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By Dave Meats, CFA | 01-04-2016 11:00 AM

Energy Bulls Must Be Patient and Picky

High-quality E&P bargains can be found today, but investors must be prepared to face new lows in the short term and seek out firms that can weather extremely challenging conditions.

David Meats: Going into 2016, the key question for energy investors is how long will it take for the oil industry to work through the current period of oversupply and rebalance itself? We are bullish on oil prices recovering long term to our midcycle estimate of $70/bbl for Brent and $64/bbl for WTI. But unfortunately, we don't anticipate a quick rebound.

Current supply imbalances are such that oil production, as of today, is effectively running two years ahead of demand. Declining U.S. oil production over the next several quarters should bring supply and demand back into balance during 2016, but it will take longer than that to work off the excess inventory that has been piling up in the last twelve months. 

Therefore, for oil markets to approach any semblance of normalcy before 2017--and for prices to respond accordingly--Saudi Arabia must reverse course from its current "maintain market share at all costs" approach and cut production, or global demand must surprise to the upside. Of course, the wild card is always the chance of a major geopolitical event, such as political upheaval in Venezuela or another oil-exporting nation. But if none of these high-impact, low-probability scenarios occur, then "lower for longer" looks to be the unavoidable near-term course for the industry. In fact, if global oil production continues to surprise to the upside--as it did throughout 2015--or if demand growth slows, then oil prices could test new lows before the downturn ends.

So, what does that mean for E&P stocks in 2016? We believe there are a handful of opportunities to purchase high-quality businesses at attractive prices after last year's sell-off. However, a further decline in the outlook for oil prices would weigh on the entire sector, so the financial wherewithal to tolerate extremely challenging conditions is critical. We recommend that investors play defense with companies with ample liquidity. 

Our favorite oil-weighted E&P is still narrow-moat rated Continental Resources (CLR), which has decades of low-cost inventory in the North Dakota Bakken and is one of the few E&P firms in our coverage that is expected to balance spending with cash flows in 2016. This firm is well positioned to endure even if prices deteriorate further, and should truly outperform in a recovery scenario.

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