Why You Should Start Looking For Investment Ideas In The Oil Sector: 2020 Looks Promising

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Angel Martin Oro
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Summary

  • I explain why the under-owned oil equities space presents a compelling investing opportunity, one that great investors such as Peter Lynch have recently embraced.
  • Valuation multiples of oil stocks are at extremely low historical levels, and there is significant room for investors to increase their positioning to the sector.
  • This might happen soon, as investors start to focus on the inevitable consequences of past underinvestment, the new capital paradigm among US shale companies, and a potential demand uptick.
  • A couple of macro tailwinds, which may reinforce the case for energy stocks at this particular stage of the economic cycle, are also discussed.

Introduction: The Contrarian Approach

These days it's very common to read or write about investment themes and ideas that might play out nicely in the coming year. And, although it makes little sense to draw a line between the year that is ending and the one that is about to begin, as if a different phase were starting, here we are not going to be less. It is just an excuse to talk a little bit about some ideas that may be interesting. Who knows if they will work in 2020 or 2021 or even 2022, but at least they look good now.

A feature of the investment theme I will talk about in this article is that it is such an unloved sector, which has been severely punished by the market in the last few years. From this pessimism embedded in prices, which translates into low valuations, is where the opportunity arises.

This contrarian approach sounds very good in theory, but in practice it is not easy whatsoever. It has several potential risks that it is worth taking into account. Hedge fund manager Mike Alkin, who is now focused on the nuclear fuel cycle bull thesis, told me about this in a previous interview:

I have always been contrarian, but over the years, and from the lessons learned from those great investors, I learned that being contrarian for the sake of being contrarian is not a sound investment philosophy. Often times consensus is right and stocks are priced about right. It requires peeling the onion back many layers to determine if consensus is right or wrong. Finding either real value on the long side or a compelling short idea is not easy.

I also learned that a deep-value long can stay cheap for a long time and that you must identify catalysts to unlock that value.

One of those risks is being too early to a beaten-down sector. Mike Alkin himself knows that too well, as the uranium equities are still on the doldrums, however with very attractive long-term prospects. Regarding the risk of being too early, I read a very intelligent advice recently that said:

As a value investor when you spot a bargain & make a buy the first thing that will happen is the price will go lower.

That is because the reasons that caused the stock to be loathed & hated didn't stop because you discovered an undervalued stock.

So be careful & start slow.

Oh, by the way, if you want to have a definition of what a contrarian investor is and does, read this from one and only Peter Lynch from "One Up On Wall Street":

The true contrarian is not the investor who takes the opposite side of a popular hot issue (i.e. shorting a stock that everyone else is buying). The true contrarian waits for things to cool down and buys stocks that nobody cares about, and especially those that make Wall Street yawn.

The Opportunity In Oil Stocks: Why Peter Lynch, Sam Zell And Others Are Interested

Peter Lynch is a very good spot to end this introduction and start with why I think the oil sector should be a source of investment opportunities in 2020 and perhaps beyond. The legendary investor said in a succinct but insightful interview with Barron's that he is currently seeing opportunities in energy services and the oil sector (shipping too, but that is another subject).

Well, he is not alone in that positive bias towards energy. We can point to portfolio manager Chris Mayer's "Ideas for 2020" post in which he wrote: If you are looking for an interesting place to put money in 2020, the energy sector deserves a look. Billionaire Sam Zell, who made a fortune buying distressed real estate assets, is also interested. The global macro guy from Macro Ops, Alex Barrow, recently wrote: I'm thinking this is a 2H 2020 play. But the opportunity is so great it's worth keeping a very close eye on now. Dylan Grice from Calderwood Capital summed the setup in the oil sector in the following way: an industry in one of the worst downturns in its history; blood in the streets; dumb money selling; smart money buying. And of course, natural resource investors Goehring & Rozencwajg (G&R) are also extremely excited about the "unprecedented value" they see in oil equities.

So, why is that?

Valuation And Investors' Positioning/Sentiment

Let's start with oil equities' valuations and we will realize that the investment opportunity in oil equities does not hinge on higher oil prices. Of course, that would certainly help and might be the catalyst to make investors to start look at the sector again. But, although we will later see why that scenario of higher oil prices is likely, I don't think is needed to make money here.

Much has been talked about the fact that energy equities' weight in the S&P 500 is at extremely low historical levels of around 4-5%, while the average in the last few decades has been about 9%. Specifically, the last decade has been consistently on decline.

Source: Bespoke

It is not only that the energy sector's performance has been very poor, but also that the S&P 500 has shown outstanding returns.

But these pieces of data do not tell us much about whether the increasing irrelevance of the oil sector in the equity market is justified by fundamentals or not.

Recently, G&R did a valuation exercise and concluded that current valuations are extreme on the low side. Simply put: "An entire industry is nearly priced as though it will simply run off its existing assets." Let me copy the relevant excerpt from G&R's latest quarterly report:

We analyzed the universe of all US-listed E&P companies with market capitalizations over $100mm and proved reserves that are at least 50% oil. We then compared the current stock price to the net-debt adjusted SEC PV-10 measure from their 2018 10Ks. As you may recall, a company's PV-10 measures the discounted cash flow of all proved reserves at the prevailing oil and gas prices. Under normal market conditions, E&P stocks trade at a premium to their SEC PV-10, reflecting the expected value of any future reserves not yet "booked" in the reserve statement. However, due to the overwhelming bearishness among energy investors, the average company now trades at a 12% discount to its net-debt adjusted SEC PV-10 per share value.

While we have seen individual companies trade at a discount, we cannot recall a time when the industry average was less than its SEC PV-10 value. We should point out that the price used in most companies' SEC PV-10 analysis for 2018 was $55 per barrel, not materially higher than today's price. (Note: as of this writing, WTI price is close to $62)

Mark Gordon, Ascent Oil Fund CIO, also highlighted the "unprecedented" (his wording) low valuation levels of Exploration and Production (E&P) oil companies. In a presentation he has been giving lately, he shows the median EV/EBITDA 2020 of his portfolio is 3.6x and 2.9x at an oil price of $55 and $65, respectively, while these companies usually trade at around 7-9x EBITDA. Furthermore, in terms of PV-10 basis, his portfolio median is below 0.5x while historically has been about 2x.

In order to illustrate this in a more visual fashion, just pay attention to the below chart. If we take the S&P Oil & Gas E&P ETF (XOP), we can see how, despite a recent uptick from extreme lows, it now trades at about the same levels of the lows it marked at the Great Financial Crisis with a WTI price of around $40, or at the panic levels of the Oil Crisis early 2016 when WTI hit below $30. Today, the oil price sits at above $60, twice as much 2016 lows, when the US shale oil production flooded the market, the OPEC didn't cut supply and panic hit over emerging markets growth.

If you want to see the divergence in an even more visual way:

Source: Topdown Charts

So, this clearly shows investors are extremely pessimistic on the energy sector and have their portfolios positioned consequently. BofAML Global Fund Manager Survey has been systematically portraying Energy as one of the most underweighted assets for a while, along with the UK. I have also read a few portfolio managers saying some of his peers considered this sector as categorically uninvestable, with ESG criteria adding fuel to the fire.

This despite FactSet estimates S&P 500 Energy companies' earnings growth will be the highest among all different sectors in 2020.

Source: FactSet

Oil Market Fundamentals

Besides valuation and investors' positioning/sentiment, which gives us some indication there may be opportunities in this space, it is important to analyze oil market fundamentals to have a view on oil prices. At the very least, higher oil prices may be the catalyst the thesis needs to play out. Otherwise, in the absence of an uptick in oil prices, oil equities might be extremely slow to move upwards. So let's briefly revise the supply and demand picture of the oil market.

First of all, we should say that, in my view, it is very difficult to have great conviction on the direction of oil prices, as it is such a complex market with many moving parts, both economic and geopolitical considerations. Here, we do not aspire to set an oil price target range, but to have a view on the probabilities of oil prices medium-term going down or up. (Readers may benefit from reading Massif Capital's 2Q Letter to Investors on their approach to investing in mining companies, where they explain how commodity prices are factored into their analysis).

Nowadays, it seems to us the probability of seeing higher oil prices in the next 1-3 years is higher than the probability of seeing lower prices. While this is not saying much, it may be enough for the thesis to play out. Not much higher prices are needed for current low valuations of oil sector equities to start attracting generalist investors' money, which so far has been far and away from.

Our arguments are not original, but mainly come from reputable sources such as HFIR and Mark Gordon's work, recently summed up in a very insightful presentation.

Supply: The Capital Cycle

As an extractive and capital-intensive industry, the oil sector is highly cyclical, prone to boom and busts cycles driven by the supply side. The capital cycle analysis, as popularized by Marathon Asset Management's approach, is highly relevant. The following figure nicely captures its essence:

Source: Capital Returns - Investing through the Capital Cycle: A Money Manager's Reports 2002-15

As Mark Gordon says, the oil market tends to alternate phases in which the narrative is one of "scarcity" and others in which it is one of "abundance". Today and from 2014 we would be in a regime of "abundance", caused by several factors: fears about demand (electric vehicles, environmental issues), new sources of supply (mainly from the US shale basins) and OPEC increasing production. But in his opinion, we are close to entering a new phase of "scarcity", where oil prices will be materially higher and valuation multiples of oil equities will also rise. Partly because the reduction in capex investment by global E&P companies in recent years has been unprecedented in recent history, as the graph below shows.

Source: Mark Gordon's presentation

To better understand the importance of this point for those who are not familiar with this type of extractive sector, keep in mind that this is an industry in which to simply maintain production levels constant, more capital must be put in each year to find more oil reserves because of oilfield decline and depletion rates. (This is a key reason why natural resources industries are usually one of the worst investments in the long run in contrast to asset-light businesses).

This decline in investment will be manifested in the dearth of new non-OPEC production coming online starting from 2020. Bear in mind there is a significant lag of a few years between capital spending decisions on conventional non-shale oil projects and its impact on supply. So, the oil market in these years is sort of reaping the fruits of the sowing of several years ago.

In addition, US shale production, which was breaking record after record and surpassing expectations to the upside (remember, one of the main factors in the "oil abundance" narrative), has ceased to do so and its growth is now slowing markedly (see HFIR's chart). More importantly, this slowdown is expected to continue going forward (see Goldman Sachs' chart). Why? Apart from likely geological sustainability considerations, because of lower well productivity and fewer wells, in a context of capital discipline - what some have called "capital starvation" - after so many years of very loose financing buoyed by ultra-low interest rates, which has forced companies to focus on achieving positive free cash flow rather than growing production.

Source: HFIR

In Gordon's view, the supply-side bullish thesis in oil should be very visible, and even a focus of concern for the general market, in the second half of 2020. We will see if and when prices start pricing in this scenario. Perhaps the current uptick in prices is just the beginning of that process?

Before jumping into the demand picture, you may wonder why is the general market not aware of the bullish supply set-up that we have just described? We might say it is just about popular and incomplete narratives, biases and so on, but maybe the best answer was given in the introduction to the Capital Returns book:

Because most investors (and corporate managers) spend more of their time thinking about demand conditions in an industry than changing supply, stock prices often fail to anticipate negative supply shocks.

Demand: The Global Macro Picture

The demand side is more uncertain and difficult to predict than supply. As we said, there is a lag between capital spending decisions and their impact on supply. The flipside to this uncertainty is that demand is relatively inelastic, so big moves rarely happen. All in all, it is certainly the other side of the coin, and thus, we should have at least a general view on that.

Weak demand has arguably been the key reason why oil equities have underperformed during 2019. The global manufacturing recession and notable trade growth slowdown have clearly weighed on the sector. However, there are hopeful signs of an economic upturn, although these are still incipient (see chart below). For the oil market, rather than a growth re-acceleration in aggregate, it is the manufacturing sector that holds the key, since the world's largest economies are heavily biased towards services, which consume much less energy and raw materials than manufacturing. So, the most important macro indicators to watch are not so much global GDP, leading indicators or composite PMI numbers, but rather manufacturing and trade-related data.

Source: Topdown Charts

One could argue that the oil sector has been one of the most punished ones because of the trade tensions, and that consequently, it would significantly benefit from a softening of these tensions. Who knows, but what is true is that this less uncertain environment should help global trade and growth in turn affecting demand positively.

The biggest risk regarding the bullish thesis would be an impending global recession causing oil demand to plummet. This is unlikely to happen in my opinion, and as we can see in the chart below, a big crisis needs to happen in order for oil demand to contract meaningfully. Of course, this is something to watch, but currently is not in the cards, at least in the next 1-2 years.

Source

Besides, historically recessions have been preceded by substantial oil price and inflation rate increases. This is well documented in James D. Hamilton's paper titled "Historical Oil Shocks". He concludes with the following:

All but one of the 11 postwar recessions were associated with an increase in the price of oil, the single exception being the recession of 1960. Likewise, all but one of the 12 oil price episodes [i.e. large price increases] were accompanied by U.S. recessions, the single exception being the 2003 oil price increase associated with the Venezuelan unrest and second Persian Gulf War.

The correlation between oil shocks and economic recessions appears to be too strong to be just a coincidence.

Indeed, energy stocks tend to do very well at the later stages of the business cycle, as can be seen below:

Source: Macro-Ops

One last point I would like to make is that in the current stage of the cycle, given the Federal Reserve stance and the global monetary policy of the last decade, I believe investors would do well owning some real assets that might benefit from an unexpected rise in inflation. Energy is one of them.

Concluding Remarks

As you will have noticed, this article was not about discussing specific stock ideas, i.e. which oil companies are most attractive, but to point investors into an area of the market that has become very overlooked. Once you believe that the oil space may be attractive, then you should dig deeper to look for the vehicle you want to bet on. Perhaps we will talk about that in upcoming articles.

Energy stocks are very volatile and most often a bad investment in the long term. Many investors may consider them as uninvestable or think they are always a waste of time and money because of their vast underperformance in the last decade. Recency bias and extrapolation are powerful biases. But this is a cyclical sector and has to be treated as such. The risk of oil demand structurally going substantially down in the coming years I think is overblown and perhaps one of the reasons why the opportunity exists.

In short, I think the current set-up in the oil equities space is quite compelling for investors. First, it offers attractive valuations in an unloved industry with extremely underweight positioning and negative sentiment. Second, oil market fundamentals make us think it is more likely to see higher prices than lower prices, and not in the too distant future, 1) as supply will significantly tighten next year due to past capital spending decisions and US shale's new capital starvation paradigm, and 2) demand might pick up as a consequence of a rebound in global manufacturing and trade activity. And third, there are macro tailwinds worth taking into account, such as the fact energy stocks perform very well when inflation rises.

This article was written by

Angel Martin Oro profile picture
684 Followers
Individual investor and economist specialized in international economics and business cycles. Passionate about financial markets, both in theory and practice. I consider myself as an eclectic investor focused on global macro and value investing. I manage my own and family and friend's money, mainly equities through mutual funds and individual stocks.
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Disclosure: I am/we are long VAL. 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.

Additional disclosure: Nowadays, I am only long Valaris directly and looking to add an E&P name soon. Also own a couple of mutual funds that are significantly overweight energy stocks.

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