BOTTOM FISHING IN THE OIL POOL? THINK AGAIN!

This chart from Ed Yardeni will likely alert the value investor in you. It sure made me work!

Natural resources investors Goehring & Rozencwajg provide more bait to wet your appetite for undervalued sectors in this overvalued equity market:

In the thirty years we have been investing in global natural resource markets, we cannot remember seeing greater value than we do today in the global oil markets. With both crude
and oil-related securities, the price action appears to have completely divorced itself from underlying fundamentals.

By any measure, oil and oil-related securities are radically undervalued. Over the last 120 years, we estimate it took 17 barrels of oil on average to buy one unit of the S&P 500. Today it requires over 53 barrels. The only time it has taken more was during the parabolic dotcom blow off–incidentally an excellent time to become an oil investor. At the same time, energy-related
equities now make up a mere 4% of the S&P 500 by weight. Not only does this represent the lowest level in at least 20 years (when our records begin), it is 75% below the peak levels reached in 2008 at which point energy stocks made up 16% of the S&P 500.

In particular, the bear market in oil exploration and production companies has created value that can hardly be believed. We analyzed the universe of all US-listed E&P companies with market capitalizations over $100 mm 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.

We also computed the discounted value of the companies’ proved developed producing reserves (PDPs). This represents the most conservative possible measure of value: a company’s
discounted cash flow from currently producing wells only. As you might imagine, it is very unusual for an E&P company to trade at a discount to this most conservative measure. Today, we estimate that twelve of the twenty-nine companies in the universe are trading at a discount to their PV-10 value using only their PDP reserves. Furthermore, the average premium to PDP PV-10 value across the entire industry is now only 7%. Once again, we have never seen anything remotely like this before. Investors often act irrationally at the bottom of long, drawn-out bear markets and we believe that is what we are witnessing today. (…)

In past cycles, as energy prices fell and E&P stocks sold off, two groups of investors would begin to accumulate positions: natural resource specialists and value investors. Our analysis tells us that natural resource funds continue to suffer material redemptions as investors look to reallocate capital away from the industry. We estimate that nearly 25% of the industry’s assets under management are flowing out through redemptions each year and this figure shows no sign of abating. As a result, resource fund managers are constantly forced to sell positions to meet redemptions, instead of stepping in to take advantage of the deep value. Value managers are also suffering net redemptions. After a difficult ten-year period, growth continues to outperform value and investors continue to chase the momentum of the former by selling the latter. In past cycles, value investors could be counted on to buy during extreme bear markets. but today they are either on the sidelines or liquidating positions to meet redemptions as well. In fact, active managers in general are seeing capital being allocated away into passively managed index funds. As we mentioned earlier, energy now makes up its lowest ever weighting in all the major indices. Therefore, as capital gets redirected from actively managed funds towards passive index funds, energy shares end up being liquidated.

There are no natural buyers for natural resource stocks in general and energy stocks in particular. This has allowed the sell-off to be more severe than past cycles and resulted in unprecedented value for those able to invest in this most contrarian space.

Goehring & Rozencwajg go on to demonstrate that equity markets are totally missing the point on energy stocks, that oil demand is stronger than statistics suggest and that supply, particularly from U.S. shale areas will prove materially less than expected.

Spending one’s working life analysing and investing in natural resources companies is a constant challenge trying to keep pace and understand the large number of low-visibility macro and micro variables impacting these industries, making forecasting in these industries an exercise akin to shoveling clouds.

If you are inclined to bottom fish energy equities, also consider these factoids unexplored by the above quoted duo:

It does take about 50 barrels of Brent oil to buy one unit of S&P 500, making oil seemingly cheap compared to some other periods, but I hardly see any meaningful point in this relationship, certainly not a clear high/low pattern one can secure a valuable hat on. The fact is that the economy needs less and less oil to grow.

Price to Book for the median U.S. energy stock is currently 1.2, near the very bottom of its 25-year 1.0-3.0 range. Trailing ROE, measuring the return on said Book Value, was 4.3% in 2019, also near the low end of its 0-18% range. Unless ROE can recover meaningfully, the low P/B is justified by the current low return on book.

Energy sector ROE has historically been intimately tied to oil prices which rose from $13 in 1994 to their current $66 with flares exceeding $120 in 2008 and 2011-12. As this CPMS/Morningstar chart illustrates, the problem is the constant decline in the energy industry’s ROE per dollar of oil prices (red line):

The industry’s trailing 12-month cashflow margin is 17%, at the low end of its 25-year range of 15-30%. But when oil prices averaged $65 in past years, cashflow margins were 19% (2015), 22% (2010), and 25% (2007). This industry clearly has a cost (or efficiency) problem that, to this day, shows no sign of abating. Lower cashflow margins reduce funds available for production and exploration, even more so when oil prices are low.

The median energy company has a debt/equity ratio of 0.7, at the high end of its 25-year range and nearly double its 2006 level when oil prices were also $65. Critically, higher leverage has not translated into higher ROE. The average D/E ratio is 1.0, down from 1.3 at the end of 2015 but well above its 0.8 high between 1993 and 2014. Some large companies are highly leveraged.

As recently revealed by the WSJ, North American oil-and-gas companies have more than $200 billion of debt maturing over the next four years, starting with $41.2 billion in 2020, reaching $68.1 billion in 2022 according to Moody’s Investors Service. It is not clear whether the apparent asset values quoted above fully take this high debt leverage into account.

Energy equities are currently selling at 17.0 times forward EPS per Ed Yardeni’s numbers. The 6.6% discount to the S&P 500 P/E of 18.2 is nowhere near its 30% level of 2000-01, just before Energy’s strong outperforming decade, and hardly compensates for the uncertainty inherent to the sector’s macro variables and its poor, deteriorating fundamentals:

Forecasting oil prices has been an elusive and slippery activity, even for full time seasoned analysts like Goehring & Rozencwajg. Good luck if you buy energy stocks on a rising oil price forecast. If you are right, you are still invested in a leveraged sector with poor cost control and numerous moving macro parts offering very limited visibility. If you are wrong, you find yourself holding a sharp, oily knife.

While I do not pretend to be part of a typical family (though not very far from it), I can only notice that of my 9 immediate family households, five recently changed one of their cars and four opted for either a hybrid electric vehicle (1) or full EV Teslas (3). One of our sons bought a Model X and we and a nephew each now drive a Model 3. Frankly, these are truly unique and really great cars, totally redefining the car ownership/driving experience with unique, efficient software that gets regularly updated to constantly improve the car efficiency, safety and driving/owning pleasure. Of my immediate family’s combined 12 cars, 3 no longer need to visit a gas station, ever, and one only very occasionally.

In many respects, Teslas remind me of the cellular phone in the early 1990s. Early adopters bought Blackberries and IPhones for their portability. When people started to realize/understand the power of the software embedded in these little boxes, they wanted/needed them for their various and ever expanding functionalities. Cellphones went from portable telephones to increasingly convenient, efficient and evolving software in the pocket. It may not be long before people realize/understand what owning a Tesla really means: beyond being a great electric vehicle, a Tesla is convenient, efficient and evolving software on wheels. This disruptive trend is there to stay and accelerate.

This chart from Ed Yardeni shows world oil production’s relentless rise…

…while this chart, using the U.S. EIA numbers, illustrates how production keeps outrunning world consumption.

The truth is that oil has a growing demand problem that some producing nations attempt to offset with complicated and elusive controls of a pool of supply that is becoming more and more marginal. Meanwhile, technology keeps reducing production costs for the marginal barrel, dragging down commodity prices along with margins for this high legacy costs industry.

In such a context, it is difficult to see who will be the next “natural buyers of energy stocks”. Certainly not the increasingly environmentally conscious young investment managers and their increasingly environmentally conscious clients, and certainly not the growing cohort of Tesla owners.