Energy stocks: What’s next?

Why oil prices may rise, which companies may benefit, and what the election may mean for the sector.

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Energy stocks have whipsawed in recent years, plummeting along with oil prices in 2014 and 2015 and then recovering this year as oil firmed. In recent weeks, the Organization of Petroleum Exporting Countries (OPEC) agreed to a plan that would reduce production, and the Russian government has given some signs that it may support the reduction, causing prices for oil to climb. What's next?

Viewpoints checked in with John Dowd, manager of Fidelity® Select Energy (FSENX) , to ask him where the sector stands now, where he thinks it’s headed, and how the presidential election could affect that outlook. He told us that declining supply should support higher oil prices over the coming year, but that certain stocks stand to gain far more than others—no matter who’s elected to the White House.

Would you walk us through the last two years in the energy sector? They’ve certainly been volatile—why?

Dowd: The primary factor driving this volatility has been disruptive technology entering the energy business. Back in 2008, oil prices hit $140 per barrel. That led to massive investment in research and development, and the result was new technology that enabled producers to extract oil from shale deposits—a change that enabled the U.S. industry to start growing production in a meaningful way. That production led to oversupply, which in turn pushed oil prices down and caused oil companies to take production offline. In the past two years, the U.S. rig count dropped 80% and investment by integrated oil companies dropped by a third.

Now supply is no longer growing much faster than demand. We still have high levels of oil inventory, but supply and demand look to be coming into balance. I believe the market will continue to come into balance and supply reduction will continue over the next one to three years.

Will the recovery in oil prices cause U.S. producers to bring more wells back online?

Dowd: I think for companies to bring up rig counts enough for real production growth we’d need oil prices in the $55 to $60 range. That said, in my view the most important development in the energy industry has been the push by U.S. energy companies to move down the global cost curve. That change will allow these companies to maintain production and even grow in a commodity price environment that’s causing stress throughout OPEC and among other international producers. This is because companies with disruptive technologies can thrive despite a lower commodity price environment.

How are you investing in this environment?

Dowd: I think we’re close to a cyclical turn in commodity prices, which I believe supports a higher-than-normal exposure to the sector. It’s rare to see non-OPEC supply fall, as we have recently, and that decline is likely to support higher oil prices. I don’t know when oil prices will rally, but they will need to rise in order to balance the market and spur production growth in line with global demand.

That being said, I’m not investing solely based on a positive view for oil prices. The opportunity for stock selection is huge in energy right now, because disruptive technologies are enabling some companies to thrive and causing others to suffer. Virtually all U.S. production growth in the last five years has come from a few basins that allow for low-cost production: the Bakken, Eagle Ford and Permian, and for natural gas the Marcellus and Utica. Companies without exposure to those resources have struggled not just to compete, but to survive. About 10% of the names in the energy benchmark went bankrupt last year. So this has been a brutally difficult situation for companies that have overleveraged their balanced sheets, that don’t have a good cost position, or that don’t have a geological resource that enables them to invest and grow competitively.

So what I’m looking for are companies with a differentiated ability to grow production and earnings. In my opinion, the good companies in the exploration and production industry keep getting better. There’s a learning curve to drilling these shale deposits, so you want a company that not only has a low-cost position, but also has running room. Every time they drill one of these wells, they learn something about the resource and can become more efficient.

What is your take on the natural gas market?

Dowd: Natural gas is very similar to oil. It’s been oversupplied for years, and the rig count has plummeted. But the inventory trends have been bullish over the past six months, which tells me that the market is coming into balance. The long term is more complicated, but I think the outlook for natural gas over the next one or two years is fairly bullish.

Master limited partnerships—MLPs—have been volatile. What is your view on that market?

Dowd: MLPs generally operate energy infrastructure, such as pipelines and storage facilities. People loved MLPs two years ago, when they offered substantial dividend yields and a bullish backdrop, since the U.S. was increasing production and there wasn’t enough pipeline capacity to get it to market. Today the U.S. is no longer growing production, and the companies are continuing to invest aggressively in pipeline infrastructure. So margins have tightened, funding has gotten more difficult, and valuations have become much more attractive.

Again, I’m investing selectively. I am working with our analysts to pinpoint which companies have stronger resource bases and which are seeing improved capital efficiency. I think the pipeline companies focused on the Marcellus and Permian basins are likely to outperform the others going forward.

Is renewable energy an investable theme at this point?

Dowd: Alternative energy is very challenging to invest in. Barriers to entry have been practically nonexistent, so there’s been rampant competition. At the same time, companies have the problem of serial obsolescence of technology. The concept is great: Solar and wind have gone from about 0.5% of U.S. electricity production a decade ago to 5.5% today. These are important disruptive technologies. But the WilderHill Clean Energy Index® has fallen about 80% in the same period. How can demand growth be phenomenal, but stock performance be abysmal? The industry is just extremely competitive.

I approach alternative energy by trying to pinpoint segments with defendable barriers to entry or advantages due to scale or technology. But it’s challenging, and I have been going slowly.

Any thoughts on the upcoming election and how it could affect the energy sector?

Dowd: The media has generally tried to make the case for which candidate would be good or bad for the U.S. energy industry. For example, commentators have said that Hillary Clinton would be bad for fracking companies and Donald Trump would be good for the coal industry. I don’t really believe either of those statements is useful when it comes to factors affecting investing decisions for energy companies. Coal is suffering because natural gas has moved down the cost curve. That’s just economics, and it’s going to be very hard for a president to remedy. On the other side, I think there are enough geopolitical concerns about oil and natural gas that it seems unlikely that either candidate would seriously curtail U.S. production.

How do you think energy fits into a portfolio today?

Dowd: Active management makes a lot of sense for energy, because any space with disruptive new technologies is one where owning the last generation of winners isn’t likely to work. The last generation of energy winners were OPEC and the integrated oil companies. The new winners will be whichever companies figure out how to reduce costs materially enough to get a cost advantage versus competitors. So far that’s been shale oil companies, but I think there could be an opportunities for wind and solar technologies as well.

More broadly, I tend to take a contrarian approach. I think that it can be attractive to invest in the energy sector when the biggest companies in the industry aren’t making money. You want to invest at the cyclical inflection points, when everybody’s bearish and the environment is gloomy—because this is when you can get the best values. Right now in energy, lower prices are stimulating demand at the same time the industry is curtailing supply. That’s a really, really powerful combination. So I think now is a pretty good time to invest in this sector.

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Before investing, consider the investment objectives, risks, charges, and expenses of the fund, exchange-traded fund, or annuity and its investment options. Call or write to Fidelity or visit Fidelity.com for a free prospectus and, if available for the options, a prospectus or summary prospectus containing this information. Read it carefully.
John Dowd is a portfolio manager for Fidelity Investments. Mr. Dowd currently manages energy sector portfolios and subportfolios. He joined Fidelity in 2005 as an equity research analyst. References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
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Investing involves risk, including risk of loss.
Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.
Because of its narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. Sector investing is also subject to the additional risks associated with a particular industry.
The energy industries can be significantly affected by fluctuations in energy prices, and by supply and demand of energy fuels, energy conservation, the success of exploration projects, and taxes and government regulations.
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