Cheaper Energy Could Be a Mixed Blessing

Cheaper Energy Could Be a Mixed Blessing
If Prices Fall Too Far, They’d Crimp an Industry Critical to Overall Growth

Tumbling oil and natural-gas prices are great for the U.S. economy, consumers and global financial markets, right?

Not so fast. Because the U.S. is enjoying a historic expansion in energy production and the sector is more crucial than at any time in decades to the overall economy, plunging prices represent a mixed blessing for the economy and a challenge for investors.

The bottom line: If oil prices remain at current prices, about $80 a barrel, consumers and businesses will enjoy lower energy costs, while stronger energy companies will continue to profit. Investors should search for energy stocks that have been unfairly beaten down and could be bargains, analysts say, along with companies that could benefit from cheaper energy.

But if oil drops to $70 or lower, oil and gas drilling likely will slow, putting a crimp on a boom that’s moved the nation toward energy independence.

Energy prices remain “more than high enough to allow the U.S. energy revolution to remain an important growth engine in the U.S. economy,” says Daniel Arbess, who runs the Xerion hedge fund and is a partner at Perella Weinberg Partners. He argues that shares of growing American energy companies remain attractive, as are airline stocks.

“Lower oil prices are good for the U.S. economy, good for U.S. stocks,” he says.

Investors are breathing a deep sigh of relief as financial markets have rallied, after several weeks of difficulty. Falling energy prices have helped, some say.

On Friday, the Dow Jones Industrial Average closed the rocky month up 2%, the S&P 500 Index rose 2.3%, while the Nasdaq Composite Index jumped 3%. Crude oil closed on Friday at $80.54 a barrel, down 11.6% for the month.

The energy business has been among the economy’s biggest drivers. The country now produces about nine million barrels a day of crude, up from just five million barrels six or so years ago. But oil prices are down 24% from a recent high of $107 in June, and profits for energy producers likely will fall. Last week, oil giant BP was the first to report earnings that were impacted by lower oil prices.

High oil prices drove the energy expansion by making costly drilling techniques, such as hydraulic fracturing, or fracking, economically feasible. Now, oil-rich states could see slower job growth. But companies that are heavy users of oil and gas likely will benefit.

J.P. Morgan Chase argues that falling fuel prices could benefit U.S. airlines over the next few years. The bank notes the industry’s expected 11% operating margins could hit a record 14% in 2015, thanks to an estimated $4 billion fuel-bill decline. Margins could hit 15% in 2016. The bank upgraded its rating on Southwest Airlines.

Retail and restaurant shares could get a boost if energy prices remain at these levels or fall further, says Blaze Tankersley, chief market strategist at BayCrest Partners, as consumers get a break. In 2012, families with income below $50,000 spent on average 21% of their income on energy, according Bank of America Merrill Lynch.

The U.S. Energy Information Administration expects U.S. retail gasoline prices, which have declined 64 cents a gallon over the past few months, to continue falling in the weeks ahead. For the first time since December 2010, the national average pump price is below $3 a gallon. That could boost consumer spending heading into the holidays. It’s one reason U.S. consumer confidence is at levels last seen before the housing crisis.

“While domestic energy production has gotten a lot of attention lately, the fact remains that nearly 90% of the American economy are energy buyers,” says Jack Ablin, chief investment officer of BMO Private Bank.

As a result, Mr. Tankersley recommends retail shares including TJX (TJX), Ross Stores (ROST) and Target (TGT). “It’s important to realize it takes time for the effects of cheaper energy to bleed into the results, but our opinion is this trade is going to be a long one and so we accumulate these U.S.-centric consumer plays,” he says.

Investors should focus on well-run master limited partnerships—publicly traded entities that generally own and operate oil and gas pipelines—that have been pushed down, says Ethan Bellamy of Robert W. Baird & Co. Examples include Energy Transfer Equity (ETE) and Plains GP Holdings (PAGP), which have dividend yield of nearly 3% and high growth rates.

“The downturn saw some indiscriminate selling of very high-quality, highly resilient business models,” says Mr. Bellamy.

Darren Pollock, portfolio manager of Cheviot Value Management, is a fan of Chicago Bridge & Iron (CBI), an engineering and construction company that helps build energy infrastructure but whose shares have slid 25% since May, partly due to falling oil prices. “Fluctuations in energy prices cause people to forget that energy consumption grows nicely over time,” Mr. Pollock says. “Spending on energy infrastructure build-out continues to have a long runway ahead of it.”

As the U.S. begins to ship liquefied natural gas abroad in the years ahead, Chicago Bridge will play a role building export terminals and other energy facilities, Mr. Pollock says. Chicago Bridge is growing in China, a nation expanding its energy capacity. Some of the world’s top investors are its biggest shareholders, among them Warren Buffett ’s Berkshire Hathaway, the company’s largest holder, and David Tepper ’s hedge fund Appaloosa Management.

For investors convinced that oil and gas prices won’t fall much more, attractive exchange-traded funds include SPDR S&P Oil & Gas Exploration & Production ETF (XOP) and Energy Select Sector SPDR Fund (XLE), says Steven Azarbad, chief investment officer at Maglan Capital.

But if China’s economic growth continues to slow, Saudi Arabia keeps pumping crude apace, and U.S. energy companies continue to boost oil and gas production in shale formations, energy prices could fall further, hurting small and midsize energy companies with heavy debt, says Daniel Katzenberg, a senior analyst at Baird. Many of these companies have found it easy to raise money by selling junk bonds and through other methods, but they’ll likely find it harder to raise funding unless oil prices rebound.

Among the companies to be wary of, he says: SandRidge Energy, Halcon Resources and Goodrich Petroleum.

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