Introduction
For those who followed my previous article on Suncor (SU), or who follow the oil markets in general, you'll know that it's been a pretty favorable market for energy stocks here recently. The purpose of this article is to declare that it's time to buy Oil and Production names (XOP) and provide some digestable rationale.
Many think this is just a short term spike to be sold. I disagree. The Saudi Energy Minister Prince Abdulaziz bin Salman declared last week that "'Drill, baby, drill' is gone forever".
These comments come along with the OPEC+ announcement to continue to allow the market to stay under-supplied cements the control of OPEC, and also shows their confidence that they can retain control of the oil market over a longer period of time. In this article I want to call out a few factors that make me think they will stay in control, at least in the short term.
Being an oil investor is not easy, just look at the comments section on any long article. You'll see comments about crude oil going by the way of whale oil and EV's replace ICE cars and making the industry uninvestable. More on that later. For now I want to share a couple of anecdotes that have recently helped me as an oil investor keep my finger off the sell button:
Bull markets climb a wall of worry
I'm not exactly sure who to attribute this to, but reader Fred L. pointed it out to me in the comments of my prior article. It's extremely true that through all of this there continues to be risks and concerns that threaten us. Put in a different way, I heard a television personality use this one:
There is always a shark circling the boat and a tidal wave on the horizon
In case it's not obvious, this points out that there will always be plausible arguments why your investment is bad. Many of these arguments may be right, but the important thing is timing and in this case understanding the scale of the data. It's never a slam-dunk as to which way the market is going to go, if it was the valuations would be astronomical.
Risks to oil demand
There are a number of risks:
- COVID-19 variants
- Work from home continuing
- International jet travel not coming back
- Lockdowns continuing or expanding
- Chinese demand soft after Luna new year lockdown
- EV's will be coming fast and ICE cars are going to stop being produced
- World governments hate fossil fuel and will legislate against it
- Rising prices are going to crimp demand
The simplistic bull case for owning energy
Whatever the reason, I want you to consider this one fact:
Q4 2020 world oil demand was down 6% from all-time highs
Let that sink in ... with parts of Europe locked down, with much of the USA working from home and not commuting, cities with quiet streets, tens of millions unemployed, we're down just six percent from all-time highs. To verify that stat for yourself (which I encourage), hit page 35 of this pdf from OPEC.
How is that possible? The simple answer is that we consume a lot of energy just keeping the basic wheels of our economy turning.
With the OPEC cuts now putting the world oil market into deficit, a frac spread that's just recovering to 160 from mid 300's pre-pandemic, we're in a completely new oil market. However, oil company valuations have not caught up.
Again, the simple argument I am making for an investment at this point in time right now is for a reversion to longer-term average valuations.
For example, let's take a look at the SPDR Oil and Gas exploration and production ETF (XOP). Here is the 5-year chart:
Data by YCharts
Another one to note, my favorite Suncor Energy (SU).
Data by YCharts
For these charts we're going to ignore what happened prior to 2016 and focus on what was a very challenging time for oil producers, Canadian takeaway, and pretty much every negative threat you can imagine. Where do you see the price then and now?
Notice there is some catching up to do here, especially as we're likely to see a price spike here this summer if WTI price forecasts from the major banks (which they keep needing to raise) hold true.
Does it feel like this run is overbought, or has it just begun?
What about clean energy (ICLN)? Is that a buy after the massive sell-off? I personally don't think so, but there is certainly an incredible amount of positive sentiment, and a few of the names in this ETF will be big winners. However, I think with an ETF that probably has a majority of long-term losers, the math is not in your favor in my opinion. Plug Power (PLUG) is almost 9% of this ETF. In my opinion PLUG does not have a long-term viable business, but right now it's raised lots of cash and has a lot of hype, so you can't short, but you can steer clear.
Data by YCharts
Here is another chart directly comparing the return on both clean energy (ICLN) and fossil fuel stocks.
Data by YCharts
I'll let you make your own determination where your money should go. Some would say "follow what has been working", and that has been a fantastic idea, but the market is undergoing a huge rotations, and I think we'll see a shift in returns going forward.
What about Midstream?
I'm going to keep it simple again for midstream names such as Energy Transfer (ET). While I see their infrastructure as incredibly valuable, their revenue is based on volumes that, while contracted, are also not being fully utilized in a number of cases. Occidental Petroleum (OXY) just announced they expected 40% unused pipeline capacity from the Permian this year. This puts pricing pressure on these names in the future, even though many of the pipes are monopolies. In the case of Occidental, they are contracted to 2025 for their capacity. This does give the midstream names some certainty, but it's quite honestly not giving me a lot of confidence when you're billing for value that the customer is not getting, especially with the enormous debt load that ET has. Investors may also punish midstream on sentiment alone, although they could be a good place for stable returns over the next decade, they are not the place for dramatic capital appreciation in my opinion.
What about the energy transition?
This is the topic of a much greater conversation, but I'll put it simply; As a civilization we must try to find alternatives to crude oil and other hydrocarbons, but it's an incredibly difficult task and I see it as unlikely that we'll to succeed in ways that allows us both a) maintain the same lifestyles we have now b) completely eliminate hydrocarbon use. The idea that we're able to switch to EV's in an orderly fashion is extremely optimistic. If I'm wrong, that would be fantastic news for my kids and grandkids and I'll happily lose money in my oil investments, but I'm investing not on what I want to happen, but what I think will happen. I ask respectfully that as a reader you do not confuse the two. I believe that eventually the price of oil will get so high that alternatives are viable, but it's not at all going to be orderly.
There is some incredible content out there that details, with data, why the energy transition to electric is a worthwhile but likely unattainable goal. At very least Natural Gas will be huge portion of our energy supply going forward.
Summary
This run in energy equities has just begun in my opinion and has at least a couple of months to run quite hard. Oil is now an incredibly good long-term investment and should have a place in your diversified portfolio. With many large funds avoiding energy in their portfolios, we're unlikely to see stretched valuations any time soon. However, with vaccinations rolling out at a faster daily pace, and ICE still being the predominant transport between now and 2030, this is the time and the year to make some great returns in oil.
Humanity is going to face some tough realities over the next couple of decades and those that are saying the energy transition from oil to electric is going to result in oil demand dropping off are correct, but in my opinion it will likely be when oil is priced well over $250 a barrel due to lack of supply, not when oil is $5 a barrel due to lack of demand. At that point overall consumption will have to be dramatically reduced.
