Finding Value After Energy Sell-Off

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The energy sector has been hit particularly hard during the sell-off. I'm here with David Meats, who's a senior equity analyst, for his take on why that could be happening.

David, thanks for joining me.

David Meats: Of course.

Glaser: It's impossible to ever point to one particular issue of what's driving an entire sector, but what do you think some of the factors are behind this sell-off?

Meats: It was a pretty strong rally in oil prices in the last six months. WTI went from probably $45 to $65 since June of last year, and I think there's really a false sense of security in oil markets caused by the OPEC production cuts and by the disappointing growth from U.S. shale last year. U.S. shale last year was expected to grow much more robustly than it actually did. Volumes were stagnated during the middle of the year, and I think that with the most recent data suggesting that that surge is finally coming, that gives investors the realization that maybe the current tightness in oil markets is more temporary than they're perhaps thinking.

Glaser: One of the big drivers really is just that the price of oil is falling here, or could be?

Meats: Essentially, you had a lot of issues in oil markets recently. There is potential for further sanctions on Iran which were waived in January, but you have the 120 day window. Maybe that's something that gets revisited later in the year. And you have a huge output decline in Venezuela, which is very positive for oil prices, but I think that investors are really assuming the worst case scenario for production this year, so on the supply side, and that actually sets us up for some potential oversupply in the back half of the year. I think it's definitely oil price-focused. I think that the rally that we did see in the last six months was not really justified, and I think that we're seeing a correction to adjust for that.

Glaser: Let's take a look at where that leaves us in terms of valuations. Even after the sell-off, are you seeing value across energy? Are there places that look more attractive, less attractive?

Meats: I think there are pockets of value. Obviously, stocks are correlated with energy prices, so a bearish outlook like we have for oil prices is not great for sector valuations. But in certain particular cases, there are opportunities. I would point to the shale focused companies at the very bottom of the cost curve that can still thrive in an environment with proof prices in the $50 or $55 a barrel range.

In particular, we like RSP Permian and Diamondback Energy. Both of those companies have very high quality acreage. We call it "Tier 1," right in the core of the play where the well productivity is the highest, which gives you the best bang for the buck in terms of the returns. We like the shale focused companies at the bottom of the cost curve, and I would also point to the midstream industry just because it's not levered to oil prices because the contracts are fee based.

We would again, as we favor the Permian Basin as the main growth engine for shale, I would point to Enterprise Product Partners and Plains All American Pipeline, those companies that are positioned to capitalize on that Permian growth.

Glaser: David, thanks for the update on energy today and for those ideas.

Meats: You bet.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.