Eric Nuttall: Why investors aren’t late to the oil party

Look not to where energy stocks have been but where they are going

Eric Nuttall, Partner and Senior Portfolio Manager, Ninepoint Partners LP
Originally Published on May 26, 2021

Obscured in the fog of energy ignorance is a generational investment opportunity. Divested, shunned, and largely ignored, oil and gas stocks have fallen to valuations previously unheard of. With the backdrop of a multi-year oil bull market and an industry maniacally focused on returning capital to shareholders, I believe oil and gas stocks represent tremendous value with the potential to more than double over the coming years.

As an oil bull I have up until recently felt like someone who accidentally showed up to a party an hour early, expecting to come upon a rager, instead to be met with a host still warming the hors d’oeuvre and chilling the champagne. Only in recent months have other guests started to show up with the music getting turned on and conversation of increasingly bullish oil targets getting louder and louder. The guest of honour, however, the generalist institutional investor, has yet to show up. While usually one to arrive an hour fashionably late, generalists importantly represent a significant amount of latent buying power necessary to allow for a rerating of currently depressed valuations.

What will it take then to get them to show up to the party?

Generalist investors have been conditioned to believe that oil and gas stocks are irrelevant and that any gains will be short lived, given oil and gas companies’ reputation of being chronic growth-chasing value destroyers and dulled by the enormous volatility over the past several years.

This thinking fails to recognize that the road we are on today is very different from the one we have been stuck on for the past 5+ years. Denied of short-cycle hyper U.S. shale growth in a world of recovering oil demand, supply has become increasingly inelastic to a rising oil price.

Couple this with soon-to-be exhausted OPEC spare capacity and a multi-year stagnation of global offshore production and you suddenly have an oil cycle with longevity.

Further, energy companies have pivoted from seeking growth to returns, allowing for the generation of meaningful free cash flow. While obviously good for the macro (less supply and tighter markets) this shift critically allows energy companies to better compete with other industries on a return of capital basis thereby attracting funds flow back to the sector. At US$60 West Texas Intermediate, the amount of free cash flow being generated by the energy industry is egregious and with balance sheets nearly repaired from the damage inflicted in 2020, I believe we are on the cusp of companies returning most of their free cash flow back to investors in the form of dividends and share buybacks.

This imminent wave of share buybacks and dividend increases could easily be the antidote to the still high level of apathy towards the space. This catalyst combined with building “fear of missing out” performance pressure will inevitably drag generalists back to the sector, willingly or not.

Be warned: if you are new to the energy sector and decide to pull up a random one-year stock chart it would be easy to think that you’ve “missed it.” Energy has been the best performing sub-index year-to-date in both the TSX and S&P500 and many stocks are up 300 per cent or more from their 2020 lows.

Despite this huge rally just how cheap are energy stocks still?

Irrespective of many having risen sharply, company valuations remain extremely compelling and the only reason why they have rallied so much is the extent of the pummeling they endured in 2020 when peak uncertainty around COVID’s impact on oil demand led to many oil stocks falling by 60 per cent or more. Hence, much of the recent rally has only taken them back to pre-COVID levels yet the macro backdrop now is significantly more bullish than back then. Look not to where energy stocks have been but where they are going.

At US$60 West Texas Intermediate, the average company I follow could buy back all its outstanding shares and pay off all its bank debt in just eight years from free cashflow. This shrinks to an average of 5.5 years in a slightly more optimistic US$70 environment which is my forecast for 2022 and I’m joined by several research firms that are predicting US$70 in the coming quarters.

Imagine then a company that could pay a 15 per cent to 30 per cent dividend while keeping its production flat for several years or who could privatize itself in just four years using its free cashflow. That is how cheap energy stocks are today.

With many trading at two to three times their enterprise value to their cashflow versus a historical range of seven to eight times and being on the cusp of returning egregious levels of free cash flow back to investors the energy party has just begun. Given the prospect of both a higher oil price in the years ahead as well as a trading multiple expansion the potential upside in my opinion is extremely attractive with many small to midcap energy stocks offering multi-bagger potential.

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