European Oil Majors Are Cheap And Attractive Inflation Hedges
Summary
- Indebted oil companies win on two fronts when inflation kicks in - a real decline in the value of debt owed, and price appreciation of their output.
- European oil companies are preferred due to relative valuations in comparison to the US oil majors.
- European capital markets are preferred to developing capital markets due to the risks of fraud, capital controls, and outright confiscation.
- Short- and long-term demand uncertainty is undue. Oil will remain a major component of global energy demand.
In my previous article, I wrote about why investors should short (or at the very least be cautious of) bonds, specifically US treasury bonds, provided the underlying risks of inflation. Along the same lines of macro-economic thinking, I want to offer investors another asset class they can invest in to hedge against inflation: Equity securities of European oil majors.
To me, oil companies are a superb way to hedge against inflation for two reasons. First of all, when inflation is positive, the real value of debt owed declines, which effectively represents a wealth transfer from creditors (bond holders) to debtors (equity owners). If you know that there will be significant inflation in the future, the best investment you can make is a leveraged one where the cost of debt is lower than the expected rate of inflation. When viewed in this manner, the staggering amount of corporate debt issuance at record low rates since 2009 can actually be viewed as logical and perhaps even, dare I say, smart?
The second reason to like oil companies as an inflation hedge is that inflation inevitably means an appreciation in the price of oil. This will lead to increased revenues for oil producers and a drastic expansion in profit margins. The nature of this profit margin expansion is due to the fact that currently inflated revenues will be generated using historical capital expenditures that were paid for with currency that is now depreciating in value. GAAP and IFRS standards of accounting are based entirely on nominal prices.
So, if oil companies are a great way to hedge against inflation, then why do I advocate for European oil companies in particular? First of all, European oil companies are cheaper investments than their global counterparts. This is demonstrated below by my favourite valuation metric EV/EBITDA across three European companies: BP (BP), Royal Dutch Shell (RDS.B), and Total S.A. (TOT); and three American companies: Chevron (CVX), Exxon Mobil (XOM), and ConocoPhillips (COP).
The European companies are undoubtedly cheaper than their American counterparts - as much as 50% cheaper - which makes them a superior candidate for long-term investment returns.
This valuation comparison only considers European and American oil companies and gives no consideration to oil companies headquartered in other regions. Major oil firms such as PetroChina (PTR) and CNOOC (CEO) in China, and Lukoil (OTC:LUKOY) in Russia maintain similarly attractive valuations to their European counterparts in the range of 5-7x EV/EBITDA, which should also make them potential investment candidates as per my previous logic. However, I dislike these companies for a different reason which has already been stated: They are headquartered in the regions of Russia and China.
Recent headlines have emerged surrounding the Trump administration's desire to enforce stricter regulations on Chinese firms listed on US exchanges and perhaps even an outright block on Chinese firms accessing US capital markets. This is not a 'new' capital markets war, but rather the most recent escalation in US-China tensions which have their origins long before the 2018 trade war began. These escalations will not stop anytime soon, and more tit-for-tat retaliations are coming. The risk of such tit-for-tat behaviour is eventually full on capital controls which may materialise in the not so distant future. Personally, I do not want to have my capital invested in China or Russia when capital controls are put in place restricting my access, or worse yet, my capital is outright confiscated by the relevant authorities. The valuations of Chinese and Russian oil firms are too similar to that of the European firms and hence do not warrant investment provided the additional risks involved.
Investors may rightly question the short-term demand for oil during the COVID-19 crisis and longer-term demand due to the impact of alternative energy sources. To address these issues, I refer you to the below image which shows 20+ years of growing demand for oil.
Granted, the forecast of demand growth in 2020 proved ill-timed and wrong, but the big picture remains the same. Oil demand is growing steadily and expected to continue doing so despite sustainable development policies in place by world governments. As for short-term demand the IEA sees oil demand at 99 million barrels per day throughout 2020 when considering coronavirus impact (hardly a catastrophic collapse).
Even if long-term oil demand deviates somewhat from forecasts, I believe that the valuations for the European oil companies mentioned in this article are such that a sufficient margin of safety exists to provide adequate investment returns in the future. And putting demand aside, I believe that the macroeconomic background of inflationary global monetary policy is enough of a catalyst to propel these stocks higher on its own. I hope you consider European oil majors for a place in your portfolio to protect against coming inflation.
This article was written by
Analyst’s Disclosure: I am/we are long TOT, BP, RDS.B. 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.
I am long these stocks through the iShares Stoxx Europe 600 Oil & Gas ETF (ISIN: DE000A0H08M3) as opposed to individual stock picks.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (7)
Euro companies could have debt in dollars or euros, so if euros dominate their debt - currency risk.
Do you a breakdown in their type of debt?