Converting The Cyclical Energy Sector Into A Secular Play

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Includes: CME, ICE
by: Manole Capital Management
Summary

Energy is the ultimate cyclical sector.

We prefer predictable and sustainable secular businesses.

Our approach to energy investing solves this predicament.

Manole Capital Management

June 2017

Cyclical vs. Secular - The Energy Sector:

Our kids love the craziness of SheiKra, Cobra's Curse, and Montu at Tampa Bay's Busch Gardens, and we certainly appreciate the endorphin rush of these rides. But sadly, as we get older, we tend to become less and less enthusiastic about roller coasters.

The energy sector represents roughly 7% of the S&P 500 index. After a dramatic move higher in 2013, the energy sector fell significantly in 2014 and 2015. In 2016, it was the single best performing sector, up an impressive 24%. So far in 2017, energy is down 14%, making it this year's worst performing sector.

Last year, OPEC (the Organization of Petroleum Exporting Countries) introduced production cuts, which boosted oil prices. OPEC recently met again and decided to extend this agreement to limit its production. Where we are on this cyclical roller coaster is unknown. We prefer to avoid parts of the market rife with uncertainty and geopolitical dangers - the only prediction we are confident making about the energy market is that prices should be volatile.

There are simply too many factors that determine price, outside of our area of expertise or knowledge base. We do not profess to have any true understanding about the inner workings of Saudi Arabia or its Middle Eastern foe Iran. Here's a quick example of the uncertainties involved: Saudi Arabia is looking to IPO its crown jewel - Saudi Aramco - late this year or early next year and would love to see higher prices to boost that valuation. Speculation is that its valuation could be ~ $2 trillion, which will help sustain its rather expensive welfare state. Iran and Russia are somewhat strange bedfellows, but both continue to pump record amounts of oil to boost current revenues. In addition to this murky outlook, the US is reporting varying levels/stockpiles of oil, while China is experiencing less demand for many commodities ranging from steel, iron, and oil.

These uncertainties perfectly highlight why we avoid investing in commodities and cyclical industries. The energy business is not only a capital-intensive business, subject to costly maintenance, but it also has multiple geopolitical factors that tend to wildly swing prices. We just don't see the advantage of investing in cyclical markets where there is limited ability to add value.

How We Invest in "Energy":

We focus our attention on secular, predictable, and recurring revenue business models. In this regard, we prefer to gain our "energy exposure" through the derivative exchanges. While these companies are classified as financials, one could easily label these exchanges technology companies.

CME Group (NASDAQ:CME) and Intercontinental Exchange (NYSE:ICE) are the two dominant exchanges where energy is globally traded. Both specialize in a key energy product, with CME dominating WTI crude and ICE controlling the Brent crude market. 15% of CME's total trading volumes and 19% of its total revenue are generated in the energy sector, while the same sector represents 23% of ICE's total revenue. Both generate transaction-based revenue, based on the amount of hedging companies decide to employ. Whether you are a user of energy (e.g. Southwest Airlines) or a producer of energy (e.g. Exxon), volatility in energy prices can endanger your business. Being able to hedge and lock-in key components of costs can be critical for future results.

As an example, Laredo Energy entered 2017 by hedging 70% of its price exposure at $56 per barrel. Despite crude trading below $50, Laredo was properly hedged and could focus on its growth opportunities. Instead of reacting to wild price swings in underlying crude prices, Laredo felt comfortable proceeding with its plans to spend over $500 million in exploration in interesting plays like the Eagle Ford shale.

Conclusion:

On the front page of CME's website (cmegroup.com), investors can see a running tally of trading (called ADV or average daily volume). Pricing or commissions (called RPC or rate per contract) changes based on volume, but the moves are sometimes fractions of a penny in size. If one takes ADV x RPC, one can easily calculate a decent proxy for transaction-based revenue. This is a transparent business model that is easy to understand. In our opinion, we prefer companies that can be easily modeled, have secular growth opportunities, and benefit from volatility, as opposed to being dependent on price movements.

Going back to our roller coaster ride analogy, think of these derivative exchanges as ticket collectors, ride operators, or toll-keepers. We prefer these types of predictable franchises, as opposed to the wild ups and downs of cyclical businesses. As shareholders, we prefer to benefit from higher volatility and inflation, regardless of whether prices increase or decrease. In the cyclical energy sector, since we really have no idea where oil prices are headed, we prefer not to bet on whether prices go up or down but rather on whether they will simply be more volatile in the future.

Disclaimer:

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Disclosure: I am/we are long CME, ICE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.