A Terrible First Half Comes To An End

I was certainly not sorry to see the first half of 2017 come to an end, as the price of crude oil suffered its worst first-half performance since 1998. West Texas Intermediate (WTI) and Brent crude both fell 14% in the first half of the year. Coal and natural gas were also down by more than 10%.

The major energy benchmarks were all down as energy sector weakness extended across multiple sectors. The Energy Select Sector SPDR ETF (NYSE: XLE), which represents the largest energy companies in the S&P 500, declined by 14.8% in the first half. The S&P Oil & Gas Exploration & Production SPDR ETF (NYSE: XOP), which is more representative of the smaller-cap drillers, notched a total shareholder return (TSR) of -22.9%.

Among the 20 largest North American and Western European energy companies, only four registered positive returns. Among the five supermajors, only Royal Dutch Shell (NYSE: RDS.A) managed to eke out a positive gain with a TSR of 0.7%. 

For the upstream companies (i.e., oil and gas producers), only two of the 50 largest oil and gas producers registered a positive TSR for the first half. Fortunately, these were both portfolio holdings, which I will get to in a moment.

Midstream outperformed the upstream sector. The Alerian MLP Index (AMZ), which captures about 75% of the midstream sector’s market, registered a TSR for the first half of -6.3%. Five of the ten best portfolio performers for the half were midstream companies. 

Downstream companies fared better than upstream or midstream, as one might expect in an environment of declining oil prices. Most of the major refiners turned in positive first half performances.

Portfolio Shuffling

There were a lot of changes in the portfolio of The Energy Strategist (TES) during the first half of the year. During the half, I sold 13 companies, two more disappeared as a result of mergers, and I added three new companies. I also upgraded eight Holds to Buys.

I began to consolidate the portfolio, removing the portfolio categories (Conservative, Aggressive, and Growth) but assigning a relative risk for each holding. My goal is to shrink the portfolio down to a more manageable size. People typically only ask me about my top picks, but we still have more than 50 companies in the portfolio. 

My objective is to work the portfolio down to maybe 20-30 of my best ideas. That is reasonable considering all of the subsectors in the energy sector, and accounting for investors of varying risk tolerance. It has taken longer than I expected to whittle the size down because I believe there are so many undervalued companies in the portfolio. As the energy sector recovers, I will pick up the pace of trimming the portfolio, even as I add attractive new opportunities.

Breaking Down Performance

So, how did we do in the first half? Let’s start with the good. A year ago in May, we added solar inverter maker Solaredge Technologies (NASDAQ: SEDG) to the portfolio. (I also bought it for my portfolio). The company fundamentals looked strong, especially over the long term. Unfortunately, 2016 was a down year in the solar sector. Following an initial rise in share price, Solaredge shares fell for the rest of the year. Our recommendation ended the year down 36%. 

I couldn’t bring myself to sell, because the fundamentals continued to look good, and the outlook for the sector was bright. Strong fundamentals will ultimately win out, so I will seldom sell a company just because the stock price fell. 

So I stuck with Solaredge, and it has rewarded investors with the top portfolio performance in TES. During the first half of 2017, SolarEdge returned 61.3%, and investors who have exercised patience with this one are finally in the black.

In 2nd place, but far behind SolarEdge was recently announced buyout target Rice Energy (NYSE: RICE). Rice shares surged last month on news that it would be acquired by fellow portfolio holding EQT Corporation (NYSE: EQT). Rice ended the half up 24.7%.

The solar sector was well-represented among the top performers, as First Solar (NASDAQ: FSLR) landed in 3rd place with a first-half gain of 24.3%.

The 4th best performer was the first of five Master Limited Partnerships in the Top 10. EQT GP Holdings LP (NYSE: EQGP) generated a first half TSR (which includes dividends) of 21.2%. 

Those four companies were the only TES portfolio holdings that returned over 20% for the first half, but a total of 16 companies in the portfolio registered a positive TSR in a bear energy market. One other company worth noting is Cabot Oil & Gas Corporation (NYSE: COG), which returned 7.7% for the half. It was the only other company besides Rice Energy among the 50 largest oil and gas producers to register a positive TSR for the first half.

Now let’s discuss the negatives. At the bottom of the list for first-half performance was Bakken oil producer Whiting Petroleum (NYSE: WLL). The company operates in an area that needs >$50/bbl oil to thrive, and we just didn’t consistently have that. Whiting turned in a forgettable TSR of -54.2% for the first half.

Within the Bottom 10 is one that pains me a great deal, and that is my April recommendation Smart Sand (NASDAQ: SND), which fell 26.5% in less than three full months in the portfolio. Smart Sand has been a victim of concern that lower oil prices will reduce demand for its hydraulic fracturing sand, but I think such concerns are overblown. The very reason oil prices could remain low is due to high U.S. oil production, and that is enabled by high sand usage. 

I view Smart Sand sort of like I viewed Solaredge last year. It is unfortunate that I recommended it just before oil prices slumped, but I still believe the company has strong fundamentals, particularly in relation to its competitors. Also as with SolarEdge, I bought this one for my own portfolio, and I am sticking with it for now.  

Of 51 companies held at the end of the half, 16 had positive returns and 35 had negative returns. The average first-half return of all companies held at the end of the half was -8.0%. Of course, that doesn’t properly account for companies that were sold during the half, and it includes some that were bought during the half. Just counting the companies that were in the portfolio for the entire period, the first half return averaged -6.5%. Companies that were added during the half averaged -9.5%. 

Conclusions

The first half has mercifully come to an end, but the overall performance of the portfolio wasn’t bad considering that two of the three major energy sector benchmarks were down by double-digits. The excellent performance of the two solar companies in the portfolio certainly helped.    

I believe the energy sector is oversold, but oil prices showed strength near the end of the second quarter. I will be closely watching crude oil inventories as the rest of the year plays out for signs that OPEC’s production cuts and global demand growth are more than offsetting increased production from U.S. shale oil producers. Or not. In either case, there will be more portfolio adjustments in response to evolving market conditions. 

Finally, I want to personally thank all of the subscribers who continue to hang in there. Three of the past four years have been challenging in the energy sector, but we are weathering this storm. I will continue to constantly search for opportunities worthy of your hard-earned investment dollars. This bear market will come to an end, and I believe the portfolio is well-positioned to profit when it does.