COMMENTARY

July 2021 – The Mother of All Energy Stock Setups

Finance, Retirement, US Equities

On August 2nd, 1990, the Iraqi army invaded and occupied Kuwait. Global energy markets reeled as some of the largest supplies of crude oil were suddenly in doubt. Speculators piled into crude oil, doubling the price to about $80 per barrel. The consensus expected more fighting from a US response, more uncertainty, and less supply of oil resulting in higher oil prices. What happened when coalition forces invaded in January 1991? Prices plummeted 50% to the $40 range, and by 1993, another 50% decline to the $20 range. When everyone is on one side of an “obvious” trade, often the market gets it completely wrong. Energy stocks, though they have outperformed in 2021, have suffered immensely over the past few years, and the consensus calls for renewable energy to destroy oil demand. This lack of interest from both investors and the industry itself has created tremendous opportunities in select energy stocks.

Myth 1 – Renewable energy will destroy demand for oil

Reality: Long-term forecasts from both OPEC and the EIA show growing demand. The OPEC World Oil Outlook report has oil increasing from 91.0 million barrels per day in 2019 to 97.7 million in 2030. Renewable energy is a paramount consideration among OPEC members, and they are predicting long-term renewables annualized growth of 6% compared to less than 1% for oil. The world will shift to more renewables, but since growth in global energy demand will exceed renewable energy capacity growth, more, not less oil, will be needed to keep people moving. The US EIA also has long-term oil demand growing rather than shrinking. Growth of 1% might not sound like much but remember oil reserves are constantly depleted and need to be constantly replaced. Instead of meeting this long-term increase in demand, most major energy producers like Exxon and Shell are reducing capital expenditures.

Myth 2 – Investors have already run-up energy stocks in 2021

Reality: Yes, the energy sector is up 40% YTD in 2021, but there are two major problems with this. First, Energy was the worst performing sector in the S&P 500 in 2020 (down 34%), 2019 (down 12%) and 2018 (down 18%.) Most of these companies are far from all-time highs in 2021. Second, if you’re using the S&P 500 for energy exposure, you’re doing it wrong! Energy is only 2.8% of the index.

An outsized position in the energy majors within the S&P 500 has worked well, but our research shows these are the few companies within the energy space that have not reduced debt, thereby limiting further upside. Instead, hundreds of smaller energy companies have either paid down or wiped away debt in Chapter 11 and are now running some of the strongest and best balance sheets in the entire US stock market! These companies are significantly off their lows from March 2020, but many are producing cash in compelling amounts relative to current valuations. Longer-term, cashflow of small cap energy names like Frank Value Fund holding Civeo (NYSE: CVEO) could materially outperform as the world will be forced to find new sources of oil.  

The Setup

We are finding small cap energy companies trading above 10% free-cash-flow yields at current levels of earnings. Compare that to the S&P 500 which is trading at 1.6%. As oil and gas prices increase along with world demand for energy, energy analysts and management teams are guiding significant future growth in revenue and earnings. Despite this rosy outlook, companies have drastically reduced capital expenditures related to finding new sources of oil and gas.  Even though the industry and investors are bearish on oil, consumer demand is not. Consumers are rushing back to travel, with TSA checkpoint numbers down only 22% in June 2021 from June 2019 compared to down 38% in April 2021 vs. April 2019, and gasoline demand is up 10% from last June. Additionally, with energy just 2.8% of the S&P 500, the most popular investing style, passive indexation, is opting for large allocations to technology (26%) and Health Care (13%), two sectors that have benefitted from lockdowns that may not continue robust growth with re-openings.

That’s the setup. Valuations are cheap based on depressed trailing earnings, industry insiders are expecting increases in future profits, yet companies are underspending on exploration. Meanwhile, consumers, in their rush to travel, are increasing energy demand along with population growth in emerging markets like China and India. Meanwhile, index-investors are sitting on the sidelines due to rigid, float-based allocations. For the nimble investor, small cap energy names are primed for a gusher of returns.