Why own something that will be diluted into strength?

2016-02-18 4pm EDT  |  #oil #energy #DVN #Devon Energy #XLE

Over the past few days we have seen some ferocious buying in the energy equity square. Investors have piled into the down and out energy stocks, hoping they have somehow managed to pick the bottom.

Even though I am a big oil bull, I am not chasing energy stocks. If I somehow manage not to be wrong with my bullish crude oil commodity call, energy stocks will still have a long slog ahead of them. A rally in crude oil to $40 or even $50 is not enough to save us from the wrath of bankruptcies and restructurings that lie ahead.

Any rally in energy equities will be used to issue equity and pay down debt. It’s as simple as that. Your upside in energy equities is capped.

Why would you want to own something that will be immediately diluted into any strength?

Don’t believe me? Yesterday was a perfect example. Energy equities had a good couple of days, but in the big picture, they are still near their lows. Yet Devon Energy used the few days of improving sentiment to issue $1.3 billion of equity at a new low price.

This was after Devon recently slashed their dividend and capex by over 75%! They are in full blown batten down the hatches mode. And well they should be. Devon management knows there is a wave of bankruptcies and much more supply coming down the pike. Issuing stock at the first decent uptick was a shrewd move.

But that begs the question - why should investors chase energy equity prices? Of course they shouldn’t.

Instead investors who don’t believe oil is headed to single digits should have a good hard look at these energy companies’ high yield bonds. For example instead of buying Devon equity, have a look at the Devon 5.6% bonds due 7/15/2041. They are currently trading at a price of roughly $66 with a yield to maturity of 9%.

With a 9% yield for the next 25 years, the stock price would have to appreciate from $19.50 to more than $127 for you to be better off buying the equity. I have made an assumption of the dividend yield for the stock staying at this level and that might not be the case, but you get the idea. You need everything to go perfectly to be better off in the equity versus this bond. Not only that, but if things don’t go smoothly, you could still earn your 9% in the bond. And even if you don’t end up being paid back in full, you are ahead of the equity which would be zeroed.

Energy equity investors are much too optimistic versus their high yield counterparts who have abandoned energy bond issues like the black death. Have a good hard look at taking advantage of this glaring inconsistency. Or at the very least, be skeptical of the rally in energy equities until the energy high yield market rallies significantly…

The gold rally is hated

One last thing thing before I leave you. Gold has managed to get off to a great start for 2016. Although it is rocketing higher, most investors seem to still be looking for excuses to short it. Have a look at this great chart from Bloomberg:

And this comes right after Goldman Sachs came out with a “sell gold” call (from Bloomberg):

Goldman Sachs Group Inc. says it’s time to bet against gold as bullion’s rally to the highest in a year isn’t justified, backing the bearish call with a comment from a former U.S. leader in a report that was issued, appropriately enough, on Presidents’ Day. Gold will slump to $1,100 an ounce in three months and $1,000 an ounce in 12 months, analysts including Jeffrey Currie and Max Layton wrote in the report that was dated Feb. 15 and received on Tuesday. It was headlined with a remark from former President Franklin D. Roosevelt. There’s “nothing to fear but fear itself,” the analysts entitled the seven-page note, channeling comments from Roosevelt’s 1933 inauguration when the U.S. economy was being ravaged by the Great Depression. “It’s time to sell the fear barometer,” the bank said, and recommended shorting gold.

The fact that gold is still climbing in the midst of all this pessimism only makes me more bullish. It reminds me of all the negativity that surrounded the equity market in 2009 and 2010. Even though everyone was looking for the bear market to resume, the market just kept climbing. It was only when everyone was convinced the stock market would never go down again that we finally rolled over. Buying in the face of doubts was the right call for equities in 2010, and it is the right call for gold in 2016.

Thanks for reading,
Kevin Muir
the MacroTourist