In some ways, not much has changed since we published our last Best Buys list on Dec. 29.

Crude’s about $8 per barrel cheaper, which in the wake of the crash last fall almost looks like stability if you squint hard enough.

And while it’s not the sort of stability that’s going to leave anyone among the drillers and their suppliers happy, energy stocks heavily oversold in December have since held up OK, considering the price of oil and natural gas.

Old friend XOP, the small and midcap drillers ETF, has managed against all odds to break even so far in 2015, while the supermajor-tilted XLE is down 6% and the Alerian MLP index has shed 9% year-to-date.

The change in the volume of crude stored in the U.S. has been more dramatic. Over the last 2½ months, it has expanded by 63 million barrels, or 16%, to a record high. The incremental increase in supplies as a result of continued overproduction so far in 2015 would be enough to flood NRG Stadium, the home field of the Houston Texans, with crude roughly two-thirds of the way to its roof beams.


Storage facilities are filling up worldwide as a result of global overproduction now estimated at 1.5 million barrels per day, with the International Energy Agency suggesting they might fill to the brim as early as June.

I think the question of how quickly all the storage tanks might fill is less important than the one about why demand is still running so far behind supply months after a 50% markdown.

U.S. fuel demand is growing meaningfully for the first time in years. But China’s consumption gains slowed appreciably last year in what’s looking less and less like a hiccup and more and more like a permanent step change.

The country’s long-running investment boom has run its course, leaving behind ghost cities, white elephants and systemic banking problems exacerbated by the slump in real estate. That’s likely to temper fuel demand not only in China but for hard-hit Chinese commodity suppliers like Brazil and Indonesia as well. Leading oil exporters Saudi Arabia and Russia have also contributed a lot of demand growth in recent years, but are now feeling the sting of reduced export earnings and, in Russia’s case, a deep recession.

Most other industrial commodities are in bear markets as well. The long advance driven by Asian and Latin American booms is now history like the building sprees that stoked it, unlikely to be repeated any time soon.

U.S. oil production, meanwhile, is widely expected to level off near a 33-year high later this year, then grow again at a slower pace as shale drillers continue to drive down costs.

If China, Russia, Latin America and the Mideast go through a prolonged downturn, even a recovering developed world won’t offset the resulting weakness in global oil demand.

That would be very bad news for all the crude traders now paying to store crude in hopes for significantly higher prices no later than next year. They’ll be looking to sell those bulging inventories eventually. The other overhang over crude prices is the historically weak hedging position of crude oil producers. They’ll be looking to expand their hedges on any strength, as in fact they’ve been doing even in the downward drift prevailing so far this year.

None of this means that crude prices must head significantly lower, or that they can’t spike in the event of a serious threat to supply. But it does suggest the market is likely underestimating how long oil prices are likely to stay weak, if only because a significant recovery would result in another spurt in North American output. At current cost levels, good Texas shale can make money even with crude at $50 a barrel.

The upside of demand downturns caused by a global recession, as in 2009, is that recovery tends to come quickly. In contrast, past oil market imbalances caused by growth in supply, as in the 1980s, have tended to generate prolonged weakness.

We still believe crude will head toward $70 a barrel over the long haul, but the long haul is looking a little longer every day, and will continue to do so until demand stops looking so punk.

Just as the build in storage stocks represents the gap between current supply and demand, the widening differential between globally traded Brent crude and West Texas Intermediate, now near $10 a barrel, captures the value transfer from domestic crude producers to U.S. shippers, processors and refiners. The margins of these midstream and downstream operators benefit disproportionately because the U.S. accounts for much of the global crude glut and also a lot of the world’s incremental growth in fuel demand at the moment.

That won’t always be the case, but it’s a  condition that’s likely to persist long enough to affect portfolio construction. It’s certainly shaped our new Best Buys list, which jettisons many of its drillers in favor of the pipeline operators, refiners and tanker fleets that tend to do best in a low oil price environment.

1. Valero (NYSE: VLO)

The leading U.S. refiner has the scale and reach to fully take advantage of the domestic crude glut.  We won’t rehash the favorable refining fundamentals discussed in the last issue in “Cooking With Cheap Crude.”  Rather, we’ll just note that operating income grew 49% in 2014, allowing the company to return $1.9 billion to shareholders via buybacks and dividends even before Valero raised its dividend by 45% in January.  The trailing Enterprise Value-to-EBITDA ratio stands at little more than 4, and the stock trades at less than 6 times the last year’s cash flow. The annualized dividend yield based on the recent hike is 2.8%. Buy VLO below $70.     


2. Energy Transfer Partners (NYSE: ETP)

The second-largest and perhaps the most diversified master limited partnership has limited exposure to crude prices and in fact the retail segment that will make up some 15% of its profits following the Regency merger does better when fuel prices are low. The unit price is down 16% year-to-date, but only 4% since Labor Day, dramatically outperforming its sector over the last four months of 2014.  Meanwhile, the well-covered distribution recently growing at nearly 9% annually currently yields 7.3%. Buy ETP below $70.

3. Western Refining (NYSE: WNR)

As elaborated in the last issue, Western is  a thriving regional refiner with a strong record for delivering value to shareholders. Last year its share repurchases and dividends amounted to $553 million, or more than 10% of the company’s enterprise value. Western has also spun off a logistics MLP that will remain a source of inexpensive capital via dropdowns and acquired another refinery organized as a variable-distribution MLP. Western’s wholesale and retail distribution networks help its margins. The valuation metrics are in line with Valero’s. Buy WNR below $57.



4. Capital Products Partners (NASDAQ: CPLP)

The operator of fuel and crude tankers is benefiting from rising rates in both market segments as the rising global fuel trade boosts demand while the shipping sector’s years of struggle have constrained capacity. The master limited partnership, which like many shippers reports its distributions on form 1099, currently offers a yield of 10% with a 1.2x coverage. Capital Products Partners is planning to increase its payout this year for the first time since 2009, after holding it level the last four years. Buy CPLP below $10.

5. Energy Transfer Equity (NYSE: ETE)

The general partner of Energy Transfer Partners (NYSE: ETP) and, effectively, of Sunoco Logistics (NYSE: SXL), ETE benefits disproportionately over time from the growth of its affiliates via incentive distribution rights (IDRs). Led by the industry’s most successful dealmaker, Energy Transfer Equity recently increased its distribution 30% year-over-year and announced a $2 billion share buyback. The current annualized yield is 3%. Buy ETE below $66.



6. Marathon Petroleum (NYSE: MPC)

The second-largest pure-play U.S. refiner after Valero, Marathon Pete returned $2.7 billion to shareholders last year via dividends and buybacks, for an industry-leading 10.7% return of capital. Like the other refiners on this list, MPC a sponsor of a fast-growing logistics IPO. It’s also the operator of the country’s second-largest filling station chain after its Speedway subsidiary acquired the retail arm of Hess. A retail spinoff along the lines of Valero’s separation of CST Brands (NYSE: CST) could serve as a further valuation catalyst, though the stock is already more expensive than VLO or WNR. Buy MPC below $118. 

7. Enterprise Products Partners (NYSE: EPD)

The largest MLP is, like the midstream sector as a whole, going through a rough stretch. While near-term cash flows are well shielded by fee-based contracts, Enterprise’s long-term growth trajectory as the leading processor of natural gas liquids is sensitive to the health of crude, off which NGLs tend to be priced. But ample surplus distribution coverage, low-cost capital and the best credit rating among MLPs give EPD plenty of flexibility to ride out the short-term price swings. And its strategic positioning as the leading value-added handler of U.S. energy exports from the Gulf Coast remains unmatched. The current annualized yield is up to 4.8%, up from 3.5% in September. Buy EPD below $42.50. 


8. Targa Resources (NYSE: TRGP)

While the affiliated MLP’s gathering and processing operations will lose some steam as a result of low energy prices, they remain positioned in the most lucrative domestic shale basins. Its liquefied petroleum gas export terminal near Houston is also a strategically valuable asset and its fractionation footprint along the Gulf Coast is second only to Enterprise’s. A lean year might mean a dividend currently yielding 3.5% might grow only 20% or so this year instead of the 35% promised last fall. While management expects only a modest recovery in energy prices over the next two years, Targa remains an attractive growth story with lots of upside. Buy TRGP below the reduced price target of $110.


9. EOG (NYSE: EOG)

The leading shale driller has the most enviable footprint in the Eagle Ford and lucrative acreage in the Permian Basin and the Bakken. The $5 billion it will spend this year to keep output level will be financed entirely by operating cash flow and represents a 40% cut in capital spending. The company has suspended what had been industry-leading growth in expectation that crude prices will strengthen before long, and it can afford to do so given breakeven cash flow and an investment grade credit rating. EOG has said that its positions in the Eagle Ford, Permian and the Bakken can deliver 35% after-tax returns with crude at $55 a barrel. Based on that price, the stock looks fairly valued at an 9 times next year’s cash flow. When crude eventually gets back to $70 a barrel, EOG is likely to once again look cheap. Buy EOG below $100.


10. Williams (NYSE: WMB)

The general partner to a large gathering and processing MLP, Williams also controls a leading pipeline system distributing Marcellus natural gas across fast-growing Southeast, along with important offshore crude pipelines and petrochemical plants along the Gulf Coast. The stock currently yields an annualized 5%, and the company expects to increase the payout by 22% this year, followed by 10% in 2016 and again in 2017 even if oil prices improve only slightly. Buy WMB below $59. 


11. Devon Energy (NYSE: DVN)

The only driller on this list besides EOG, Devon also possesses a rock-solid balance sheet and the can finance its growth from operating cash flow. Last year the company sold its Canadian gas and non-core U.S. assets for more than $5 billion, while spending $6.4 billion to secure a big position in the Eagle Ford. That acreage is now fueling plans to grow oil production 20% to 25% this year while cutting capital spending by 20%. Devon is also building shareholder value via a growing midstream business with its own publicly listed MLP and general partner. The dividend yield is up to 1.7%, while the stock now trades at an enterprise value of less than 4 times last year’s EBITDA. One of the best hedge books in the business had a fair market value of $2 billion as of year-end, and will cushion the blow from low energy prices this year. Buy DVN below $70.


12. Frontline (NYSE: FRO)

The cheapest crude tanker stock, Frontline is selling by some estimates at less than three times annual cash flow if charter rates merely hold recent gains. The rise in rates after a prolonged slump in crude shipping has helped Frontline raise the cash it needs to pay off a convertible debt issue coming due next month. If rising crude inventories depress spot prices and near-term futures, a deeper contango could develop, making offshore crude storage more profitable and boosting demand for the company’s 40-tanker fleet. Frontline is controlled by Norwegian-born shipping and drilling tycoon John Fredriksen. Management has set the goal “to rebuild Frontline into a leading tanker company” after facing down the threat of insolvency. No other tanker stock is so heavily discounted or offers as much upside. Buy FRO below $3.