The Only Dip Worth Buying

With the S&P 500 closing in bear market territory this week, oil futures held strong despite a slew of negative news. However, oil producers and exploration companies dove with the broader market, which caught my attention. In an environment where the market went from “Buy the Dip” to “Sell the Rip” practically overnight, I believe there is still an opportunity here to buy a portion of this market dip for the long-term investor.

Oil had a significant run in the last 24 months. Going from -$40 a barrel in the spring of 2020 to highs just around $140 this year (2022) is quite impressive considering travel has not reached pre-pandemic levels, and the clean energy movement that has been taking over the globe. The world is banking on moving off of oil as a primary fuel source soon. However, this is not a reasonable outcome in the short term for several logistical reasons. The main reasons are that the infrastructure to run the globe on electric cars is not yet in place, and the efficiency of clean energy outside of nuclear are all less than that of oil. This means more energy is needed to be stored and produced to run the same infrastructure currently in the United States and the rest of the modernized world. This energy problem gets amplified as you go to countries that rely entirely on carbon energy. These countries lack the investment ability to produce clean energy efficiently. They opt for energy sources either supporting their country’s revenue or that are the easiest to import. Along with this, developing countries continue to grow in population and wealth. Wealth increases precede improvements in lifestyle (i.e., cars, air conditioning, and major construction projects), and a boom in oil and gas demand like we saw in developing America and China. This energy demand is going to have a hard time being met with green initiatives at an affordable price. The result: higher oil demand at an increasing rate.

Layering on top of this extended demand timeline for oil, the “green” movement across the globe has reduced and even eliminated CAPEX investments for oil-producing companies. A limited amount of banks will finance these oil endeavors with their corporate ESG pressures, and investors have been flooding the market of everything but oil companies in the last few years. This trend has resulted in energy companies making up a mere 5% of the S&P 500 index (which is up from the 2020 lows). This energy weighting in the broad market is a massive disconnect from previous decades, where the energy weighting in the S&P 500 was 10% or more and the demand for oil is higher now than it has been in the previous decade according to IEA reports. So, what does this mean for oil? As fewer oil rigs and fewer efficiencies are produced in the oil industry (especially in the US), the supply from these oil companies will deteriorate. This trend will open the door for more of the market share to be awarded to OPEC. OPEC will produce more oil to meet the demand, but there will be a consistent lag time between the demand and the supply, which will continue to push prices higher. This lag is caused by oil production taking several months to get up and running fully. If there is a spike in demand (I believe we are on the brink of this with China reopening), oil producers will have to make draw-downs in the reserve supply and rush to keep up with demand. This will lead to prices shoving forward in the near term and staying elevated long term as the globe continues to discourage oil investments.

Together, these global trends result in oil prices staying higher for much longer than expected. This poses a massive opportunity for investors in international markets to profit from this macro backdrop. The term structure for oil futures is in severe backwardation, with a projected 40% decrease in price from 2022 to 2025.

Term Structure of Crude Oil Futures (Source: Interactive Brokers)

This backwardation assumes prices are steadily declining over the next few years while the world becomes “greener”, and it is an incentive for producers to deliver supply now versus in the future. Since oil producers have a time lag for providing supply, the price even two years out at $80 is not incentivizing producers to open capacity. This is one of the most bullish indicators for oil prices. As supply is constrained and oil producers choose to look the other way, oil prices will stay higher longer. I believe this sets up oil investors for success long term as oil producers can sell their supply at higher prices and print cash flow to investors.

Decade Long Trends: Comparing Oil to Semiconductors

I heard this brilliant analogy recently regarding semiconductors and oil. The computer chip shortage we have seen was an event long in the making. For decades, chip producers consolidated operations in Taiwan, and low investment in the production process for the rest of the world led to inefficient operations outside of Asia. COVID-19 produced a surge in demand for these chips, and the race to keep up with demand along with supply chain bottlenecks dramatically delayed the supply side. This is a simplified example, but we could be seeing this same environment play out in the oil industry for years to come. With the low investments being proposed by the IEA in the oil industry, we could see a significant impact on the oil supply with consistent under investment causing bottlenecks in the system. We are already beginning to see this with Russian oil and gas being taken off the market and the supply shocks this event has caused across Europe. The developed world’s only response was to reduce strategic reserves, which is a very temporary approach. Once this reserve release fades from the market, the structural issues in this macro theme remain. The reserve release could cause prices to go even higher as the SPR replenishing will drive oil prices up to get inventories back to baseline for countries across the globe.

Oil and Rising Interest Rates

To make matters worse, attractive capital is becoming harder to find for oil producers with rising interest rates. As interest rates rise, the economy begins to cool down as “cheap capital” is less abundant for companies to pour into projects. This trend is even more pronounced in an industry that has been starved of capital for years. When oil producers see interest rates rising and capital becoming more expensive, they stop producing and exploring. This causes an even worse environment for the supply of oil and gas. Exploration is becoming non-existent in this industry. Oil companies do not have excess capital to fund exploration and drilling, so they choose to reinvest cash flow into their own shares or pay down debt. This is great for shareholders, but long-term, it sets the industry up for higher oil prices and more challenging times meeting quotas in the future when oil wells go dry.

Buy the Dip?
With a pull back on this energy sector bull run, I believe it is an excellent opportunity to buy up strong oil producers with healthy balance sheets at these depressed prices. This entry will provide the long-term investment with a high upside and low downside for the next few years as oil prices show no sign of decreasing. On top of this, the oil sector rally has been strong with little capital flowing to it due to ESG mandates, indicating that if more money starts flowing this way as oil prices climb, these energy stocks have huge potential upside.

Another critical factor to consider here is the price of oil now (2022) versus 2014 and the company valuations during these two time periods.

Price of Oil vs Select Energy Stocks From 2012-2022 (Source: Koyfin)

Oil prices are at levels last seen in 2014, but most of the multiples for the oil-producing companies are not even close to their 2014 levels. We are still seeing major producers trading at a few times cash flow and P/E ratios under 10. The chart above is an excellent depiction of this theme and how much more these oil companies can potentially rise in the near term. With global stocks living in bear market territory, energy stocks still show promise with low multiples, high cash flow generation, and high oil prices.

Disclosure: Funds I Control are Long OXY

Note: This post consists of high level commentary on research conducted by Tetelestai Capital, LLC into companies in the energy sector. Though compelling, your own research should always be done before investing into any security. This post should not be viewed as investment advice. If you have any questions about the research Tetelestai Capital conducts, please reach out through the website for more information.