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Rekenthaler Report

Energy Stocks--The Unknowns

Energy is tempting, but its prospects are oh-so-uncertain.

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The Lure Allures
A former college roommate urged me to look at energy stocks. While not a professional investor, he has the right mindset for the task, being analytic and contrarian. And, to judge from his upcoming retirement plans, which include a beach house on a fashionable island (those liberal arts majors make a killing), he has done a few things right with his portfolio. So, I am listening.

Consider the case of  Kinder Morgan (KMI). One of the few businesses in any industry to have a wide Morningstar Economic Moat Rating, KMI has lost more than half its value during the past year. What sold for $44 as recently as last spring can now be purchased for $18.

  - Source: Morningstar

Now that's a pretty picture! (There's nothing lovelier than to watch the price of a good company go down, unless one already owns it.) History comforts, too. KMI's graph resembles those of the leading cyclical and financials companies in 2009. That summer, on the simple logic that the then-downtrodden companies would eventually resume their previous levels of profitability, and thus eventually recoup their stock losses, I bought the stocks of two cyclical companies ( 3M (MMM) and  Terex (TEX)) and--being too chicken to own their equities directly--the preferred stocks of banks (via PowerShares Financial Preferred ETF (PGF)).

Those trades worked out well, and energy companies now look to be in similar straits, so why not bite on Kinder Morgan? Believe me, I am tempted. But this time, I think, is different.

Two Unknowns
In summer 2009, there was a great unknown: the economy. The unemployment rate had jumped from 5.6% in mid-2008 to 7.3% by the year's end, and then again to 9.5% during the next six months. Unsurprisingly, consumer demand was simultaneously plunging. Neither employment nor consumer demand showed any signs of improving when summer 2009 rolled around, nor did default rates on bank loans. With the economic news going from bad to worse, most stocks understandably traded far below their previous highs.

But counterbalancing that great unknown was something that was reasonably predictable: the nature of the economic cycle. Aside from the very large counterexample of the Great Depression, all U.S. stock-market crashes in the previous century that were caused by recession (as opposed to, say, inflation or war fears, or 1987--which we still haven't figured out) ended within two years at most. The self-correcting nature of economic slumps, along with the government's fiscal and monetary interventions, has tended to reverse the stock market's reversals.

Commodity prices lack that predictable element. They have not one but two great unknowns. The first unknown is the same as the unknown of a recession: the inability to know when the decline will cease and the recovery will begin. For commodities, there is an additional unknown: Will the recovery occur at all? The cycle associated with many commodity prices, energy included, is so much more variable, so much more uncertain, that it resists being called a cycle at all. It more accurately should be regarded as a random event.

(In Donald's Rumsfeld's lingo, commodity-cycle randomness would qualify as a "known unknown." It's not a secret that commodity prices don't follow anything resembling a predictable pattern. This particular unknown is not as murky as the "unknown unknowns," which are so unknown that we don't even realize that they exist yet. However, even if known, this condition remains plenty dangerous.)

Low Conviction
Thus, to buy energy stocks today on the expectation of a rebound, with the belief that the decision might be penny-foolish during the several months but surely pound-wise during the next few years, is to be overconfident. There's nothing in the history of oil prices to suggest that recovery must come within the next three or even five years. Oil prices have the ability to surprise everybody.

Don't take my word for it--ask Jeremy Grantham. As Ben Carlson (not Carson!) reminds us, five years ago GMO's often-bearish principal enthusiastically advocated holding commodities. Wrote Grantham, "Statistically, most commodities are now so far away from their former downward trend that it makes it very probable that the old trend has changed--that there is in fact a Paradigm Shift--perhaps the most important economic event since the Industrial Revolution."

It's possible that Grantham will eventually be proven correct. It could be that 2011 through early 2016 was the very last gasp of the old regime in commodities prices and that the New Normal will be the "permanent" upward shift in value that Grantham expects. He certainly does not look to be correct right now. It's been a brutal half-decade for most commodities' prices, including oil, which was $80 per barrel when Grantham made his call.

In addition to the ongoing tug of war between supply and demand, which is an uncertainty that affects the overall U.S. economy as well as commodity prices, commodities are strongly affected by technological changes and geopolitical events. Technology may strongly increase the need for a particularly commodity, or provide a substitute, or--as with fracking and crude oil--boost its production. Geopolitically, as witnessed by Saudi Arabia's recent vow to keep pumping, commodities can be powerfully influenced by factors outside of U.S. control.

In short, if understanding the U.S. economy is difficult, understanding the direction of commodity prices is nigh impossible. John Paulson was smart to turn a $4 billion profit shorting American housing (through credit-default swaps) in 2007, but his 2012 statement that gold was his favorite long-term bet has so far looked anything but brilliant: Bullion prices are languishing at 30% under 2012 levels. As for the more-modern currency/commodity of bitcoin, it went from a few dollars to nearly $1,000 in two months, then gradually receded to $250, then recovered to $430 in the past six months. Good luck explaining that.

I will probably nibble on an energy stock during the panic. While commodity prices are mostly a random walk, it seems likely to me that oil prices are closer to a bottom than to a top. If nothing else, sentiment is terrible, and at some point--perhaps well into the future--low spot prices will improve pricing by encouraging production. But any such trade will be with house money. The case for energy in 2016 is not as compelling as was the case for economically sensitive stocks seven years back.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler has a position in the following securities mentioned above: MMM, PGF, TEX. Find out about Morningstar’s editorial policies.