Deep Dive: Oil & Gas
Industry deep dive + four unique ideas
We were recently featured on Stream by Alphasense’s investor webinar where we argued that investors should have an allocation to oil & gas. The free webinar can be accessed here and is a great way to quickly get up to speed on the key industry fundamentals.
In this report, we build on the discussion and also highlight four of our favorite investable ideas from the oil & gas sector.
Energy has been the best performing sector this year. In fact, it is the only sector that has given investors a large positive absolute return.
What’s interesting is that:
Even after the rally, many oil & gas companies are still trading at high free cash flow yields (and in some cases very high!)
Investors remain skeptical. Global funds on average are still underweight the sector, as shown below and also here (Goldman’s prime brokerage report)
Investors are perhaps uncertain that these oil prices and the resulting free cash flow yields will last. Having been burned by the poor industry returns in the most recent cycle, they may have given up altogether. Or possibly, they are bound by ESG constraints, or may be worried about the terminal value of their investments given new technologies like EVs and renewable energy. There are many reasons to explain investor skepticism today.
Due to these factors, the energy sector weighting is currently about 5% of the S&P 500 index. It had sunk below 2% in October 2020 (before Covid vaccines were announced), which was an all-time low. The current macroeconomic environment is often compared to the inflationary 1970’s, and there’s an important observation here.
In 1972, energy was 7% of the S&P 500, but it would peak at 28% at the end of 1980. Notably, only oil (and gold) produced positive inflation adjusted returns over the entire decade. It is important to keep in mind that if indeed the energy bulls are right this time - and even if you think that’s a big “if” - most investors with no energy exposure today could be severely mispositioned over the coming years.
Energy has a sector weight of 5% but contributes to 10% of total earnings of the S&P500 index. This is shown below. You can also see that historically sector weight has tracked earnings weight.
One needs to keep in mind that oil cycles are long, and historically up and downcycles have each lasted 15 years or longer. Even seasoned investors can spend most of their careers just living in one leg of a cycle. The mental adjustment required to adapt to a new reality is not easy. For example - someone looking at the chart below in 2012 could have convincingly told you that Exxon is a compounder. But this dynamic also works in reverse. An investor who has only seen a structural downcycle are likely to conclude that energy cannot maintain sustained outperformance given its commodity nature.
One investor who has seen more cycle than anyone is of course Warren Buffett. And Buffett has started investing heavily in oil & gas since February of this year. He most recently filed to acquire up to 50% of Occidental Petroleum (OXY) and has a big stake in Chevron (CVX). OXY has a market capitalization of $55bn and an enterprise value of $90bn so Buffett is making a sizable bet here. Notably, Buffett hasn’t bottom-ticked oil price swings - he kept buying with conviction even as oil prices kept rising to above $100 per barrel earlier in the year. We believe Buffett wants sufficient exposure to oil & gas ahead of what is in his view the start of the next long upcycle:
“I would think if you owned Occidental, you'd be bullish on oil over the years – and you’re probably bullish on the Permian Basin because they have such a significant portion of their assets there. It’s a bet on oil prices over the long-term more than anything else. It’s also a bet the Permian Basin is what it’s cracked up to be… If oil goes way up, you make a lot of money… You have to have a view on oil over time. Charlie and I have some views on that…” - Warren Buffett
Ok, so Buffett has a positive view of oil prices.
There are two ways to gain exposure in this sector - by owning the underlying commodities (e.g. oil futures) or by investing in producers. We clearly know which approach Buffett prefers. This is consistent with his preference for productive, income-generating asset. His investing style, as seen by his previous investments, is to invest in income-producing assets with long reserve life that have optionality to higher prices run by competent management.