Diversify Your Core Energy Portfolio

The Sage of Omaha, Warren Buffet, once memorably said that we should be fearful when others are greedy and greedy when they are fearful. On that basis, now is a great time to invest in energy. The dramatic fall in the price of oil that took place in the second half of 2014 highlighted the risks associated with investing in a sector dependent on commodity prices, but has left most energy related stocks, even those with only an indirect relationship to the price of oil, looking cheap.

In the short term, of course, oil could continue to fall and drag all energy stocks with it, but from a long term perspective, energy is still a huge growth area. The world’s population continues to grow and developing countries continue to develop. Those two facts mean that demand for energy, while it may fluctuate with economic conditions, is firmly set on an upward path.

That doesn’t mean, however, that the energy market will still look the same in the future. Investors are entitled to whatever view they wish to take on climate change, but from an investment perspective it always pays to act on what is happening rather than what you think should happen. The fact is that even countries that previously prioritized growth over the environment, such as India and China, are beginning to work towards a future with lower emissions. Alternative energy sources will no doubt continue to attract research and investment and the “cleaner” fossil fuel, natural gas, will gain ground on oil and coal.

Exposure to energy, then, is a must for any investor, but that exposure must be balanced. The complete makeup of an energy portfolio should remain somewhat flexible as the global energy market is in a state of flux. Given these shifting conditions and the natural volatility of energy markets, diversification is essential for a core portfolio. Some risk mitigation and volatility reduction can be achieved by using one stock from each of three sectors, conventional oil, alternative energy, and oilfield services. These three companies, one from each of those sectors, would be ideal as core energy investments.

Conventional Oil: Chevron Corporation (CVX)

Chevron, along with everything else even vaguely connected to oil, got hammered from the end of June 2014 until October as oil prices fell.

The chart for that time (above) looks pretty scary but put that period in the context of a 10 year chart and it becomes obvious that the inevitable upward trend of oil stocks is still intact.

From that perspective the recent volatility looks more like a buying opportunity than a cause for concern.

Conventional measures of value for a stock confirm that impression. Large oil companies, because of the risk involved in exploration and production and because the days of rapid growth are considered to be behind them, usually trade at a discount to the broader market in terms of the Price to Earnings Ratio (P/E). Even so a forward P/E of around 11 for Chevron when the average for the S&P 500 is around 50 percent higher than that is remarkably low.

I can understand some degree of pessimism regarding big oil with the prevailing trend towards conservation and clean energy, but demand for oil keeps growing. The International Energy Agency (IEA) predicts that it will continue to do so, reaching 94.69 million Barrels per Day by the end of 2015.

Chevron certainly doesn’t think the future looks bleak. They continue to invest in new oil plays, conventional, offshore and shale, and produced the first oil from the Gulf of Mexico “Tubular Bells” field in November. Meanwhile, they continue to invest in alternative energy sources, with geo-thermal, wind and solar plants and fields already developed. In other words, big oil isn’t going anywhere and a diversified multinational such as Chevron should form the cornerstone of any energy portfolio.

Alternative Energy: First Solar (FSLR)

The likelihood of governments around the world continuing to favor alternative energy, however, means that the potential that many have seen in alternative energy, particularly solar power, may be fulfilled over the next 5-10 years, so a pure exposure to that area makes sense in a core energy portfolio. The problem that investors face in this field is one that always exists in heavily subsidized industries; it is hard to separate the wheat from the chaff.

For that, if for no other reason, it pays to look for companies that have already experienced tough times. Firms such as SolarCity (SCTY), the Elon Musk backed company that has rapidly become the largest supplier of domestic solar power units in the U.S. market, may have enormous potential, but they have yet to show that they can survive in less favorable market conditions than at present. First Solar (FSLR), however, is another story.

FSLR went public at the end of 2006 at $20 per share, and investing in the potential of solar power quickly became frenzied. So much so that by May of 2008 the stock was trading at over $300. When the more general market collapse began, FSLR got hit hard. “Potential” and “risk” were dirty words as recession took hold and FSLR was punished for embodying both.

Then, just as it seemed that the rot had stopped, the Chinese government began investing heavily in solar technology and effectively flooding the PV cell and panel market with cheap products. Despite the recession and the massive increase in competition, however, First Solar is still around. As the market to supply panels for individual houses has become more competitive, they have shifted focus to concentrate on utility projects and, in doing so, returned to profitability the last two years. In 2012, when it became clear that demand growth in the solar business was not going to meet the exaggerated expectations that some still clung to, they set about rationalizing their business and closed or idled plants in Germany and Malaysia.

This ability to adjust to a changing market bodes well for the future. Assuming that demand growth returns steadily in the industry, as alternative energy continues to become increasingly mainstream, First Solar is well positioned to benefit and now is a good time to buy.

In the fourth quarter of 2014, FSLR has dropped over 35 percent, reflecting lower energy prices in general, but falling even more than oil has fallen. Several years ago, when solar power was extremely expensive compared to more conventional sources that would have made sense, but with costs now running at close to $0.60 per Watt, and continuing to fall, that relationship between the oil price and demand for solar panels is becoming less fixed.

If we therefore assume that demand will continue, then FSLR, at a forward P/E of around 11, looks remarkably cheap. I can understand that investors would be nervous about solar power in general given the industry’s failure to live up to the hype in the past, but the future looks decent. Many companies, even ones with a solid record of profitability such as FSLR, look to be priced from an assumption that they will disappoint again. If they do not, then a discount of over 30 percent to the broader market will look like a bargain over the next few years.

Oilfield Services: Schlumberger (SLB)

The big drop in oil prices has resulted in some value in certain sectors of the energy industry, but in many cases that value is dependent upon the declines being arrested fairly soon. The fact that oilfield service companies have fallen almost in lockstep with oil prices, however, makes little sense wherever prices go in the future and smells more like the kind of panic Mr. Buffett was referring to.

Oilfield service companies have very little direct exposure to oil prices. While prices that fall further and then remain low would impact the medium term prospects for capital expenditure in the oil and gas industries somewhat, that impact will not be in direct proportion to the price of oil. The vast majority of existing wells will continue to produce and exploration and production (E&P) activity will continue as demand continues to increase, even If prices stay low. Companies that are fee-based and provide oilfield technology, support, equipment and services will continue to see strong demand, even if not quite as strong as some had forecast.

In that context, this chart for SLB looks like a classic case of fear overtaking logic.

Even if the incredible, exponential growth of shale oil E&P in the U.S. slows considerably, this fall in line with oil’s drop makes no sense. As Societe Generale analyst Edward Muztafago points out in this Reuters piece, “Weakening oil prices really don't have an impact on services companies' results. Outside of sentiment issues that affect the stock, it doesn't influence the companies."

The companies themselves presumably feel that way, as Halliburton (HAL) announced in November a plan to buy rival Baker Hughes (BHI), indicating that they see value in the sector. In the case of SLB that value is even more evident, as they are the least exposed to the U.S. among the big four service companies (themselves, Halliburton, Weatherford International and Baker Hughes), and as such will be less affected by slowing growth in the relatively high cost U.S. shale oil production.

Schlumberger has a below average forward P/E of 15.62 at the time of writing and has an above average dividend yield of 1.6 percent, so is not expensive by basic, fundamental measures. That is not the point, however. Rather it is that the oilfield service companies in general represent a remarkable opportunity, having been dragged down by market conditions that actually have very little negative impact on the companies. As the largest of such companies and with Halliburton and Baker Hughes facing the uncertainty of a merger, Schlumberger represents the best long term opportunity in the energy sector. As such it has to be a part of any core energy portfolio.

The fall in oil prices in the second half of 2014 hit energy investors hard, but for those considering the sector it is a godsend. It enables them to start an energy portfolio from scratch with a logical, diversified core. Even for those already invested, reshaping energy holdings to include a diversified core makes sense while prices are depressed.

There are very few certainties in an uncertain world, but long term growth in energy demand is one of them. With these three stocks forming the core of an energy portfolio, investors can position themselves to benefit from that growth regardless of short term trends.