We’ve added a number of new subscribers recently. Today I want to welcome them, thank all the subscribers for choosing us, and highlight some of my investing principles as well as the outlook for the oil and gas sectors.

The Energy Strategist is a collaboration with my colleague Igor Greenwald. We divide up the workload; each of us will typically contribute at least one article per issue. In addition, Igor will usually write the introduction, while I do the commodity update and news headlines.

I do a lot of the big picture and industry outlook stuff, while Igor researches investments within promising sectors. We are in constant communication, and we often debate and discuss the sectors and companies that we expect to do well (and others we expect to perform poorly.)

I describe myself as a cautiously aggressive investor. The “cautious” part of me tries to limit losses while the aggressive side realizes that riskier investments often provide the richest payoffs in the long run. Thus, I am willing to accept short-term volatility because I know the market’s long-term track record. I take calculated risks, but I do not gamble.

But “long term” is a key phrase. Practically speaking, this means that I often avoid making aggressive short-term trades, which are more akin to gambling than investing. Igor, on the other hand, is more comfortable with short-term speculations, so he will often initiate those.

Our styles mesh well, and during the nearly four years we have worked together we have managed to beat the broader energy sector on a consistent basis. It is of course impossible to pick all winners, but we strive to be right more than we are wrong. Over the long haul, that’s the key to accumulating wealth. That, and making sure that when we are wrong that we don’t throw good money after bad.

Given that we are sometimes wrong, it is possible that you have lost money on our recommendations. I am afraid that is really unavoidable at times. I go through stretches where I lose money in my own portfolio, but over time the wins have outpaced the losses. I would encourage you to look at the overall performance of the portfolios, and to stick with us as long as we continue to beat the broader energy sector on a regular basis. Try to diversify and pick several of our Best Buys if your investment budget allows, as this will improve your odds.

Now let’s take a look at the outlook for oil and gas producers.

Breaking Down the Sectors

First, a quick review of some industry terms. The oil and gas industry can be broadly split into three segments. “Upstream” refers to the extraction of oil and gas. An upstream company can be predominantly an oil producer or a natural gas producer, but generally will extract both.

“Midstream” businesses are those that move oil and gas from the site of production to the processing plants and storage facilities that they often own, and on to end customers. Midstream consists largely of the oil and gas pipelines that crisscross North America. Many midstream companies are organized as master limited partnerships (MLPs). Midstream companies generally act as toll collectors, charging for the use of storage tanks, pipelines and other oil and gas gathering infrastructure.

“Downstream” is the business of refining, marketing and distributing the products made from oil and natural gas. The upstream and downstream segments typically trade out of sync, with downstream often thriving when oil prices are falling (as in 2015).

Large, integrated companies like ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX) encompass all three segments. Because of the offsetting upstream and downstream business trends, the highs and lows of an integrated company will be less extreme than those of a pure upstream or downstream producer.

The Outlook for Oil

Within the upstream sector, companies can have differing outlooks depending on whether they produce primarily oil or natural gas, and depending on their geography. Right now, with oil hovering near $50 per barrel, the producers heavily focused in the Permian Basin will fare best, but they also tend to trade at a premium.

Occidental Petroleum (NYSE: OXY) is the most prolific producer of crude oil in the Permian. Large, geographically diversified oil and gas drillers like Oxy, Apache (NYSE: APA), EOG Resources (NYSE: EOG) and ConocoPhillips (NYSE: COP) are all among the region’s leading producers.

Beyond the Permian Basin, oil prices are going to have to climb into that $60/bbl range in my view in order to lift the fortunes of a broader slice of the oil sector. When might that happen? It really depends on what OPEC decides at its meeting next month.

Should OPEC announce a definitive agreement to cut production by ~740,000 bpd (the preliminary number that the group has floated), crude could get a boost to $60/bbl by year end. If an agreement fails to materialize, we are likely in for six more months of oil bouncing between $40/bbl and $50/bbl while the markets rebalance.

Given the global supply and demand trends reported by the International Energy Agency, the global crude oil market will be in balance in the second half of next year. As the growth in inventories begins to slow ahead of the markets coming into balance, traders will likely bid oil back up to that $60/bbl mark.

The Outlook for Natural Gas

In a recent conference presentation, I made the distinction between the price action of natural gas and the outlook for natural gas producers.

Throughout the year, I have argued that natural gas remains undervalued. Over the past 20 years, when natural gas prices have dropped below $2.50 per million British thermal units (MMBtu), the price proceeded to more than double within two years. The drop below $2.50 earlier in the year was only the fourth such occurrence the past 20 years, and thus a likely buying opportunity.

Over the short-term, natural gas consumption in the U.S. is strongly influenced by the weather. Cold winters increase demand, but so do hot summers as people crank up air conditioning, using more power.

The past summer was a hot one across most of the U.S., and while natural gas inventories remained relatively high thanks to prolific shale gas production, they’ve trended closer to historic norms as low prices discouraged drilling, stalling output growth.

As a result, natural gas prices that fell to $1.49/MMBtu in early March spiked to $3.34/MMBtu on Oct. 13. On that date, which corresponds to the highest point on the graph below, I published an article for Forbes titled Time To Get Cautious On Natural Gas. As you can see, my timing was nearly perfect:

Source: NASDAQ.com

OK, so maybe I was a bit lucky on the timing, but my point was that the downside risk had begun to outweigh the potential upside. It is certainly still possible that winter will be extremely cold, and natural gas prices may run up to $4. But remember, I don’t gamble. I didn’t feel like at $3.34/MMBtu the risk/reward was acceptable. As prices head back toward $2.50, on the other hand, it is once again starting to look attractive.

But natural gas stocks have been a different story of late. Many have pulled back significantly from recent highs despite the rising price of natural gas, and so present a much more compelling proposition.

This is a point Igor made in a recent update highlighting our favorite gas producer, EQT (NYSE: EQT):   

“When the share price of the best and lowest-cost producer underperforms the sector and rational expectations even as that of its principal product rises dramatically, it’s only natural to start asking questions. But after too much time spent looking for monsters under the bed, I can report that there are none under EQT’s. Rather, there’s opportunity created mostly, I believe, by investors chasing some of the hotter growth stories in natural gas.

“We expect them to circle back to EQT, perhaps after the company reports third-quarter results burnished by higher gas prices on Oct. 27. Growth pick EQT is the #2 Best Buy below $80.”

EQT did in fact report strong results, and its share price has since bounced nearly 5%.   

Our outlook for natural gas remains cautious over the short-term, primarily as a result of high inventory levels:

A mild winter, with inventories where they are, could push prices back under $2/MMBtu. A cold one, on the other hand, could send natural gas to $4. It’s really a bet on the weather, with the initial disadvantage of high inventories somewhat offset by slowing production.   

Long-term the outlook for the sector is very bright, and long-term investors should do well investing in our natural gas recommendations. I don’t know where natural gas prices will be at the end of this winter, but I believe the long-term outlook remains higher. And Marcellus natural gas producers like EQT, Cabot Oil and Gas (NYSE: COG) and Rice Energy (NYSE: RICE) will be prime beneficiaries.  

In the next issue I will give a rundown of the near and longer-term prospects of the midstream, downstream, and renewable sectors.

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