2019 has been another strong year in the stock market, with unrealized and realized gains aplenty. As we near year-end, now is a good time to start your tax planning and consider netting some of your realized gains through harvesting of unrealized losses. In this vein, we recently assessed upstream public energy stocks as potential loss harvesting candidates.
Knowing that upstream public oil and gas stocks are trading at extremely low levels, we selected a basket of 36 stocks; a dozen each in the small-cap, mid-cap, and large-cap domains. For each company, we gathered specific data points, including: 52-week high and low trading prices as of the close of business Oct. 18, 2019 (Measurement Date), market capitalizations as of the Measurement Date, and debt levels from each company’s most recent Form 10-Q filing. Separately, we gathered 52-week high and low trading prices for West Texas Intermediate (WTI) crude oil and Henry Hub natural gas for the period ending with the Measurement Date.
We then correlated movements in commodity prices with stock prices of public entities producing the underlying commodities and identified which upstream energy market segments possess the best loss harvesting potential.
Commodity prices: Statistics
Closing Measurement Date WTI crude oil and Henry Hub natural gas prices of $53.75 and $2.32 compared with 52-week high prices of $68.63 and $4.96, respectively. In percentage terms, Measurement Date crude oil and natural gas prices were 22 and 53% lower than their 52-week high counterparts. Natural gas prices traded over $4.00 only 22 trading days during the 52-week coverage period, suggesting short-term price spikes contributed significantly to natural gas’ implied volatility. Basis differentials added another layer of volatility on a net price basis.
Stock prices: Statistics
Stock price performance of the basket of small-cap stocks fared unfavorably versus the comparable baskets of mid-cap and large-cap stocks. Similarly, stock prices of the basket of mid-cap stocks performed poorly in relation to the basket of large-cap stocks. Share prices of both small-cap and mid-cap basket companies performed worse than the underlying commodities they produce, suggesting commodity price erosion only partially explains the dramatic drop in share prices.
On average, Measurement Date stock prices of companies comprising the small-cap basket fell 72% from their 52-week highs, with half falling more than a whopping 80%. By comparison, stock prices for the basket of mid-cap and large-cap stocks fell 51% and 31%, respectively. There was a definitive correlation specific to market cap size and magnitude of value destruction. The enormity of the fall of small-cap stocks, and to a little lesser extent mid-cap stocks, is stunning.
The market didn’t discriminate as to a company’s crude oil versus natural gas orientation. Nor was the geographic location of assets or local regulatory climate antiseptic to energy’s ailments. Not unexpectedly, those with highly leveraged balance sheets paid a steeper price than those with proportionately less debt; however, the market took a sledgehammer to virtually all small-cap companies and most mid-cap entities.
The enormity of the fall of small-cap stocks, and to a little lesser extent mid-cap stocks, is stunning.
For comparison, we expanded our analysis to include a basket of 12 midstream sector companies. Unlike its badly beaten upstream company brethren, the midstream companies yielded a modest 18% reduction in Measurement Date trading prices versus their 52-week highs, including two outliers skewing the reduction from 11 to 18%.
The market pendulum
The market continuously searches for equilibrium, pricing in ever-changing input variables. History demonstrates the impact of these variables are all things overdone at times, while at other times not fully appreciated until they simmer. The market has made a considerable statement thus far in 2019, making it clear it lacks confidence in upstream public energy companies to deliver returns competitive with other market sectors. What remains is a futuristic reflection on 2019 and prospective judgment of whether it was a year of simple market dislocation, or more toxically, the realization of a “this-time-it’s-different” long-term swing of the pendulum.
Some sentimentalized fossil fuels are destined for the scrap heap because of climate change transformation inertia set in motion by wishful proponents of a new energy economy, believing Silicon Valley-like technology changes are imminent. Offsetting this moribund view are those opining raw physics precludes technological change pace rivaling the digital revolution. If the former view is true, one is left pondering why share prices of public midstream companies, inextricably linked to the fortunes of upstream players, are holding up better than their upstream counterparts.
Recently, the market shifted away from companies spending big on acreage accumulations and associated development programs. This movement was prompted by investors unable to realize returns through traditional M&A transactions due to untenably high “bid” and “ask” spreads. Raising capital in IPO’s and secondary offerings is out of vogue, and traditional lending sources are tight, forcing growth into a secondary role for the foreseeable future.
Many of these companies may lament the timing of their buybacks given the precipitous slide in share prices.
Today, the charge of investees is to operate within cash flows and return cash to investors the good old-fashioned way — through distributions. As of the Measurement Date, the baskets of small-cap, mid-cap, and large-cap stocks yielded .3%, 2.38%, and 2.82%, respectively. Moreover, mid-cap and large-cap entities have been active purchasers of their own shares through share buy-back initiatives. Many of these companies may lament the timing of their buybacks given the precipitous slide in share prices. Their buy-back actions are generally in response to what they believe to be sell side irrational exuberance and support confidence in their ability to create and return value to investors.
The shift to current returns likely explains the market’s stair-step value proposition for small-cap, mid-cap, and large-cap stocks. Since the motivating force is to return more cash, the higher yielding mid-cap and large-cap stocks have been punished less than small-cap stocks. This thesis is consistent with the favorable market treatment currently afforded participants in the higher-yielding midstream sector. Although the short-term prescription appears to have been written, much is now being penned about the struggles many industry players, even the largest ones, are having in generating necessary cash flows to satisfy investor expectations.
Loss harvesting: How and what?
Many factors play into your loss harvesting strategy. First, if you need large losses, your small-cap and mid-cap energy investments are likely deeply discounted and may be central to your loss generation solution.
Notwithstanding the upstream energy sectors current woes in the small-cap and mid-cap categories, you may believe the sell-off is overdone and you’re reluctant to permanently sell your holdings. Wash-sale rules are in place to preclude you from recognizing investment losses, and then buying back the same securities within 30 days. This stock buy-back rule is expansive, including your other investment and retirement accounts, accounts maintained by your spouse, and potentially your kids’ accounts, as well.
If you are bullish on the small-cap and mid-cap energy stocks included in your loss harvesting plan, and therefore hesitant to part ways with them for 30 days, you might consider purchasing other small-cap or mid-cap energy securities evaluated as suitable replacements. On the other hand, 30 days comes and goes quickly, and your best strategy may be to simply exercise patience.
If you have questions, please reach out to our team today.