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A strong third quarter notwithstanding, energy – which was the best S&P sector performer in 2016, with a market-thumping 24% return – has not exactly had a great year. The Zacks Oil-Energy sector is down 1.4% year-to-date versus 18% growth for the broader S&P 500. Compare this to 17% growth during the same period last year and one wonders whether the stellar run for the sector is over.

Market participants argue that fundamentals point to a looming oil supply growth despite WTI crude crossing the $55 per barrel mark on more than one occasion. In fact, crude’s recent gains could become self-defeating if elevated realizations induce producers – especially U.S. shale drillers – to ramp up activity. Together with the scheduled conclusion of OPEC/non-OPEC production cuts in March next year and we are looking at another selloff in oil prices.

As it is, despite OPEC’s claims of ‘successful’ implementation of supply curbs, output from the group was 32.75 million barrels a day in September, a gain of almost 90,000 barrels a day from August. Not surprisingly then, oil has struggled to stay above the psychologically-critical $50 threshold for a prolonged period, pointing to the cartel’s failure to shrink the global oil glut sufficiently. At the same time, OPEC's moves to trim output and restore the demand-supply balance has incentivized shale drillers to churn out more.

As per Energy Information Administration’s (“EIA”) latest inventory release, U.S. production rose to 9.6 million barrels a day – near the highest level in more than two years. Moreover, stocks at the Cushing terminal in Oklahoma – the key delivery hub for U.S. crude futures traded on the New York Mercantile Exchange – are close to five-month highs.

Finally, restored output from exempted OPEC producers Libya and Nigeria have added to the surplus and further slowed the rebalancing of the market.

As long as there is excess oil, the arduous market environment will continue - suggesting that the odds are firmly stacked against a sustained rally. With U.S. crude stockpiles remaining high on the back of robust shale production, money managers do not rule out chances of more pain ahead for energy stocks.

Challenging Distribution Growth Outlook for MLPs

Master limited partnerships (or MLPs) are essentially infrastructure holdings of energy companies that feed off the broader sector. But these midstream operators are not direct oil and gas plays as they derive a major portion of their revenues from fee-based contracts depending on volume and are largely insensitive to commodity price fluctuations. Therefore, volatility should be low with this asset class.

But so far, this year, they are doing worse than the broader market. We note that The Energy Select Sector SPDR (XLE - Free Report) , a popular way to track energy companies, has logged a return of -10.5% year to date, while the benchmark Alerian MLP Index AMLP is currently down a punishing 15.6% over the same period. The slide has been primarily triggered by a host of negative distribution surprises – cuts and moderations.

Of late, capital market access has remained tough and credit metrics stretched, making it difficult for the oil and gas transporters to execute on their growth projects. As a result, the distribution outlook became uncertain with a number of MLPs left with no choice but to trim their expected payouts. And with most investors owning MLPs for the benefit of generous, periodical distributions, many have understandably abandoned the sector. A recent case in point is Genesis Energy L.P. (GEL - Free Report) , which lost more than 3% after slashing its distribution to 50 cents per unit from 73 cents.

We expect the commodity price-associated volatility for the MLPs to persist for some time and advise investors to steer clear of this asset class. In addition to Zacks Rank #5 (Strong Sell) NuStar Energy L.P. (NS - Free Report) , other bottom-rankers, including DCP Midstream L.P. (DCP - Free Report) and Crestwood Equity Partners L.P. (CEQP - Free Report) , are risky bets that are best avoided at the moment. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Little Hope for Embattled Drillers

Despite the uptick in tendering activity and contract fixtures over the past few months, the oil drilling industry is in a bad shape. Waiting for that ‘elusive' recovery for about three years, the current oilfield environment remains one of the most difficult. With new competitors entering the market and drilling contractors too rattled to make new investment decisions, rig owners have seen a number of their vessels get idled.

Even Transocean Ltd. (RIG - Free Report) – the world’s largest offshore drilling contractor and leading provider of drilling management services – have been a victim of this sustained period of stubborn low oil price environment. In late September, the company announced that it will retire six of its cold stacked floaters, costing Transocean around $1.4 billion. This comes after commodity price rout has already made a number of deepwater drilling projects uneconomical.

While we agree that the market is far from being dead, it is no secret that there is a major overhang of drilling rigs ordered when crude prices were trading at $100 a barrel prior to the boom years of 2014, compared with around $50 recently.

Consequently, the drillers are struggling with diving dayrates, lower rig utilization and margin compression. Several quarters of reduced activity and diminishing contract backlog have meant that most of the players are facing continued pressure on revenues, earnings and cash flows.

With no signs of immediate improvement in market sentiment, 2017 is likely to rank as another challenging year for the drilling market. Even if commodity prices improve, the structural oversupply and pricing pressure will weigh on the sector components’ operating margins, who are basically looking for ways to narrow their losses by cutting costs.

Companies like Flotek Industries Inc. (FTK - Free Report) , Nabors Industries Ltd. (NBR - Free Report) and Tesco Corporation (TESO - Free Report) look to be in most trouble. Eating through backlogs without replacing them with new business, cash flow for these operators are likely to dry up further.

Depressing Prices Make It Difficult for Gas-Weighted Companies

Natural gas rebounded strongly after hitting 17-year lows of around $1.6 per million Btu (MMBtu) in the first quarter of 2016, rising a phenomenal 150% to a cent below $4 at the end of December. However, selling came back to the market since then. Year-to-date, natural gas has been one of the worst performers among major commodities, diving more than 20%. While prices have rebounded somewhat, they are still unable to stay above $3 for a reasonable period of time.

Things have gone from bad to worse with the U.S. Climate Prediction Center predicting a warmer-than-normal winter through much of the Lower 48. Agreed, we are heading into the withdrawal season with stocks at their lowest in three years but if Heating Degree Days (HDD) are lost and higher temperature persists into late 2017, the commodity is set for a steep sell-off. 

The resulting effect will ensure natural gas storage creep back to five-year average in the near future, with surpluses piling up later on. Over time, these secular tailwinds are likely to drag down natural gas sentiment and price. Already, the bearish winter outlook has send natural gas futures to their lowest level in eight months.

Consequently, natural gas-weighted exploration and production companies like Cabot Oil & Gas Corporation (COG - Free Report) , Rice Energy Inc. RICE, PetroQuest Energy Inc. (PQ - Free Report) are in for a tough time. Gas-focused partnerships like Williams Partners L.P. (WPZ - Free Report) tend to suffer too, from falling sales for their natural gas liquids (NGL) processing.

Check out our latest Oil & Gas Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy.

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