Macro: Sandcastle economics
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Are energy stocks a historical opportunity or a falling knife?
Peter Garnry
Chief Investment Strategist
Summary: The energy sector has underperformed global equities by 75% since the oil price peak in 2008 as operating costs have accelerated to unsustainable levels and now a demand collapse due to COVID-19. The big quesiton is whether a contrarian case can be made for going long energy stocks despite the weak technical picture? We argue that the opening up of the economies could surprise against the current expectations for the oil price and valuations are decent although they could go a bit lower.
Oil prices have recovered from the dismal levels in April when the market hit ‘tank tops’ with physical storage completely filled in the US. Today Brent crude attempted to make news highs but have failed ahead of the US session which now suggest that the market is finding an equilibrium point here in the range $28-33/brl. At these levels oil production is not an attractive investment for oil companies and its shareholders.
Nevertheless, our view is that there might be a tactical trade in energy stocks although the technical picture looks ugly across most energy stocks. As we have said in recent presentations with clients we recommend investors to express a positive view on the oil price through the oil majors as they have a positive sensitivity to oil prices, have the storage to maximize profit opportunities and have the balance sheet to get through the crisis. Expectations for energy companies are rock-bottom evident of investors betting on a drastically altered society and its oil consumption behaviour. While behaviour will probably change somewhat it will probably not change so much that oil couldn’t find a higher equilibrium price point. Most Asian economies have normalized to a great degree and Apple’s mobility data suggest normalization in the US and Germany with UK and Italy still lagging. As economies open the demand picture will improve but inventories will first need to fall before prices can be restored to meaningful levels and part of that solution is still reduced overall production globally.
In terms of valuation the global energy sector is now valued at 3% free cash flow yield on a 12-month forward basis which is actually a decent return for shareholders given the alternatives in bond markets. However, estimates for free cash flow can vary greatly due to the large uncertainty in the economic outlook. The current valuation measured by EV/Sales measure more directly what investors are willing to pay for the revenue stream today. In this measure there is a discounted expectation of future profitability which is quite low but could go even lower if the lows in early 2009 is used as the yardstick.
The biggest obstacle for investors to climb mentally is the fact that the energy sector has underperformed global equities since the oil price peak in 2008 and has now underperformed global equities since 1994. On a relative basis the energy sector is down 75% since 2008 against MSCI World. What’s even more depressing is that the underperformance has happened during low interest rates, which should have benefitted capital intensive industries, and decent oil prices. The conclusion is that the energy sector has too much production and too high operating costs. This will have to change to restore profitability and attractiveness of this sector.
We don’t feel confident in a long-term bet on the energy sector but we are guessing the market is getting too pessimistic on oil demand when we look into the second half. Investors that believe in higher oil prices could add exposure to the energy sector at current levels, but it should be done with a tight stop loss $27.50 using Brent crude.
The key risks to going long the energy sector is of course a deeper economic recession, permanently changed oil consumption behaviour, stronger USD and governments’ willingness to power on with the green transformation which could lead to taxes on carbon-intense behaviour.
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