Portfolio Manager Q&A:
The Energy Sector
Derek Rollingson, ICON Portfolio Manager
November 11, 2016
Give us some perspective on recent oil prices.
Oil prices reached their highs for 2014 on June 19th, as the spot price for Brent crude topped out at $115.06 per barrel. Since then, oil has struggled, declining 75.56%, to a low of $26.21 per barrel on February, 11 2016. Of recent significance, on September 28th, 2016, OPEC came to an agreement to reduce oil production. This marks a significant policy change, as it is the first time since 2008 the group has agreed to a cut in production. Despite the rise in oil prices since the low, the future remains uncertain.
What has caused the steep decline in oil?
We believe the 2014 downturn in oil price can been attributed primarily to an increase in supply coupled with a slowdown in anticipated demand growth. With a market for oil in the lucrative $80 to $100 price range from 2010 through most of 2014, U.S. companies sharply increased production to take advantage of a high price environment. Further, we believe innovations in drilling efficiency, primarily horizontal drilling and fracking, have increased individual well production. The net increase in production made the U.S. one of the world’s largest producers.
Further, we have seen a lack of strong global economic growth, particularly in emerging markets, which appears to have eroded confidence in expected demand for oil. Emerging markets, like China and India, are significant drivers in marginal demand for energy. The net result is that marginal supply is outstripping marginal demand, contributing to the decline in oil pricing.
How did the sector respond?
So far in 2016, companies in the Oil & Gas Exploration & Production industry have been heavily focused on shifting their operations and cutting costs. For example, the U.S. rig count has been reduced from 1,931, as of September 2014, to a low of 404 by the mid-May of 2016. Globally, the rig count declined from 3,736 in February 2014, to a low of 1,405 by the end of May 2016. Further, the average cost to drill new wells has gone down significantly over the past two years. These cost savings come from both increased efficiencies and a more favorable pricing environment from the companies that provided services for drilling. Finally, land purchases and exchanges have been designed to increase the continuous land mass that Oil & Gas Exploration & Production companies control, enabling increased horizontal drilling length, increasing cost savings. These factors, combined with other economic and market impacts reduced the break-even price for oil extraction in the U.S. recently.
While it is difficult to predict commodity movements, the industries’ response to the current market environment has led to leaner, more efficient energy companies.
We believe that when conditions improve these companies will be better positioned to capitalize on a more favorable commodity pricing environment.
How does the current Energy environment affect holdings and potential holdings in the ICON Energy Fund?
ICON’s valuation methodology has responded to changes in the Energy sector market environment through three primary mechanisms:
- Earnings: First, as equity research analysts revise up/down their forward-looking earnings per share, a company’s average earnings, a component of our valuation process, are reduced or increased. This lowers/raises the value that ICON calculation for the companies.
- Future Growth: Second, as forward-looking earnings per share are adjusted, expected future long-term growth rates are also adjusted. The effect is that ICON’s valuation for the company reflects this change.
- Hurdle/Discount Rates: Third, as the fixed income market predicts a higher or lower probability of debt default for a company, that company’s bond prices change and the yields reflect that change. As a company’s debt yield, which is the discount or “hurdle” rate in ICON’s valuation model, increases/ decreases, the value of the company changes.
However, not all energy industries’ profitability is tied directly to commodity pricing. For example, the Oil & Gas Storage & Transportation industry relies more on long-term, fixed-fee pricing contracts. Despite a revenue structure that is somewhat insulated from commodity price volatility, companies in this industry sold off aggressively in the second half of 2015. Because these companies’ valuation variables (as discussed above) were relatively unaffected, it provided the ICON Energy Fund with a good entry point to establish a meaningful position in this industry.
Where does the sector go from here?
The global slowdown in economic productivity has had a significant impact on emerging market growth. For example, China’s year-over-year GDP growth was above 12% the first quarter of 2010 but by mid-2016 slowed to around 6.5%. Brazil actually had negative GDP growth in 2015. As these markets recover, we anticipate that they can provide a strong base for upward pressure in energy pricing.
The curtailing of domestic production as a result of steep oil price declines may result in a decline in supply. All else being equal, the reduction in domestic supply may create upward pressure on prices, which could benefit the sector.
Lastly, as seen recently in their significant policy change, actions supportive of oil pricing by OPEC could be a boon for the Energy sector in general.
Past performance does not guarantee future results.
Investing in securities involves inherent risks, including the risk that you can lose the value of your investment. There is no assurance that the investment process will consistently lead to successful results. An investment concentrated in sectors and industries may involve greater risk and volatility than a more diversified investment. There are risks associated with small- and mid-cap investing such as less liquidity, limited product lines, and small market share. An actively managed investment product does not guarantee better returns or performance than any other kind of investment.
Opinions and forecasts regarding sectors, industries, companies, countries and/or themes, and portfolio composition and holdings, are all subject to change at any time, based on market and other conditions, and should not be construed as a recommendation of any specific security, industry, or sector.
ICON’s value-based investing model is an analytical, quantitative approach to investing that employs various factors, including projected earnings growth estimates, in an effort to determine whether securities are over- or underpriced relative to ICON’s estimates of their intrinsic value. ICON’s value approach involves forward-looking statements and assumptions based on judgments and projections that are not guarantees of future results. Value investing involves risks and uncertainties and does not guarantee better performance or lower costs than other investment methodologies.
Brent crude price per barrel is based on the current pipeline export quality Brent blend as supplied at Sullom Voe. ICE Brent Futures is a deliverable contract based on EFP (exchanging futures for physical) delivery with an option to cash settle. Data source: Bloomberg.
Consider the investment objectives, risks, charges, expenses, and share classes of each ICON Fund carefully before investing. The prospectus, summary prospectus, and the statement of additional information contain this and other information about the Funds and are available by visiting www.InvestwithICON.com or calling 1-800-828-4881. Please read the prospectus, summary prospectus, and the statement of additional information carefully before investing.
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Investing in securities involves inherent risks, including the risk that you can lose the value of your investment. There is no assurance that the investment process will consistently lead to successful results.
Consider the investment objectives, risks, charges, expenses, and share classes of each ICON Fund carefully before investing. The prospectus, summary prospectus and the statement of additional information contain this and other information about the Funds; please read the prospectus, summary prospectus and the statement of additional information carefully before investing. ICON DistributorsSM, distributor.
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