Eric Nuttall, Partner and Senior Portfolio Manager, Ninepoint Partners LP
Originally Published on June 23, 2021
The worst bear market in the history of the energy sector has left some lasting scars. A seemingly endless barrage of negative events that include price wars, trade wars and a global pandemic has resulted in repetitive head beatings for energy investors conditioning them to be constantly looking over their shoulder in anticipation of the next bad thing to come.
No one wants to be disappointed by holding out hope for better days ahead, believing things are truly different this time, only to be let down yet again. This lingering trauma is contributing to a collective apathy most visibly seen in the absence of generalist fund managers willing to invest in the energy sector despite extremely strong macro fundamentals, combined with massively attractive energy stock valuations. Given the degree of mental trauma — what will it take to get generalists to come back to the energy sector?
As one of the few remaining sector specialists left in the country, it boggles my mind that generalists have not yet shown an interest in energy stocks missing out on a 50 per cent year-to-date rally. In my 18-year-career the fundamental outlook for oil has never been so positive, yet oil stocks are so unbelievably mispriced. Modelling out free cash flow projections at US$70 for a barrel of West Texas Intermediate, I can see many examples where companies could privatize themselves and pay off all their bank debt in as little as four years. These deplorably low valuations seem almost impossible to believe, yet I check and check again to find errors in my modelling and find none. Why are others not seeing what I see? How can I still be able to buy oil stocks at such distressed levels?
The fog of energy ignorance clouds this generational opportunity. Ravaged by years of endless disappointment and relative underperformance, and now worn down by daily headlines about climate emergencies, net zero government aspirations, growing environmental, social and governance (ESG) pressures and decarbonization efforts, have combined to make it that much harder for generalists to reevaluate a sector which they largely abandoned several years ago.
Those viewing the sector through a stale lens would wrongly believe the past equals the future, and that U.S. shale growth will soon derail any oil price rally, just as it has in years past. By contrast, barring a new vaccine-resistant strain, it is difficult to identify a catalyst that could derail the coming multi-year bull market in oil.
So why now? Why should investors reassess oil stocks and can they justify them despite ESG pressures?
Already Canada produces one of the highest rated barrels on an ESG basis in the world and the recent announcement by the majority of oilsand producers to jointly achieve net zero status by 2050 only cements that position.
With the backdrop of normalizing oil demand, the imminent exhaustion of OPEC spare capacity, years long insufficient investment in long-cycle offshore projects, and the end of U.S. shale hyper growth the backdrop for oil is overwhelmingly positive and suggestive of meaningfully higher prices in the years to come.
In addition, the runway for alternatives to displace oil is several decades long implying at least a decade of further growth in global demand. This macro setting, combined with enormously compelling valuations with oil stocks trading at less than half of historical multiples and 20 per cent-plus free cash flow yields, is a powerful combination.
Already the energy sector is the top performing sub-index in both the TSX and S&P500 and now calls for US$80 for a barrel of WTI in the months ahead are becoming increasingly voiced. Going forward with every macro strategist sector upgrade, every incremental headline about oil demand normalization, every company press release announcing record free cash flow, and every new 52-week high, the pressure to add energy weight will at some point, in my opinion, become too difficult to ignore.
What if I’m wrong? What if the energy sector continues to be viewed as toxic and somehow an absence of energy exposure is justified in the name of energy wokism? How can energy stocks go up further if there continues to be a broad based buyers’ strike?
Given egregious levels of free cash flow at current oil prices and the finality of balance sheet deleveraging in the coming months, oil companies stand at the cusp of returning significant levels of capital back to shareholders. While this will likely include dividend increases, my bias given such profoundly mispriced valuations is for meaningful share buybacks, and I have been persistently vocal of this view in conversations with oil company executives.
Sector wide initiation of meaningful share buybacks (i.e. 10 per cent of shares outstanding) could act as the antidote to the historic level of apathy plaguing oil stock valuations. In effect, energy companies could become the buyers of their own stock and with forward cashflow being that much more valuable on a per share basis could result in a multiple rerating closer to historical levels.
Depressed valuations will not last when companies themselves can act to fix them, with or without the help of generalists. The challenge for investors now is to intentionally forget the difficulties of the past and look to where oil and energy stocks are likely headed. The world is entering into an oil supply crisis that, in my opinion, will result in meaningfully higher oil prices. In that context despite the year-to-date rally, I believe energy stocks remain enormously mispriced and the road ahead is increasingly clear. This time is indeed different.