The U.S. oil patch has earned a well-deserved boom-or-bust reputation over the past century. Fortunes were made in the good times but evaporated almost as often when the cycle turned down. The cyclicality of the business was the price of admission.
The last decade has perfectly encapsulated this cyclicality with a pair of oil price “busts.” Not surprisingly, energy stocks have been whipsawed right alongside the price of oil and, as a result, the S&P 500 Energy Index, which represents the U.S. energy sector, now sits almost exactly where it was 10 years ago. The sting of this “lost decade” for energy investors is sharpened by the fact that the broader S&P 500 Index has doubled over the same time period. Exhibit 1
Evercore ISI analysts estimate that normalized returns for the six supermajor oil companies1 and U.S. exploration and production companies (E&Ps) degraded from 20% and 14%, respectively, in 2004, down to 3% and -1% in 2016, despite spending a combined $1.8 trillion in capital.2 Of course, as Sir Arthur Conan Doyle remarked, “It is easy to be wise after the event.” In other words, the notion that energy companies have been reckless and free-spending has been exaggerated in hindsight when viewed through the lens of this oil price collapse. Correcting this impression has become an explicit goal for many U.S. producers.
Even as oil pricing has stabilized around $60 per barrel on much-improved inventory levels, healthy global demand expectations, and the Organization of Petroleum Exporting Countries’ (OPEC) compliance with its own production caps, U.S. producers seem dedicated to greater capital and cost discipline with a focus on returns.
Our blog last summer highlighted this improvement in economic footing and the potential of the U.S. shale sector to emerge as one of the few growth areas in a lower-oil-price world. More specifically, shale producers are shifting from resource delineation into full-field optimization. Or said differently, from science into manufacturing.3 More importantly, it may allow for double-digit returns on capital employed (or ROCE) by 2020, even at an oil price of $50 per barrel.
Energy Stocks’ Improving Growth Potential
While energy has begun to gain some interest among investors at the start of 2018, this early attention appears to be largely based on “Dogs of the Dow” type technical trading theories.4 We believe, however, such focus will begin to highlight that many energy stocks are fundamentally cheap, with improving growth potential. Pick your valuation methodology of choice.
- On earnings growth, Guggenheim cites the energy sector as having the lowest price-to-earnings growth (PEG) ratio among the S&P 500 sectors; specifically, energy’s PEG ratio is about half the overall market.5
- Guggenheim also notes that the energy sector weight within the S&P 500 of 6% is at a trough level relative to energy’s actual GDP contribution; the historical mid-cycle weighting is closer to 10%.
- Goldman Sachs estimates that the free cash flow (FCF) yield of the energy sector is set to improve to ~4% in 2019, which is only slightly below the S&P average of 5%. Importantly, this expectation is based on a $55 per barrel oil price and may approach 10% by 2022, even with a flat oil price assumption.6
The awakening of the U.S. shale sector caused a paradigm shift within the global energy markets and appears to have moved the oil price curve lower. Now, the maturation of shale from the science phase into the development phase is set to allow producers to turn towards manufacturing real returns. We believe the market continues to underestimate this value-creation opportunity.
We also believe that the philosophical shift to a more disciplined and returns-focused business model extends beyond producers and into the midstream space. As noted in our recent 2017 review of the master limited partnership (MLP) sector, the massive and expensive buildout of pipelines and other infrastructure needed to accommodate the increase in new shale production appears to be moderating. As a result, we expect that as cost-of-capital and access to capital concerns begin to diminish, investors may begin to recognize the long-term growth opportunities present within these traditional cash-cow midstream operators.
Within the SteelPath Panoramic Fund, we express this view via an outsized exposure to U.S. producers versus the megacap-weighted energy index, as well as significant exposure to the midstream MLP sector.
- ^The six supermajor oil companies are: BP (NYSE:BP), Eni SpA (NYSE:E), Total SA (NYSE:TOT), Chevron CVX (NYSE:CVX), ExxonMobil (NYSE:XOM), and Royal Dutch Shell (RDSA:London).
- ^Source: Evercore ISI, “Energy Portfolio Strategy: Positive Outlook,” Jan. 11, 2018. Normalized Returns are defined as Return On Capital Employed (ROCE) based on flat oil and gas prices since 2004.
- ^Source: Deutsche Bank, “The Times, They Are a Changing: Shifting Paradigm for the US E&Ps,” Dec 18, 2017.
- ^The “Dogs of the Dow” is an investment strategy that says investors should buy the 10 stocks in the Dow Jones Industrial Average with the highest dividend yield at the start of every year and adjust the portfolio annually.
- ^Source: Guggenheim, “18 Reasons to Be Bullish Energy in ’18,” Jan. 16, 2018.
- ^Source: Goldman Sachs, “How to Attract & Retain Through-the-Cycle Investors,” Jan. 9, 2018.
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