stock Picks). He also suggests investors take a look at exploration and production companies leveraged to natural gas and land and offshore drillers with "a lot of North American exposure."

Companies like Ensco (ESV Quote - Cramer on ESV - Stock Picks) and Global Marine (GLM Quote - Cramer on GLM - Stock Picks), as well as Nabors (NBR Quote - Cramer on NBR - Stock Picks) and Anadarko (APC Quote - Cramer on APC - Stock Picks), are on Pickering's radar screen, although he believes they may all be available at lower prices in the coming weeks. "Don't buy anything that you wouldn't want to buy more of if the stock fell 10%, because it might do that in this ugly tape," he notes. Simmons has not provided banking services to any of the companies mentioned.

Given the uncertainty, Pickering is using the recent pullback to put "incremental money to work at selected price points and start establishing positions in selected names."

He still has conviction that energy will outperform the broader market over the next several years, a result of too much demand chasing too little supply and the need to build infrastructure and production in natural gas, power and oil.

Still, energy investors may endure a stormy spring as economic uncertainty and a seasonal slowdown in demand pushes temporary storm clouds over the sector.

"When the market decides the economy isn't going to be any worse than is built into assumptions right now, the energy group will have hit a bottom, but not until then," Pickering says. "It is hard for these stocks to go up until investors believe earnings and the positive outlook are sustainable. Is that six weeks or six months from now? It's hard to know."