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Oil's Slide Is Causing Slick Investing Conditions

Matthew Coffina, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. A slide in oil prices has led to pressure on the energy sector. I'm here with Matt Coffina--he's the editor of Morningstar StockInvestor newsletter--to see what impact it's going to have on his portfolios. Matt, thanks for joining me today.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's start by looking at that slide in oil prices. What, in your mind, is really the biggest driver here? Is it just too much supply in the market?

Coffina: Well, it seems to be a combination of both supply and demand. So, certainly, the outlook for economic growth in much of the world has been weakening in recent months, particularly outside of the U.S. in Europe, China--and China really has some follow-on effects in other emerging markets. And then that has coincided with very robust supply, especially out of North America but also a return of production in Libya and surprisingly strong production in much of the Middle East. So, the combination of strong supply and relatively weak demand has really hammered oil prices here. As of right now, Brent crude oil is trading at about $67 a barrel, which is basically a five-year low and down from $115 as recently as June of this year.

Glaser: That's a pretty substantial slide. Is that within the realm of what you would expect from commodities? Or has this really caught you and the rest of the market off guard?

Coffina: Well, I think we were definitely taken by surprise in terms of the extent and the speed of the decline. I wouldn't say that this level of volatility is necessarily unusual or abnormal for commodity markets. In the last five years, the price of oil has ranged anywhere from $67 a barrel now to a high of about $128 a barrel. Over the past 10 years, the low was maybe $34 a barrel and the high was $144 a barrel. So, oil prices are very, very volatile and I think that's important for investors to keep in mind. If you are going to be an investor in energy, you need to be willing and able to weather these kinds of disruptions that will happen from time to time.

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Glaser: Given that this volatility is out there, how does it impact the way that you think about the energy holdings in your portfolios? Have you gone back and reassessed your thesis for holding them?

Coffina: Well, it definitely has an impact on the intrinsic value of pretty much any energy company. The good news, first of all, is that we're very well diversified in the Tortoise and Hare portfolios, so our energy weighting is roughly in line with the S&P 500--about 9% in both of our portfolios. We talked a couple of weeks ago about how I'd sold Energy Transfer Equity (ETE). And certainly, I had some company-specific concerns about the valuation there, but that sale also enabled us to go from an overweight to energy in the Hare portfolio to more of a market-weighting. So, I don't think we're overexposed, nor are we underexposed, if energy prices recover here.

Other than that, I'm really focused more on the somewhat more conservative side of things. So, in our Tortoise portfolio, we only hold midstream energy companies, which should have well-below-average commodity-price sensitivity, especially our particular midstream companies. They tend to be much more focused on natural gas or natural gas derivatives rather than oil. They are broadly diversified. They have a very broad set of assets. For the most part, they have long contracts with shippers--take-or-pay contracts--so the shippers are obliged to pay them regardless of whether or not they use the capacity. So, there's relatively little direct commodity-price sensitivity with our midstream energy companies and, in particular, sensitivity to oil prices.

In the Hare, we take on a bit more risk. We own two oilfield-services or equipment names, National Oilwell Varco (NOV) and Schlumberger (SLB). I really made a big mistake here, buying Schlumberger in mid-August of this year. My timing couldn't have been much worse. At that point, Brent crude oil was trading at about $99 a barrel. So, it was down from the peak of $115 earlier in the summer; but still, the price of oil is down more than 30% since I bought Schlumberger.

So, if I'd had any notion that oil prices were about fall off of a cliff, I certainly wouldn't have done that. But the good news is that, on one hand, we're protected by diversification. On the other hand, our fair value estimates for Schlumberger and National Oilwell Varco have been falling, and there is no doubt that lower oil prices are going to have an impact on these companies. That's going to result in oil and gas producers cutting back on exploration expenditures, cutting back on big projects--and the capital expenditures of oil and gas companies are the revenue of oilfield-services and equipment names.

So, our fair value estimates have been coming down. But we started with such a wide margin of safety; these stocks were generally trading at such a wide discount to fair value--and Schlumberger, in particular--that even with the fair value down significantly, it's still meaningfully above our purchase price and even further above the current stock price, which we think is baking in a bit too much pessimism about exactly how long this oil price slide is going to last and what it's going to mean for a company like Schlumberger.

Glaser: Our energy analysts, on this slide, are seeing a number of opportunities opening up. Do you see this as a chance to maybe increase your energy weighting, to go above what the S&P 500 has?

Coffina: I think the most important thing that we've learned from this experience is that commodity prices are just very, very difficult to predict. Our analysts do their absolute best. It's necessary to come up with a long-run oil price forecast to be able to value energy companies. Right now, our long-run oil price forecast is still $100 a barrel, which is based on what we think is the marginal cost of production for the highest-cost resources--things like oil sands mining, ultra-deep water.

But that marginal cost is really a moving target. There is a very high degree of uncertainty, in my view, surrounding that $100 a barrel price forecast, and it could just as easily be $75 or $125. So, for example, if demand weakens, it could push some of these very high-cost sources of supply off of the supply curve altogether. Maybe you don't need oil sands mining or ultra-deep water to meet demand anymore, in which case they are no longer relevant to setting the price. Similarly, the price of oilfield services and equipment: As companies pull back on their capital expenditures, the price of equipment tends to go down, labor becomes more easily available, and all of that can weigh on marginal costs.

So, there's a very high degree of uncertainty surrounding future commodity prices. I'm cautious for our portfolios about increasing our weighting beyond what we already have--which, again, is a roughly market-weighting, or in line with the S&P 500. And I think, on balance, our companies are somewhat less exposed to commodity prices than a lot of the rest of the energy sector.

I think investors who are willing to take a little more risk, or maybe who have a little more confidence in the long-run oil price outlook or natural gas prices for matter, could certainly take on more risk and get a lot more potential upside out of some smaller exploration-and-production companies or some of the oil majors and so on. But it really just depends on how much risk you're willing to take and how confident you are that this is a short-term pullback in oil prices versus a sign of longer-term change in supply-and-demand dynamics.

Glaser: Matt, thanks for your take on the oil price slide today.

Coffina: Thanks for having me, Jeremy.

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

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