Don't Run Out Of Energy!

Value investors are screaming energy is cheap! And although fossil-fuels are bastardized due to the impending EV wave about to sweep the world and the Greta Thunberg effect (and rightly so), they still very much form the basic fabric of our daily lives.

Lithium cannot replace oil

A “value-trap”? Saudi-led ROPEC+ did not cut production post the COVID-19 shock and are on a war-path to kill US shale. It is important to note that this war is not an "Infinity War". It will run its due course in the medium run and there is an eventual "Endgame". US shale companies are acquiescing to investor demands and given the incredibly low oil cash prices, are cutting capital expenditures drastically (30-60% range)!

Growth for the sake of growth and stock buybacks are being shunned in favor of buttressing balance sheets. Having been a vehement proponent of this mantra since the beginning of the shale revolution, companies are finally doing what's best for their stakeholders!

To top it off, rig counts are slowing down, drilled but uncompleted well-inventory is falling due to the “up spacing” of wells, “good inventory” has been exhausted and hopefully post the virus scare, demand expectations will stabilize. These actions, although constructive will have a marginal impact on 2020 US production as a result of the long lead-time (4-6 months) onshore shale projects, but we will see a precipitous decline (10-15%) in 2021 shale oil supply, just when the world is recovering from the COVID shock. Another price shock looms, but this time to the upside?

It's Cheap

Regardless, when you have a sector that is trading at 2-4x forward EBITDA, that ought to garner interest. But sadly, the energy sector is just 3-4% of the S&P500. So why have investors shunned this space? It almost seems like they have vowed never to invest in this sector. Ex post, there are a few reasons for this:

1. Declining Asset: Energy is an inherently declining business. It is a depleting asset that one is trying to extract value from.
2. Value Destroyers: Exploration & Production (“E&P”) companies are notorious value destroyers. They have been guilty of growing for the sake of growth and a lot of them have had negative debt-adjusted cash flow per share CAGR for many a year.
3. High Leverage: As commodity price takers, you would imagine that energy companies would generally have a median leverage ratio of <1.5x, but most are disconcertingly well above that.
4. Serial Equity Issuers: While it is prudent to engage in M&A and A&D, it is imprudent to dilute shareholders by issuing equity and pay full asset price plus a premium to buy up “acreage” whenever anything perceived as a shiny asset shows up on the market. Water under the bridge at this point, partly because shiny new acreage deals are now non-existent, bid-ask spreads are super wide and acquirer valuations are so depressed that they just don't have the currency (high cost of capital) to make an accretive acquisition.
5. Dirty Business: It is not carbon-zero! Never will be, unfortunately.
6. Other Asset Classes: Why energy when I have the technology, consumer discretionary or the *plug sector of choice ex-energy* sectors to choose from?

Oil does not have a zero terminal value

Non-Zero Terminal Value. To a value investor like Mr. Buffet, this is likely music to his ears. A distressed asset which the world still is in dire need until electric vehicles take over our roads. If you think oil doesn't have a zero terminal value and the EV phenomenon is a decade-plus away on a global scale (a lot of questions on this lately), this could be an opportunity in disguise. Moreover, valuations in the “new” economy technology, biotech and healthcare sectors are still over-inflated. Some of these companies likely will never generate positive cash flow, leave alone earnings. But their weighted average cost of capital in some cases is at historical lows (think ~3.0%), even lesser than the widely accepted risk-free rate of 4.0%. So is it time to rotate into some value or distressed sectors like energy? Perhaps!

A distressed asset which the world still is in dire need until electric vehicles take over our roads.

So should one and how does one invest in this sector? Does it mean one has to take a directional view on oil? No, not at all! This means that once things stabilize, more money is going to flock into the energy space in 2021, and therefore the fundamental price discovery for equities will get better due to higher liquidity.

What are the real implications?

The above set of constraints and boundary conditions imply that idiosyncratic opportunities will abound. Good company differentiation from bad companies will get magnified and long-short alpha will return to the market. It seems prudent that investors get more “idiosyncratic" exposure to energy. The overall market returns are seeing a slow down (tech or any “momentum” hot sector) and stock picking in unloved sectors such as energy (and even in general) may be a relative winner. 

A word of caution ..

.. being early is being wrong.

Need patience

There are plenty of high volatility land mines still out there:

• US energy patch bankruptcies
• COVID cure
• Russia-Saudi cooperation
• US tariffs on imported oil
• Economic disruption

Ad meliora!

Disclaimer: This is not investment advice. It is solely my opinion.