Cyclical stocks are closely tied to the ups and downs of a broad or global economy and thus tend to perform well or poorly based on where we are in a business cycle. US energy stocks are a good example of cyclical exposure.
While investors should insist on owning companies with high quality fundamentals, strong balance sheets and the ability to generate free cashflow, these characteristics can be overshadowed by economic forces in the short term. We saw this in 2014, when fears of a slowing global economy and lower demand for commodities from countries like China caused the price of crude oil to plummet from over $100 per barrel to under $30 per barrel in the span of roughly 18 months.
To maintain operations and conserve cash during this downturn, oil and gas exploration and production companies slashed capital expenditures and deferred projects.
The entire energy sector suffered losses during this period but those with the strongest fundamentals were able to position themselves for an eventual rebound by disposing of less valuable assets or those not core to their business model, and by refinancing their debt obligations at attractive rates.
The rebound arrived last year, with crude oil prices jumping more than 40 per cent, making energy the best-performing sector in US equity markets.
Price-sensitive explanation and production stocks like Anadarko Petroleum were among the strongest performers. In turn, higher commodity prices have given these companies renewed incentive to invest in their businesses. It was encouraging to see the consistent message in Q4 2016 earnings reports that US explanation and production companies are aggressively ramping up capital expenditures and increasing production.
After hitting a trough of 404 active rigs in mid-2016, the US rig count is now around 700 and expected to increase to over 900 in several years. Rig counts in certain non-Opec countries are also expected to rise, as companies ranging from Exxon Mobil to China’s CNOOC and Brazil’s Petrobras have communicated double-digit spending increases.
The rig count increase should support the stock prices of oil services companies. These compan-ies handle the construction of new rigs and ongoing maintenance of existing rigs, which should translate into a backlog of new business.
Those that provide drilling equipment, fracking technology, specialised labour and other services to explanation and production companies should be direct beneficiaries of this resumption in activity. Service providers like National Oilwell Varco and Core Laboratories endured negative profit margins through the downturn as they offered price concessions to subsidise their explanation and production customers.
Margins are expected to improve markedly as these companies regain pricing power and drillers are forced to replace older equipment. Pricing for pressure pumping used to extract oil from shale, for example, is up as much as 30 per cent from recent lows, while prices for land rigs, drilling fluids and most other services are also rising.
Given better economic numbers in the US and other global markets, energy demand is expected to improve and create the need for additional supply in the near future. The growth in non-US rig counts tends to lag the US, which could create an even longer cycle of new build outs for the oil services industry.
Due to their close ties to the economy, energy and similar cyclical stocks tend to be more volatile than the overall market. Investors should take advantage of these periods of volatility to add to holdings when prices are depressed and position portfolios for eventual rebounds like this.
Evan Bauman is portfolio manager for the Legg Mason ClearBridge US Aggressive Growth fund