How to Position Your Energy Portfolio in 2014

There's always a bull market somewhere in the oil patch. You just have to know where to look.

Jan 25, 2014 at 1:38PM

Right now there's a lot of happy talk in the oil patch. Thanks to new technologies like horizontal drilling and hydraulic fracturing, America is on the road to energy independence. And investors who bet big on surging shale production made a fortune in 2013. 

But cracks are appearing in the bull thesis. And investors who gloss over the nuances of the energy industry could be sideswiped by big losses in 2014. So here's the game plan for the New Year.  

1) Don't bet on higher commodity prices
Five years ago, the Peak Oil theory dominated popular discussion. Today, North America is drowning in hydrocarbons and may be on the verge of an energy glut. 

We've already seen this play out in natural gas. Shale drilling sent prices to multi-decade lows. And the recent cold snap aside, there are few catalysts for higher prices in the near future. 

But the oil patch could meet the same fate. Due to surging tight oil production, the International Energy Agency predicts that the United States will surpass Saudi Arabia in 2015 to become the world's largest oil producer. Weak economic growth in China and Europe could curtail demand. The outlook for oil prices in 2014 is rather grim. 

For upstream investment, investors should look for turnaround stories that can deliver substantial gains without higher commodity prices. 

Natural gas giant Chesapeake Energy (NYSE:CHK) is a great example of this. New CEO Doug Lawler is leading a major turnaround by shifting production to more profitable liquids and oil, slashing operating costs, and improving corporate governance. As this turnaround is completed, investors could slap a higher multiple on the stock. 

There's a similar story taking place at Canadian energy giant Encana (NYSE:ECA). This year the company plans to sell low-returning natural gas properties, spin off vast land holdings, and ramp up liquids production. Once again, there are plenty of catalysts here to deliver gains regardless of commodity prices. 

2) Focus on midstream
The biggest challenge impeding North America's energy revolution is that we simply don't have the infrastructure in place to accommodate it. Companies that ship, collect, and store these valuable commodities are poised to make a killing. 

Plains All American Pipeline (NYSE:PAA) is one example. This is one of the country's largest midstream shippers with a great set of oil pipelines and storage assets that are so desperately needed right now. 

Plains is set for a major expansion in the upcoming years. The company has $800 million in secured growth projects on the books in 2014 alone. This will be a huge cash flow driver in upcoming quarters.

The biggest risk in this trade is not in the fundamentals of the business but rather in interest rates. Midstream names like Plains are so predictable that they're almost the equivalent of long-term bonds. So rather than focusing on pipelines and energy prices, investors should be more concerned about the Federal Reserve. 

3) Downstream could be a big surprise in 2014
The thesis here is simple: the U.S. currently cannot export crude oil, but it can export refined products. This means that all of the new light crude bubbling out of shale fields across the country is hostage to North America's limited refining capacity. 

Today light oil that reaches the Gulf coast still commands international prices. But as domestic light oil replaces the last barrel of foreign imports -- which could happen by the end of the year -- crude prices could plunge. 

Every dollar that comes out of the wallets of upstream producers goes right into the pockets of refineries. The U.S. is now exporting about 2.6 million barrels per day of refined products like gasoline and jet fuel. And downstream players are making money hand over fist buying cheap U.S. feedstock and selling refined goods at higher international prices. 

This hasn't shown up in the financial results of refiners just yet. For example last quarter Valero Energy (NYSE:VLO) saw its gross margins decline 373 basis points year over year due to the tighter spread between domestic feedstock and international prices. But with U.S. oil production set for continued expansion, expect to see Valero's input costs to begin fall falling in upcoming quarters.

Foolish bottom line
It may be tempting to think that every company in a commodity industry is the same. But that's definitely not the case in the oil patch. Investors who gloss over the nuances could be hit by surprising losses in 2014. 

One energy company set to take off in 2014
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Robert Baillieul has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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