Get Ready for the Great Oil Bust of 2017

Shawn Driscoll has been ahead of the curve when it comes to oil prices.

In the first half of 2014, Driscoll—the portfolio manager of the T. Rowe Price New Era fund, which focuses on natural resources—began positioning the fund more defensively to reflect his belief that commodities had entered a secular bear market. He bolstered the portfolio with specialty chemicals and industrial companies, as well as utilities, and as such was able to avoid some of the pain when oil prices were cut in half, to $26 a barrel, last February.

The New Era Fund is up 17.3% so far this year. It has outperformed its peers over the past three and five years, although it has lagged them over the past 12 months. Like its competitors, it has lagged the Standard & Poor’s 500 Index over those periods. It has assets under management of $3.5 billion and charges an expense ratio of 0.67%.

Driscoll maintains that we are currently experiencing a bear-market rally, and that the energy sector, which has run up smartly, is due for a sharp reversal in the second half of next year. That said, he is still finding areas to put money to work. Barrons.com spoke to him recently to get his thoughts on these and other topics.

Barrons.com: We’ve just seen non-OPEC and OPEC producing countries agreeing to production cuts. How significant are these?

Driscoll: They’re significant in the short term, but our longer-term view is that we’re in a secular bear market for oil and the rest of the commodity complex.

Q: Has the OPEC move has already been priced into the market?

A: Yes. We think this bear market is very similar to the ‘80s and ‘90s—actually, we think it is worse—and OPEC was pretty ineffective except over very short time frames during that period. That’s because capital efficiency is getting so much better so quickly. Like any commodity, you take some supply offline for a short period of time, it will matter. But the supply response is always underestimated and a lot quicker than people realize when you are going through a period of technological disruption, and that’s what’s going on right now.

Q: So we’re going to see a lot more supply?

A: There is a wave coming. It has already started. U.S. oil production bottomed in September, in our view. We think U.S. fracking recovery rates are still just 10%.

Q: How long will this bear market go on?

A: Ten to 15 years.

Q: Ouch. You’ve been a very good prognosticator on prices. Where do you see them going in the next year?

A: The sugar rush is going to continue in 2017, but only for a short time. The International Energy Agency made the case that we were undersupplied for ‘17, but we’re not. We have a million barrels a day over [demand], and the missing piece in everyone’s model is how quickly and how big the U.S. comes back, and I still think that is being massively underestimated. My guess is we peak out some time in the first quarter and then by the time we exit 2017 we’re back in the soup—sub-$50-a-barrel oil—and then at some time in ‘18 we dip below $40 a barrel.

Q: That is a very contrarian view.

A: The OPEC agreement theoretically goes to late May. What do they do if we’re right? What do they do if the U.S. is up 500,000 barrels a day by mid ‘17?

Q: Coming on during this cutback?

A: Yes, and once they see it coming, do they cut again? I bet no. These cycles are all about productivity and the direction of the cost curve. Historically, it’s hard to make money when the cost curve is flattening and falling, and we think that’s true for most of the commodity complex. Until that stops, it’s hard to string together a positive message on commodities structurally.

Q: And it is only going to get worse because you’re going to have a very supportive regulatory environment in the new administration?

A: Yes, although these companies don’t need much of a nudge.

Q: As an energy investor, what do you do?

A: We’re big believers in staying at the low end of the cost curve, and in the U.S. the frackers are obliterating the global cost curve extremely quickly, especially in the Permian Basin. And so, EOG Resources (EOG), Pioneer Natural Resources (PXD), Concho Resources (CXO), and Cimarex Energy (XEC) are big holdings of ours, and we consider those long-term positions.

Q: Are they all active in the Permian Basin?

A: They all have considerable business and net asset leverage to the Permian Basin.

Q: How do you value these companies, and where could they go from here?

A: We use a blend of two metrics to value exploration and production companies—discounted cash flow on drilled locations, and our long-term view on price, which is $45 to $50. We think E&P names as a whole are pricing in roughly $65 a barrel in oil. The Permian names are pricing in $70, which is why they’ve exceeded our expectations. But we’re not exiting, and we think these are going to be the relative winners over a longer period of time. We are really struggling to find ideas. You really have to extend your time horizon

Q: Oil has doubled from the bottom at $26, and a lot of these stocks have really moved up very smartly also.

A: Some of them are almost near the 2014 peak, when oil was over $100. I hate to pull up names that are actually in my portfolio, but NovaGold Resources (NG), Concho and EOG are all at their 2014 peaks.

Q: So we want to wait until things come off a little bit before committing capital?

A: Yes. Some of these are going to see a 30% to 50% correction. It is not going to be immediate in ‘17, but back half of ‘17 into ‘18, money is going to come out of this space pretty fast.

Q: Are there any companies that haven’t enjoyed such a tremendous move?

A: On the margin, we’re finding more interesting ideas in Canada. On a relative basis, they’re not pricing in as high oil and natural gas prices that the U.S. guys are. Companies like Advantage Oil & Gas (AAV), and Arc Resources (ARX.Canada), which we own. We think they’re pricing in something below $60 and $3 gas, which, by the way, isn’t screaming cheap. But on a relative basis, it is attractive.

Q: Tell us more about Advantage Oil & Gas.

A: This is an oil and gas exploration company in the Montney Basin, an enormous basin in western Alberta. It started off as a dry natural-gas basin, but as modern fracking techniques have improved, more of these companies are finding black oil in liquids that have much better margins than natural gas.

Q: Is Arc also active in that basin?

A: They have one of the biggest land positions in the basin. Encana (ECA) is another one we own. They’re in the Permian and have a big position in the Montney.

Q: Where it is trading?

A: Encana has had a big move; some of the Canadian-listed names, not as much. U.S. investors are closer to the productivity boom. The Canadian names aren’t that expensive on a relative basis, whereas the U.S. E&Ps are overvalued.

Q: Examples, please.

A: There are a couple of names I’m buying, which is why I’m being a little elusive. They are trading at 7 1/2 times ‘17 Ebitda [earnings before interest, taxes, debt, and amortization] and 5 1/2 times ‘18. These are relative calls. There are other parts in the portfolio that we like better.

Q: Do tell.

A: Specialty chemicals, utilities, and, at some point during ‘17—and it is probably going to be simultaneously with the peak in oil—that you are going to want to go back into utilities and gold names.

Q: What’s the rationale for that?

A: It is going to be simultaneous with a peak in growth and inflation expectations. In the first or second quarter, we’re going to see the commodities peak out, inflation peak out, real rates peak out, and there is going to be a rush back into gold and utilities.

Q: Some names, please.

A: Utilities are still about 8% or 9% of the strategy. We own Atmos Energy (ATO). It has been a pretty good stock, but I still think there is a ways to go in it. It trades roughly in the low $70s and we’re playing for mid-$80s plus a mid-2% dividend. It is an upper-single-digit grower, and it has got a very long runway in terms of capital deployment. It’s a natural-gas distribution company, and there is a lot of old pipe around, so they’re doing a lot of replacing pipe. But the other aspect of the story that I think is going to be interesting over time is they have an interstate pipeline for gas in the Permian Basin.

Q: What else?

A: We own Edison International (EIX), an electric utility, and PG&E (PCG) in California. They’re trading at a market multiple or below, and are mid- to upper-single-digit growers with mid-3% dividend yields. We’re going through a cyclical reflation trade, where some of this safe stuff becomes unattractive as the 10-year Treasury yield goes up. But there is a point in the first half of ‘17 where that stops being the case.

Q: Thank you, Shawn.

Barrons