It’s never really a bear market until all the stragglers get taken out and shot. So it was just a matter of time before energy stocks, the big winners for much of the first half of this year, got nailed.
Now the Energy Select Sector SPDR Fund
and the SPDR S&P Oil & Gas Exploration & Production
exchange-traded funds (ETFs) are down 27% to 36% from their 2022 peaks – official bear-market territory.
This is an opportunity for anyone who missed the energy rally. The reason: Unfounded fears are driving the declines.
Cook and I were last bullish on energy together in November 2021. After a little volatility and sideways action, XLE and XOP went on to gain 52% to 58% in eight months.
Now three factors suggest another strong move ahead for energy names, believes Cook: decent underlying fundamentals, good valuations and solid cash flows. Goldman Sachs predicts large-cap energy stocks will gain 30% or more through the end of the year and that its buy-rated stocks could be up 40% or more.
Just remember, no one can ever call the precise bottom in the market or a group. This is not a bet-the-farm-for-instant-riches kind of call.
Here’s a closer look.
1. Favorable fundamentals
U.S. exploration and production stocks have fallen so much that they are pricing in expectations of $50 to $60 a barrel for West Texas Intermediate
says Cook, down from around $100 now. “We think equities are pricing are more dire situation than is currently reflected in market fundamentals,” he adds.
Indeed, the 2023 futures curve for WTI suggests $88 a barrel oil next year.
Prices for future delivery are notoriously fickle. But this oil price “forecast” of $88 for WTI is in line with Goldman Sachs “mid-cycle” oil price forecasts of $85 for WTI and $90 for Brent. It also makes sense for the following reasons.
Supply is constrained. That’s because oil companies have been underinvesting in exploration and production development. This helps explain why inventories are now meaningfully below historical seasonal norms.
“With very little supply cushion available, any further disruption to produced volumes, either geopolitical or storm-related, could send pricing meaningfully higher,” says Cook.
Demand will hang in there. The looming prospects of recession have hit the energy group hard. But this may be a false fear. While a recession would lower demand in the U.S. and Europe, demand will grow in China as it continues to lift COVID lockdown restrictions.
Besides, recession is not even necessarily in the cards. “While the odds of a recession are indeed rising, it is premature for the oil market to be succumbing to such concerns,” says Damien Courvalin, the head of energy research and senior commodity strategist at Goldman Sachs. “We believe this move[ in energy-sector stocks] has overshot.”
The global economy is still growing, and oil demand is growing even faster because of reopening in Asia and the resumption in international travel, he notes.
“We maintain a base case view that a recession will be avoided,” says Ruhani Aggarwal of the J.P. Morgan global commodities research team. The bank puts the odds of recession over the next 12 months at 36%.
Russian oil continues to flow. Despite well-founded outrage over Russia’s invasion of Ukraine, the European Union hasn’t been really effective at keeping Russian supply off the market. Europe still buys Russian oil, and any shortfall in demand there will be offset by buying in China and India.
Europe’s latest plan is to set price caps to limit financial gains by Russia. It’s not clear how this will work out. But it could backfire. In a worst-case scenario, Russia retaliates and cuts production enough to send oil to $190 a barrel, writes Natasha Kaneva of the J.P. Morgan global commodities research team. “Russia had already showed its willingness to withhold supplies of natural gas to EU countries that refused to meet payment demands,” says Kaneva.
As measured by enterprise value to expected cash flows, the energy group is the cheapest sector out there now, says Hennessy’s Cook.
3. Free cash flow
U.S. energy companies continue to return lots of cash to shareholders via dividends and buybacks, notes Cook. This will support stock prices.
The free cash flow yield (cash flow divided by share price ) for the energy companies in the S&P 500 is higher than that of any other S&P sector. Based on consensus analyst estimates for 2022, U.S. energy companies will generate a 15% free cashflow yield, and exploration and production companies will generate a 20% free cashflow yield, says Cook.
These numbers confirm the cheapness of the group.
This chart from Goldman Sachs shows that all comparable selloffs in recent years have been buying opportunities, given those underlying bullish factors.
Cook singles out these three companies as favorites.
A blue-chip energy name, Exxon Mobil
has a diversified business model that dampens stock volatility, says Cook. It’s a producer, so energy price gains support the stock.
But it also has a petrochemicals division that makes petroleum-based materials like polyethylene used in plastic products like food containers. This business can offset the negative impact from weakness in energy prices.
It also has a liquid natural gas business that exports LNG from the U.S. This division benefits from the sharp spike in LNG prices in Europe and Asia linked to Russian natural gas supply disruptions.
This U.S. energy producer
has some of the highest quality shale basins in the country, says Cook. This gives EOG a cost advantage over peers, and it supports strong cash flow. EOG also has a good track record of delivering productivity gains in wells, and cost cuts.
Like Exxon, this Louisiana-based company
exports LNG to Europe and Asia. So it, too, benefits from the dramatic natural gas and LNG price hikes there relative to natural gas prices in the U.S. In the background, Cheniere is paying down its debt, which should allow Cheniere to boost its dividend over the next eighteen months, believes Cook.
Goldman favors energy companies that pay high dividends and have low beta stocks, meaning their stocks are more stable and move around less than the sector or the overall market. In this group, Goldman’s favorite is Pioneer Natural Resources
Goldman likes the company’s huge inventory of undeveloped assets in the Permian basin, and the strong balance sheet and free cash flow supporting the solid 7.8% dividend yield.
Goldman has a 12-month price target of $266 on the stock.
Michael Brush is a columnist for MarketWatch. At the time of publication, he had no positions in any stocks mentioned in this column. Brush has suggested XOM and LNG in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.
American Weed Stocks Are Cheap. They’re About to Get a Sales Bump.
How Do Mega Backdoor Roths Work?
A mega backdoor Roth is a unique 401(k) rollover strategy that’s designed for people whose incomes would ordinarily keep them from saving in a Roth Individual Retirement Account. The advantage of using a Roth IRA to save for retirement is being able to make tax-free qualified withdrawals. But not everyone can contribute to these accounts; higher-income earners are excluded. That’s where the mega backdoor Roth comes into play. If you have a 401(k) you’d like to roll over, you could use this strategy to enjoy the tax benefits of a Roth IRA without having income be an obstacle.
Make sure you’re taking advantage of every opportunity to maximize your retirement assets by working with a financial advisor.
Roth Account Basics
Before diving into the specifics of a mega backdoor Roth, there are a few things to know about Roth accounts, including Roth IRAs and Roth 401(k)s.
First, these accounts are both funded with after-tax dollars. That means when you make qualified withdrawals later, you won’t pay income tax on the money since you already paid it upfront. This is the key characteristic of Roth accounts and what makes them so appealing to investors who anticipate being in a higher tax bracket at retirement.
Next, your ability to contribute to a Roth 401(k) is not restricted by your income. But it is for a Roth IRA. For the 2021 tax year, you must be within these modified adjusted gross income limits to make a full Roth IRA contribution:
Single filers: MAGI of $125,000 or less
Married filing jointly: MAGI of $198,000 or less
Head of household: MAGI of $125,000 or less
You can make partial contributions above those income limits. But your ability to contribute phases out completely once your MAGI hits $140,000 (if you file single or head of household) or $208,000 if you’re married and file a joint return. For 2021, the full contribution allowed is $6,000 with a $1,000 catch-up contribution for savers aged 50 and older.
Finally, Roth 401(k) accounts are subject to required minimum distribution rules just like traditional 401(k) accounts. This rule requires you to begin taking money from your 401(k) starting at age 72. A Roth IRA, on the other hand, is not subject to RMD rules.
What Is a Backdoor Roth?
A backdoor Roth offers a work-around for people whose incomes are above the limits set by the IRS. When you execute a backdoor Roth, you roll money over from a traditional IRA to a Roth account. This way, you won’t have to pay taxes on your retirement savings in the Roth IRA when it’s time to make withdrawals. And you’re not subject to required minimum distribution rules either.
But there is a catch. You have to pay income tax on the money you roll over to a Roth account. So while you could save money on taxes in retirement, you’re not escaping the tax liability of a traditional IRA altogether.
How a Mega Backdoor Roth Works
A mega backdoor Roth is a backdoor Roth that’s designed specifically for people who have a 401(k) plan at work. This type of backdoor Roth allows you to contribute up to $38,500 to a Roth IRA or a Roth 401(k) in 2021. This is in addition to the regular annual contribution limits the IRS allows for these types of accounts. To execute a mega backdoor Roth, two conditions have to be met. Your 401(k) plan needs to allow the following:
You can ask your plan administrator whether your 401(k) meets these criteria. And if your plan doesn’t allow for in-service withdrawals or distributions, you could still attempt a mega backdoor Roth if you plan to leave your job in the near future.
If your plan meets the criteria, then you can take the next steps to execute a mega backdoor Roth. This is typically a two-step process that involves maxing out after-tax 401(k) contributions, then withdrawing the after-tax portion of your account to a Roth IRA.
Again, whether you can follow through on the second step depends on whether your plan allows in-service withdrawals. If it doesn’t, you’ll have to wait until you separate from your employer to roll over any after-tax money in your 401(k) into a Roth IRA.
You also need to watch out for the pro rata rule. This IRS rule says you can’t only withdraw pre- or post-tax contributions from a traditional 401(k). So if you’re completing a mega backdoor Roth, you couldn’t just withdraw post-tax contributions if your account holds both pre- and post-tax funds. In that case, you may have to roll over the entire balance to a Roth IRA.
Benefits of a Mega Backdoor Roth
There are three key benefits associated with executing a mega backdoor Roth. First, you can contribute significantly more to a Roth IRA upfront this way. For 2021, the contribution limit is $38,500 on top of the regular annual contribution limit and any catch-up contribution limits that may apply.
You’ll need to know the maximum amount you’re allowed to contribute to the after-tax portion of your 401(k). So for 2021, the IRS allows a maximum contribution of $58,000 or $64,500 if you’re 50 or older. You’d subtract your 401(k) contributions and anything your employer adds in matching contributions to figure out how much you could add to the after-tax portion.
Next, you can enjoy tax-free withdrawals in retirement. This is a benefit you may otherwise not being able to get if your income is too high to contribute to a Roth IRA. By reducing your tax liability in retirement, you can help your investment dollars go further. And you may have a larger legacy of wealth to pass on to future generations.
Finally, a mega backdoor Roth IRA would allow you to sidestep required minimum distribution rules. This means that you could retain control over when you choose to take distributions from a Roth IRA.
So who is a mega backdoor Roth right for? You may consider this move if you:
Have an eligible 401(k) plan at work
Have maxed out traditional 401(k) contributions
Are not eligible to contribute to a Roth IRA because of your income
Have additional money that you want to invest for retirement
Want to leverage the higher Roth IRA contribution limits allowed by a mega backdoor rollover
Talking to your financial advisor can help you decide if a mega backdoor Roth makes sense. And your 401(k) plan administrator should be able to tell you if it’s possible, based on your plan’s guidelines.
Mega Backdoor Roth Alternatives
If you can’t execute a mega backdoor Roth because your plan doesn’t allow it, there are other ways to increase your retirement savings. For example, you could try a regular backdoor Roth instead. This might be something to consider if you still want to enjoy the tax benefits of a Roth IRA but your plan doesn’t fit the criteria for a mega rollover. You could also elect to make Roth 401(k) contributions to your retirement plan at work. This way, you still get the benefit of contributing after-tax dollars and making tax-free withdrawals. You’d be subject to the regular contribution limits and you’d still have to take the required minimum distribution. But that may outweigh the value of tax savings in retirement.
Investing in a Health Savings Account (HSA) is another option. While these accounts are not specifically designed for retirement, they can yield multiple tax benefits. Contributions are tax-deductible and grow tax-deferred. Withdrawals are tax-free when used for eligible healthcare expenses. And at 65, you can take money out of an HSA for any reason without a tax penalty. You’ll just owe ordinary income tax on any withdrawals that are not used for healthcare expenses.
Finally, you could open a taxable brokerage account to invest. This doesn’t necessarily save you money on taxes since you’ll owe capital gains tax when you sell investments at a profit. But it could help you to diversify your investments and there are no limits on how much you can invest in a brokerage account annually.
A mega backdoor Roth strategy could work well for higher-income earners who want to take advantage of Roth account benefits. There are certain rules that need to be followed to make it work, however, so you may want to talk to your plan administrator or a tax professional before going ahead. Keep in mind also that even if you can’t complete a mega backdoor Roth rollover, you still have other options for growing retirement savings.
Tips for Retirement Planning
If you’re saving for retirement in a 401(k) or IRA, pay attention to the fees you’re paying. For instance, check the expense ratios for each fund you’re invested in to understand how much you pay to own that fund on an annual basis. You can then compare that to the fund’s performance to determine whether the fees are justified. Also, consider any administrative fees you might be paying and how those affect your net returns.
Consider talking to your financial advisor about a mega backdoor Roth and whether it could be right for you. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors in your local area. You can get your personalized recommendations in minutes just by answering a few simple questions. If you’re ready, get started now.
Photo credit: ©iStock.com/designer491
Alibaba Is Tumbling. Chinese Tech Stocks Have a New Headache.
Chinese tech stocks were tumbling on Monday as two of the embattled sector’s leading players faced fresh fines from market regulators over disclosure rules.
China’s State Administration for Market Regulation announced Sunday a wave of penalties for improperly reporting past deals, in breach of competition law.
(ticker: BABA) and
(0700.H.K.) were among the companies fined as a result.
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