<November 25, 2019>
When I think of stocks that have underperformed this market cycle, energy is the first sector that comes to mind. Recent performance has been particularly troublesome. On November 11, 2019, The Wall Street Journal reported that energy is the only sector in the S&P 500 that has declined over the past 12 months. Specifically, the paper noted, “The SPDR S&P Oil & Gas Exploration & Production exchange-traded fund has lost nearly 40% of its value in the past year, while the PHLX Oil Service Index has fallen more than 40%.”
Such large losses shouldn’t be surprising, since almost everyone knows energy companies are bad businesses. Most tend to be capital intensive, extremely volatile, and incapable of generating sustainable free cash flow. Sure, they can generate huge profits during booms, but is it worth the risk of meaningful losses or bankruptcy during the busts? And after 23 years of investing in the sector, I’ve seen my fair share of energy companies stumble into bankruptcy.
Although I’m well aware of the risks associated with energy stocks, I’ve always been fascinated and attracted to their unpredictable and violent cycles. It seems to be one of few areas in the economy where business and investment cycles are still allowed to exist. In an era of artificially suppressed interest rates, gravity-defying equity valuations, and the “Greenspan-Bernanke-Yellen-Powell Put,” I find the cyclical nature of the energy industry refreshing. In effect, the energy cycle remains relatively pure and unpolluted by central bank intervention.
I was introduced to the energy industry in 1996 after joining the Evergreen Funds. I was hired as an analyst and was paired with a fund manager who loved energy stocks. Considering my new boss was known as a highly successful value investor, I was surprised she had such a high opinion of the energy sector. Until this time, I avoided energy stocks given my unfavorable views of the industry. Regardless of my beliefs, she was the manager and I was the analyst, so if she liked energy stocks, I needed to quickly understand how to analyze and value them.
My education in energy was put into motion when I attended my first energy conference in Houston, Texas. I was 25 years old and knew very little about the industry. The first thing I quickly learned was most energy CEOs are very charismatic. Considering how much capital many of these companies require, a charismatic CEO capable of raising large amounts of equity and debt is essential! The second thing I learned was the importance energy producers place on production growth. Exploration and production companies (E&Ps) love to drill, and it’s how most measure their success. The third thing I learned was that while most energy companies are not good businesses, some have very good assets. If these assets can be bought at a meaningful discount to their replacement value, they can be good investments. And finally, I learned energy companies tend to be aggressive and confident allocators of capital. If an energy company has access to capital, it will likely be accumulated and spent. I often refer to putting capital in front of an energy company as equivalent to placing a bag of cookies in front of the Cookie Monster—it’s quickly and frantically devoured!
Although energy companies have a tendency to allocate capital with certainty, energy prices and profits are anything but. When I began investing in energy stocks in 1996, energy prices traded slightly over $20 a barrel and were sufficient to generate profits for most in the industry. In fact, the energy conferences I attended during this time were filled with optimistic investors and company executives (side note: if you ever find yourself at an investment conference with standing room only—sell!). Three years later oil was cut in half, declining to $10. I’ll never forget The Economist article published in 1999 arguing why $5 oil was possible! Instead of falling to $5, oil prices increased meaningfully over the next decade, peaking at $145 on July 3, 2008. At the time, investors were infatuated with “Peak Oil.” As soon as conventional wisdom agreed the world was running out of oil, demand and prices plummeted during the Great Recession, with oil reaching $34 on December 19, 2008. As the economy recovered, demand rebounded, and oil once again traded over $100 by 2011. Higher prices and abundant capital fueled the shale boom, which eventually led to a sharp increase in production. Due to excess supply and a strengthening dollar, oil prices fell sharply in the second half of 2014, bottomed in 2016, and have recently stabilized near $50.
Energy prices, to put it mildly, have been extremely volatile and unpredictable over the past two decades. As one would expect, the volatility in energy prices has spilled over into energy stocks.
While such unpredictability and volatility has turned away many investors, we view energy’s violent price and mood swings opportunistically. Based on valuations and depressed investor sentiment, we believe there is currently value in certain energy-related stocks. From a bottom-up valuation perspective, many energy stocks are trading at meaningful discounts to the replacement value of their net assets—levels we haven’t seen since 2008 and 2009. As the following chart illustrates, the market capitalization of the energy sector relative to the Russell 2000 is near cyclical lows, even though the number of energy stocks represented in the index is elevated.
Moreover, the ratio of the Russell 2000 Energy Index to the price of oil has never been lower in my career.
Although we believe many energy companies are trading at discounts to their net asset values, we are aware that financial and bankruptcy risks are also elevated. As such, we are currently being extremely selective in our search for opportunities in energy. To help communicate our selection process, we’ve put together a list of items we believe are important when screening through and valuing energy stocks.
1. We value their assets, not their cash flows. In our opinion, energy company cash flows are too unpredictable to value with a high degree of confidence. Furthermore, considering cash flows are typically highest when energy prices are elevated, we believe cash flow valuations increase the risk of valuing energy companies too high near cyclical peaks and too low near cyclical troughs. We’ve found calculating the replacement cost of energy assets to be a more stable form of valuation. In effect, we want to buy a barrel of oil or mcf of natural gas at a meaningful discount to what it would cost to fully develop these reserves (buy the land, lease the rig, complete the well, etc).
2. Debt, debt, debt. We closely monitor the amount of debt, maturity walls, and available liquidity. It doesn’t matter if you own an energy company trading at a significant discount if the business doesn’t have the necessary liquidity to survive a prolonged period of depressed energy prices. As a general rule of thumb, we will not consider an energy company with debt to discretionary cash flow over 3x. Furthermore, we’re reluctant to rely on credit lines for liquidity needs, as they can be cut during periodic credit line redeterminations.
3. We avoid energy companies when they are making large profits and are attracted to energy companies when profits are in decline or negative. Few investors like to buy companies that are losing money, resulting in reduced competition for energy shares during industry busts. We’ve found energy profit recessions are the best time to pick up high-quality assets at meaningful discounts. We currently believe the energy industry is in a profit recession.
4. We prefer internal financing or companies that can live within their cash flows. This has recently become a very popular topic in the energy industry. After years of poor capital allocation and large write-offs, many energy companies have been cut-off from the equity and debt markets. In effect, they are now on their own and must finance their investments with internally generated capital. As a result, energy companies unable to refinance approaching debt maturities have an above-average risk of bankruptcy. To limit bankruptcy risk, we focus on companies that prudently manage their capital throughout the entire cycle and are not reliant on outsiders.
5. We favor company executives that are consistent and predictable. We avoid wheeler and dealers that jump around geographically to the latest and greatest basin. Based on our experience, companies that are constantly buying and selling properties have a greater tendency to overpay and sell at distressed prices.
6. Seek long-lived assets and reserves. We prefer E&Ps with many years of drilling inventory. We avoid E&Ps with short reserve lives that regularly need to acquire new acreage. For energy service companies, we prefer relatively new equipment. We view companies that need to refresh the majority of their equipment as having large hidden liabilities.
7. The quality of assets, cost structure, and financial strength of energy companies can vary considerably. Nevertheless, energy stocks often trade as a group and are highly correlated to sector index funds and ETFs. As such, we believe this groupthink trading mentality can create opportunity as asset flows influence the prices of high- and low-quality energy companies alike. Be selective.
8. We do not buy and hold energy stocks. Based on our experience, energy companies are usually very over or undervalued and are rarely fairly priced. Although the gains in energy stocks can be exhilarating and the temptation to hold during the booms is immense, we avoid holding energy stocks throughout a full cycle. We’ve found that when energy prices are inflated and significantly above the cost of production, excess supply and lower prices are not far behind. As is the case with all cyclical businesses, avoiding extrapolating is extremely important.
9. We prefer low cost producers. Considering we typically are buyers of energy stocks during energy busts, we are most interested in companies that we believe can survive an extended period of weak prices. Low cost production and limited capital expenditure needs increase the chances of survival. For energy service companies, we prefer equipment owned free and clear.
10. The bottom in energy prices and energy stocks is almost impossible to predict. We are prepared for the possibility of suffering unrealized losses before the cycle ultimately rebounds. We are careful to not get shaken out of our positions before the cycle reverts. During the troughs, we believe energy prices trading below the cost of production, along with tightening capital availability, will reduce supply and eventually result in higher energy prices. In effect, we continue to believe in cycles, and that busts will be followed by booms. Having conviction in cycles is essential to successfully investing in energy.
In conclusion, we’re currently searching for energy stocks trading at discounts to our net asset valuations. We prefer energy companies with strong balance sheets and high-quality properties or equipment. Given most balance sheets of energy companies remain overleveraged, we plan to be very selective and do not expect many stocks will pass our buy criteria. That said, we’re hopeful the current energy bust gathers momentum and provides absolute return investors with an even more favorable opportunity set. Although we’d prefer a broad-based bear market in small cap stocks, sector bear markets can also be very rewarding!
The Palm Valley Capital Fund can be purchased directly from U.S. Bank or through these fund platforms.
Index performance is not indicative of a fund’s performance. Past performance does not guarantee future results. Current performance of the Fund can be obtained by calling 904-747-2345.
There is no guarantee that a particular investment strategy will be successful. Opinions expressed are subject to change at any time, are not guaranteed, and should not be considered investment advice.
References to other funds or products should not be interpreted as an offer of those securities.
Fund holdings are subject to change and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk.
Definitions:
Correlated: Showing a statistically significant relationship between the values of two or more variables.
Debt to discretionary cash flow: The amount of debt relative to the amount of annual cash flow remaining after mandatory expenses and capital outlays.
Free Cash Flow: Cash from operating activities minus capital expenditures.
Mcf: One thousand cubic feet of natural gas.
Russell 2000: The Russell 2000 Index is an American small-cap stock market index based on
the market capitalizations of the bottom 2,000 companies in the Russell 3000 Index.
One cannot invest directly in an index.
Russell 2000 Energy Index: Consists of energy-related businesses in the Russell 2000 Index, such as oil companies involved in the exploration, production, servicing, drilling and refining processes, and other fuels used in the generation of consumable energy.
WTI Oil Price: West Texas Intermediate (WTI) crude oil is the underlying commodity of the New York Mercantile Exchange's oil futures contracts.
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