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Hello. Another messy day in the markets on Monday, with stocks down and Treasury yields up across the curve. Normal tremor, as we approach a Fed meeting and the war in Ukraine continues. Let us know what we should be watching in this extraordinary time. Email us: [email protected] and [email protected]
Are the American oil majors a godsend?
A lot of people don’t want to own oil stocks, and that’s reasonable.
Of course, it won’t make any difference to the environment if even a large majority of public market investors remove fossil fuels from their portfolios. The industry is not capital constrained and there are many sources of private, ethically flexible capital that can meet these needs. As long as the demand for oil, gas and coal persists, who owns which financial instrument will not change the operations of the industry.
But if you don’t want to collect dividends from (say) ExxonMobil, I understand. I myself pray that a faster-than-expected energy transition will crush the fossil fuel industry. So it’s strange that I bet my savings on this.
What follows puts all that aside. There’s been a shock in the energy market, and we’re all trying to figure it out. One of them is stock price analysis. So this is it.
Despite a strong surge in power, large US exploration and production companies still seem very cheap, at first glance. Some stats on six of the biggest (these are percentages, except for the first column):
Companies with double-digit price-to-earnings ratios and revenue growth of 50% or more are attractive, but remember that PE ratios for commodity stocks are misleading. The earnings of commodity mining groups are volatile. The denominator (earnings) rises very quickly when the price of the raw material rises, causing the ratio to fall. Often it makes sense to buy them when their PE ratios are high (trench earnings) and sell them when they are low (peak earnings) – quite the opposite of most stocks.
So the key column to look at is the last one: free cash flow yield. This is the amount of distributable cash a company generates, as a percentage of its stock market value. Take Pioneer’s 19% cash flow yield. This basically means that at its current level of profitability, it will make enough money to buy itself in just over five years. If all that money finds its way into the hands of investors, whether in the form of dividends or share buybacks and price appreciation, then you can think of buying the stock as an investment in which you recoup all your capital over five years, then you get a free option. about what the business is worth after that.
With free cash flow generation and shareholder value, however, there is a lot of slippage between the cut and the lip. For example, a company may decide to make an acquisition or an investment project rather than paying a dividend or repurchasing shares.
Recently, however, American producers have focused on returns on investment to such an extent that, with rising gasoline prices, politicians are going crazy. From a story last week by my colleague Derek Brower:
Scott Sheffield, chief executive of Pioneer Natural Resources, the shale play’s biggest oil producer, said in an interview that his shareholders won’t let him spend more. [on increased production]. Was any of them ready to move to $120 gross? “None. Not at all,” he said.
Amos Hochstein, the State Department official who coordinates much of Joe Biden’s energy strategy, told the Financial Times that was not enough. “They should call their financiers and tell them there’s a war going on,” he said of shale producers. “The American public is paying the price.”
The good news for investors is that the oil companies don’t seem to care. According to a recent note from Credit Suisse analyst William Janela:
We have caught up with most of our large cap E&Ps [exploration and production companies] in recent days and has heard a constant message that there is no appetite to increase production in response to bans/sanctions on Russian oil imports. . . companies and shareholders fear jeopardizing the low growth, FCF/cash return value proposition that has taken years to materialize and is finally resonating with investors.
American oil companies would rather make more money than produce more oil. At least that’s what they say and, so far, what they do. This is the central element of a bullish case on oil prices (and therefore on US oil producers). The other big boards would be:
Oil is a hedge against inflation.
Oil companies are in all value indices. If we are in a full growth-value rotation, the oil companies will benefit.
The nightmare in Ukraine is far from over, and shocks in the oil market will continue to occur, making the stable supply of US majors more valuable.
At this point in the argument, the US oil majors seem very cheap. But the stock market doesn’t tend to leave money lying around. There are two very large uncertainties reflected in the pricing of the majors. The first is obvious: no one knows how this war is going.
A strategist from an energy consulting firm posed the second uncertainty to me as follows:
Is this war accelerating the energy transition, and by how much? If it speeds it up from 30 years to 20 years, I buy Conoco. If it speeds it up from 30 to 10, it gets pretty hard [to own these stocks].
The investment proposition for the oil majors depends a lot on what happens in nuclear, wind, solar and energy storage technologies.
European markets are worried, rationally
A US recession, we told you on Monday, is a reasonable possibility, but it’s not anyone’s base case scenario. Europe, however, is another story. Last month, the German central bank warned the country may have already entered a technical recession (ie two quarters of negative growth). This was before Russia invaded Ukraine.
Forecasters are divided, giving the average one-in-four chance of a eurozone recession in 2022, according to data from Bloomberg. The recent projections I’ve seen downplay the risk of a recession. Here is one, published Monday by Pantheon Macroeconomics:
The war in Ukraine will lose 0.6 percentage points [eurozone] GDP growth this year in our base scenario. We have revised our GDP forecast down to 3.2%. In the worst-case scenario, where the war lasts beyond the end of this year and gas and oil prices rise significantly further, we still don’t expect a recession. Fiscal policy should prevent this.
But the markets do not wait for forecasts. They are already prepared for something bad. Since the invasion of Russia at the end of February, the Euro Stoxx 50 is down 6%, compared to 3% for the S&P 500. During the same period, the main volatility index for European stocks has climbed twice as much faster than the American Vix.
European credit markets are also getting jittery, as frequent Unhedged correspondent Dec Mullarkey of SLC Management notes. Spreads on European investment grade bonds, after trading close to their US counterparts, have widened. Investors want a dollop of extra yield to offset the geopolitical risk they take on by owning European companies. I’ve recreated Mullarkey’s array of keys below:
Something similar happens with bank stocks. European banks have long lagged far more profitable US banks, but the recent divergence is unusually wide:
The most obvious fear is that Russia’s war will drag on, sanctions get tougher, Russia will cut gas supplies to Europe and another energy crisis will erupt. The European Central Bank should choose: raise interest rates even as growth stumbles, or hold them steady and let inflation pick up. The risk of a slowdown in rate hikes helps explain the poor performance of European banking stocks.
However, jittery markets are generally a good sign. We don’t see panic fire sales, or complacency. Faced with a crisis that could worsen, investors are measuring the risks. This is perhaps another indication that the markets are functioning as they should, despite circumstances that would test even the most balanced investor. (Ethan Wu)
A good read
The nickel market simply stopped working last week. If you haven’t been following this crazy story, Bloomberg business week has a great overview filled with new reports.