We see a lot of hand-wringing lately and baggy eyes. Tired energy bulls with tired portfolios, people who are crying in unison. What just happened? How did an incredible December and January turn into a frightening February? Why aren’t our stocks moving higher when the bulk of the oil data is telling us that the oil glut is disappearing (or has disappeared), or that our companies are posting “great” earnings results and paying at least lip service to shareholder returns? Why have the market gods forsaken oil bulls?
Amidst the pleas and rhetorical questions, we have to chuckle - not because we enjoy watching the consternation and psychological pain of other investors, but because we believe this is the process. This is one of the most challenging parts of being a contrarian investor; having to personally reconcile what you see in the fundamental data with what you’re seeing in your portfolios. That chasm can not only confound, but most importantly it can frustrate and tax investors because it’s the difference between your expectations and reality. When those two don't meet, pain always follows (just take a look at the relative underperformance of the ETF XOP relative to the overall market and US oil prices).
Collectively, the market currently believes that energy is an uninvestable sector. We could show you charts, but what’s the point when we know it accounts for one of the smallest % of all time in the S&P. Moreover, why shouldn’t it when compared to the glittering narratives of today’s technology, social media, and “platform” companies, where free cash flow rains down like manna. Why even bother with a dying industry like fossil fuels when obviously, electric vehicles and renewable energy will eventually displace such backward energy sources? Hence investors stubbornly refuse to even consider it.
That intransigence, perhaps even caused by earlier traumatic portfolio losses, isn't easy to overcome, and can't be in today's environment. E&P stocks and their earnings have to be compelling before they become compelling, meaning there’s nothing magical about $60/barrel. Who told you that $60/barrel was the magical price that would sprinkle gobs of free cash flow on our beleaguered oil companies? It’s just not true. Those $60/barrel bulls are just as wrong as those who claimed that $45/barrel was the shale break-even price.
It’s not, and it wasn’t. $60/barrel oil is really subsistence living. It’s the minimum daily caloric intake for most E&Ps, nothing more and nothing less. When you ripple $60/barrel through various E&P financial models, it’s akin to getting those calories by eating oatmeal; you may be full, but certainly not fulfilled. Here's an example, the difference between $60-ish Brent oil today vs. $75 oil say at year-end going into 2019 for a company like California Resources Corporation (CRC) is the difference between $0 free cash flow and over $450M, and we've assumed no production growth and mid-point guidance for expenses. $450M in free cash flow for a company whose market cap stands at $630M. So you see, at $60/barrel oil, you survive but never thrive, and no investor is willing to take market risks on an industry that just "maintains."
So what does THIS mean?? Are we really doomed to wander this forest of lackluster performance and value traps? No, no because as they said in the Matrix, there is no spoon. $60/barrel is an illusion. It’s a way station on our journey to higher oil prices. It’s where we’re hibernating for the winter, but it’s by no means where we stop.
We’ve said all along that oil won’t stay at $40/barrel (few people believed), then we said it won’t be at $45, $50, $55, and now $60 (and still few people believed), but it doesn’t matter. It doesn’t matter what the investment community believes right now, nor that we think oil prices should already be at $70-80/barrel today. If oil inventories are drawing today at a time when they’re supposed to build, just imagine what happens when oil demand recovers from the seasonal lull. What really matters is that oil is heading higher whether you believe it or not, and as it continues its climb, our caravan will begin to attract attention. As we cross from $60-65/barrel on higher we cross from the current “zombie company thesis” to “whoa that’s what operating leverage looks like thesis.”
It’s only then, when we cross that threshold in price and continue higher will investors be forced to recalibrate their models with... wait for it... higher oil prices, to finally see that magical free cash flow rain down like manna from the heavens. When they do, they’ll finally grab their buckets to get their fill, only to see us standing there already.
So worry oil bulls if you must, but do so rationally and in a measured way. Stay the course and stay patient, if things continue the way they have, your time will come.
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Disclosure: I am/we are long CRC. 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.