September 15, 2004“You have to recognize that every “out front” maneuver is going to be lonely. But if you feel entirely comfortable, then you’re not far enough ahead to do any good. That warm sense of everything going well is usually the body temperature at the center of the herd. Only if you’re far enough ahead to be at risk do you have a chance for large gains.”
John Masters, Canadian oilman
As a Texas-based company, it only makes sense that we have historically been big believers in the opportunities available in the energy sector. Our timing hasn’t always been perfect, but our willingness to be patient and disciplined has allowed us to consistently profit from our energy investments. We’ve also been known to go against the crowd when we deemed it prudent to do so. Today we find ourselves in a similar situation. Our focus on energy stocks has proven to be very prescient over the past nine months, as crude oil prices have climbed 30% and our energy-related stocks have significantly outperformed the broad market. However, after crude reached $49/bbl in mid-August, many investors believed the run in energy stocks was over and the herd began to stampede for the exits. The consensus belief today is that energy remains a sound long-term investment, but the sector is due for a significant pull back in the near term. We, however, believe that there continues to be a serious disconnect between perception and reality and therefore remain committed to our overweight position in energy stocks. Exploiting opportunities such as this has been a key component of our success over the years, and we have every reason to believe our clients will once again benefit from such a strategy.
Our belief in the energy sector is based on three factors – the continued strong demand for crude oil, the limited supply now available or being discovered, and the strong fundamentals of the companies in the industry.
Strong DemandCrude oil demand is growing at its fastest pace in 25 years. The modernization of China and India has resulted in a global industrial revolution as well as increased demand for western products, including autos. As a result, China has become the world’s second largest consumer of crude, while Chinese imports of the commodity are rising at a 40% clip annually. Global crude supplies are currently being depleted at a rate of 4 million bbl/day while demand is increasing at a rate of 2 million bbl/day. Therefore, we need new crude production of 6 million bbl/day just to keep inventories from falling. And don’t discount America’s need for oil – the U.S. alone consumes 11 million bbl/day more than we produce.Limited SupplyOil supply is currently limited because the major producers, including large integrated oil companies like Exxon Mobil and ChevronTexaco, have significantly curtailed investment in new production over the past seven years. After years of making investments based on volatile crude prices that were difficult to forecast, oil companies discontinued investing their cash flow in new crude production and instead have allocated cash to more shareholder friendly uses, such as debt reduction and dividend increases (see chart page 3). In addition, it’s instructive to recall that crude oil is a non-renewable natural resource that the world will one day run out of. Although we believe we are a long way from that happening, a case can be made that we are closer than many believe. In fact, the average production per giant field (i.e. those that produce over 100,000 barrels per day) is significantly lower for newer fields than it is for older fields. As the chart on page one illustrates, up to 70% of the current daily supply of oil from these fields was discovered before 1970. Disciples of geologist M. King Hubbert (who correctly predicted the peak in crude oil discovery that occurred in 1971) believe that oil production will peak later in this decade. Consequently, even if oil companies were aggressively pursuing new discoveries, there appears to be little left to harvest. Lastly, the world market doesn’t even have access to the known global supply, with Iraq producing at only a 50% rate. Potential terrorist activity in Iraq and Saudi Arabia could also impact the availability of oil while continued political instability in places such as Russia, Venezuela, and Nigeria threatens to remove even more of the available supply.Attractive FundamentalsAs a result of the currently higher than expected crude and natural gas prices, as well as limited investment in new production undertaken in recent years, energy companies have very strong fundamentals today. Companies in the energy sector have historically generated very little excess cash flow, but today are producing free cash flow yields of 7-10%. In addition, current debt levels are half of the historical averages. Furthermore, the market is valuing energy companies as if crude were trading at $27/bbl instead of the actual current price of $43/bbl. As a result, as long as oil prices remain above $27/bbl, productive energy firms will generate earnings and cash flow far greater than the market expects, resulting in higher stock prices for these companies. Excess cash flow is likely to continue to be deployed for shareholder friendly uses, including increased dividend payments. Because oil companies are currently using $20/bbl as their long-term estimate for crude prices, they are much more likely to give cash back to shareholders in the form of dividends (particularly since the average dividend payout in the industry is currently well below the 10-year average) than invest in new production.Perception vs. RealityGiven all this compelling data, why would investors want to sell energy stocks today? Because there is a disconnect between perception and reality.
Investors believe that energy stocks are due for a pullback following the rally of the past nine months. Even though they have significantly outperformed the market this year, energy stocks have merely performed in line with the S&P 500 over the past 10 years, meaning that the past nine months have simply been a process of erasing a significant portion of the undervaluation in the sector. Furthermore, the current S&P 500 weighting for the energy sector is only 7%, much lower than the 30-year average of 12%. Also, energy company stocks are currently trading at prices that equate to a valuation multiple of 4-5 times their free cash flow vs. a historical average of 6-8 times. As a result, a very strong case can be made that the sector remains attractively valued.
Investors believe that energy company stocks will fall if crude prices decline. There is a high correlation between energy company stock prices and crude oil prices, but we’ve witnessed two instances in the past 3 months where energy company stock prices have actually risen while oil prices were declining. This represents the growing acceptance by the market that energy stocks remain attractive even if oil prices decline. As previously stated, as long as crude stays above the $27/bbl level, energy companies are poised to outperform.
Investors have no faith in the sustainability of oil prices at current levels. Investors maintain this belief despite the fact that prices have remained stubbornly high in the face of numerous attempts in the past six months to bring them down, including pledges by OPEC to increase production. In fact, the current Wall Street consensus estimate for oil in 2005 is $30/bbl vs. an actual price today of $43/bbl and a 2005 futures market price of $40/bbl. Because the market is expecting such a large, seemingly unrealistic, decline in prices, energy companies have the opportunity to make very attractive acquisitions of producing properties. An example is a recent acquisition by Whiting Petroleum in which the firm will assume a large amount of debt. However, because the firm can guarantee a price for the oil they produce that is close to $40/bbl via the use of hedging, the firm will be able to pay off all this debt within 3 years. In addition, as a result of the attractive purchase price, the deal is expected to be very accretive to cash flow in 2005. Such a transaction would not be possible were it not for the market’s refusal to believe in the sustainability of the current level of oil prices.
Investors believe that there is a geopolitical risk premium of as much as $8-$10/ bbl priced into the market today. This is probably accurate, but the global instability that has created this premium is unlikely to be resolved anytime soon. Furthermore, even if this premium were to disappear overnight, oil would still be trading at a level that exceeds the price used to value energy firms today.
The structural supply/demand imbalance that exists today is a problem with no near term solution and will support oil and natural gas prices at high levels for some time. The market’s refusal to accept the current price of oil as “real” creates an outstanding opportunity for positive earnings surprises in the energy sector and for attractive acquisitions of productive properties by energy companies. As a result, even though it may be cold & lonely out here away from the herd, we continue to believe the risk inherent in the energy sector is more than justified by the potential reward.
Click here if you would like a printable version of this article.
This information is provided for clients and prospective clients of Westwood Management and Westwood Trust, hereinafter "Westwood" and their employees. It is not an offer or solicitation to sell securities. The information provided here is copyrighted by Westwood and may not be used without its permission.
