Eric Green, CFA, CIO, Penn Capital Management, LLC
April 3, 2023
Investing in the energy sector is not for the faint of heart. Last year was strong for energy stocks in the Russell 2000 Index (Russell 2000), on a relative and absolute basis, returning over 40% despite the Index being down 20%. Even with last year’s strength though, many investors are still skeptical of energy since it was the worst-performing sector in the Russell 2000 for the previous 10 years. With that dismal long-term record, why would investors consider the sector? We believe there are reasons why the next ten years could prove to be better.
Lack of interest provides an opportunity
The lack of investor interest in the energy sector is considered positive and provides opportunity. At one point, the sector fell below 2% of the Russell 2000 and below 3% in the S&P 500 Index (S&P 500) despite energy earnings comprising multiples of that percentage in the indices. Weightings have increased over the last year, but are still below the percentage of earnings in their respective indices. Free cash flow yields of energy companies in the S&P 500 are more than twice the average yield of any sector. Valuations of the exploration and production group within energy are less than half the valuations of every other sector except for telecom and materials. The average exploration and production company trades at an enterprise value multiple of 4.5x this year’s EBITDA versus 11.5x for the Russell 3000 Index.
ESG investing and the demonization of the industry have also contributed to declined investor interest. Although many energy companies are reducing their carbon footprint and finding ways to help other industries reduce emissions, many ESG investors consider all energy companies as prohibited investments and believe that the industry will be obsolete in the next 10 years due to electric vehicles and other conservation measures. According to Raymond James, over $5 trillion has been spent on renewables in the last decade, yet the percentage of energy usage has remained relatively flat with hydrocarbons making up 82% of energy consumption today versus 86% in 2000. Electric vehicles will have little impact on the demand for oil for many years even with large government subsidies. If electric vehicles become 40% of total vehicles sold in 2030 as some predict, internal combustion engines would still make up close to 90% of the cars on the road. In 2022, 85% of vehicles sold in Norway were electric vehicles; however, the country’s oil consumption grew last year to the highest level in its history.
ESG issues and the fear of renewables reducing the demand for hydrocarbons have led to a long period of underinvestment in hydrocarbons. Typically, the largest finds of oil occur in deepwater offshore projects, which are long-term and can take at least seven years to produce oil. In the last 10 years, the long-term development of these projects has been dramatically reduced because very few companies wanted to spend billions of dollars with the potential decline in oil demand. The large public companies were discouraged to begin these projects by their investors, governments and environmentalists. Further, the oil spill in the Gulf of Mexico raised the costs of drilling offshore and increased the resistance of the public. Ironically, deepwater offshore oil wells are considered safer than onshore wells and contain the least amount of carbon emissions. Recently, the underinvestment has been compounded by the difficulty in finding labor and equipment. Many seasoned workers in the oil patch have moved on to other professions. Additionally, the equipment has not been maintained and very little new equipment is being manufactured.
The impact of free cash flow
Investors have also discouraged the growth in hydrocarbon production, insisting that companies use their free cash flow to pay down debt and return capital through dividends and stock buybacks in lieu of growing production. This change is one of the reasons why the sector has started to perform. Today, the average high yield energy company has leverage below 1x. A few years ago, it was acceptable for exploration and production companies to have leverage 5-6x or higher. Today, high yield credit spreads in the energy sector are 80 basis points tighter than the overall high yield market. With leverage much lower, these companies are not increasing drilling, but instead returning capital to shareholders. Previously, the companies would have spent more than their free cash flow to increase production. As they simultaneously increased production, oil prices declined considerably and many companies filed for bankruptcy. Management teams do not want to repeat the sins of the past and investors have no appetite for companies that are outspending their cash flow to increase production. Even if companies wanted to increase production, the lack of labor and equipment, inflationary service costs, lack of pipeline takeaway capacity and regulatory burdens are major impediments to growth. According to Raymond James, US exploration and production companies reinvested 31% of their cash flows into production in 2022 versus 150% in 2015 and a pre-Covid average of 120%.
Like public companies, OPEC nations learned their lesson from excessive growth and have been extremely disciplined with supply, some even arguing they had no choice. Today, OPEC has limited spare capacity in case of a geopolitical or weather-related event. Historically, OPEC kept more than five million barrels per day of spare capacity that they could turn on to make up for lost production stemming from geopolitical and climate turmoil; however, today that number is estimated at approximately only one million barrels per day of spare capacity. OPEC has struggled to meet increasing demand due to many issues, including the loss of production from Iran and Venezuela, as well as the declining rate of well production. Additionally, they underinvested over the last 10 years for similar reasons as the public companies. Saudi Arabia, the largest oil producer in OPEC, focused on diversifying their economy to reduce dependence on fossil fuel revenues. Despite Russia’s production resilience during the war, there is little optimism that they can increase production.
Oil consumption projected to normalize
Oil inventories in the US and around the world are well below average. In the US, inventories are 200 million barrels below pre-Covid levels despite the drawdown to historic low levels in the strategic petroleum reserves. Worldwide inventories are 300 million barrels below pre-Covid levels. Inventory shortages are not solely in oil; other fossil fuels including coal and natural gas have experienced shortages over the last year. Prices for commodities typically follow inventories and there is little optimism that inventories will grow at current prices.
Recently, recession expectations have created the fear of reduced oil demand. Recessions have not necessarily caused a decline in demand. Worldwide oil demand has only declined twice in the last 40 years (2009 and 2020) despite multiple recessions over that period. The two recessions occurred after oil prices hit multi-year highs and unemployment was significantly higher than today. Much of the increase in demand for oil has come from non-OECD (Organization for Economic Co-operation and Development) countries. Most developed nations have had consistent demand with little growth for many years. In China, the average consumer uses less than 5% of the oil compared to a US consumer. Assuming little change in demand, the world along with China’s demand normalizing to pre-Covid levels, demand should grow year-over-year. China lost one-to-two million barrels per day when their economy shut down in 2022 due to Covid. Preliminary demand data for 2023 shows growth from the rest of the world and Chinese oil consumption normalizing. China recently announced that they are building more than 100 coal-fired power plants. If there was not an expectation for increased demand for fossil fuels, China would not build coal plants. Worldwide air traffic is at a four-year high and along with several other demand indicators, suggests continued demand for oil. Another catalyst for oil demand is the eventual refilling of the US Strategic Petroleum Reserve (SPR). The US has withdrawn 265 million barrels of oil over the last year and a half, leaving the SPR with 40-year low inventories. Biden has expressed interest in buying crude at prices in the $67-72 range. This should limit the downside in oil if it falls to this level.
But, are there risks?
With all the issues discussed above, we believe that there are upside and downside risks. Energy securities are stocks and, as such, correlate with the stock market. It is unlikely that they perform well in a poor stock environment. Geopolitics creates both upside and downside risks. The war ending peacefully in Russia would likely have a short-term negative impact on the sentiment for fossil fuels. Conversely, disruption in the Middle East would have a positive impact on the sentiment for oil. The weather has some influence on the price of fossil fuels. The recent decline in natural gas was caused by an extremely mild winter in the US and Europe. If commodity prices decline, both the exploration and production and oil service stocks will fall.
All things considered though, we believe the risks are skewed to the upside and we expect to see strong performance in the commodities as well as the securities of energy companies for the next several years.
The views expressed are those of Penn Capital Management Company, LLC, a boutique manager on the Spouting Rock Asset Management platform, as of April 1, 2023, and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. There can be no assurances that any of the trends described will continue or will not reverse. Past events and trends do not imply, predict or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.