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Energy Investing
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Could the sector turn around?Warning - long-ish post, proceed at your own risk. I thought it would be useful to take a look at the long-term performance of oil stocks relative to WTI, and jot down some thoughts about what needs to change to correct the sector's chronic underperformance. The focus of the post is on the XLE, XOP & XEG.TO ETFs. XLE is comprised of 27 holdings. 46% of the ETF is made up of XOM & CVX, with 23% each. The top 10 is rounded out by COP, KMI, WMB, PSX, SLB, EOG, MPC & VLO, which comprise an additional 33% at weightings of 3% - 5% each. The remaining 21% is made up of 17 other companies. XOP, which holds 43 companies, is oriented more toward smaller E&Ps & refiners. The top 10 holdings, which comprise just 36% of the ETF, are DVN, FANG, PE, COP, OXY, CXO, COG, HES, MPC & PXD, with individual weightings in the 3% - 4% range. XEG.TO is more or less Canada's version of the XLE, with SU & CNQ each comprising 24% of the ETF - a total of 48%. The top 10 is rounded out by 8 companies that total another 32% - CVE (11%), IMO (7%), ARX (4%), PXT (4%), VII (4%) & WCP (2%). Note that since XEG trades in $Cdn, I applied historical change rates to convert it to $US in order to remove currency effects; the graph shows XEG.TO * 10 in order to fit the scale. As shown below, XLE has tracked WTI fairly well but XOP & XEG.TO have shown significant volatility. XOP & XEG.TO have been in downtrends for most of the past 6 & 9 years, respectively: XOP & XEG.TO tracked fairly closely until late 2011, when XOP commenced a multi-year run while XEG.TO stagnated. This divergence was likely due to US shale plays getting hot, while Canadian E&Ps suffered due to egress issues. Both ETFs plummeted as WTI declined through 2015, once the market realized that shale production was oversupplying the market. An 18-month period from late 2014 to early 2016 saw WTI, XOP & XEG.TO all decline by 70%, while XLE fell by 'only' 45%. XOP recovered somewhat between early 2016 and mid-2018, as WTI prices gradually increased. XEG.TO saw a more muted response, presumably due to ongoing concerns about transportation bottlenecks and related government policy. From mid-2018 to late 2019, XOP (-50%), and to a lesser extent XEG.TO (-40%), experienced significant declines that were disproportionate to WTI's 25% decrease. The relative underperformance of XOP was likely associated with increasing skepticism about shale plays - the market was beginning to understand the difference between powerpoint promises and reality. WTI is down 33% since late 2019, while XOP is off by 50% and XEG.TO by 55%. Cumulative declines since mid-2014 are: WTI -60%; XLE -70%; XOP & XEG.TO -85%. Stock price underperformance relative to WTI is more evident when you plot the stock price divided by WTI, as shown below: From 2003 to 2014 XLE was relatively stable, trading primarily in a range of 75% - 100% of WTI, after which it went on a run to the 150% - 175% area during 2015 & 2016. It has since declined back to the range seen over the 2003-2014 timeframe. XOP traded in the 2-2.5 x WTI range until late 2013, when it started ramping up to a high of 4.25 by early 2015. Since then it's all been downhill, declining to 1.0, the lowest level seen over the study period. If XOP was trading at a more 'normal' multiple of 2.25 to WTI, it would be at $90 instead of $40. XEG.TO traded in the 2-3 x WTI range from 2003 until mid-2011. From then until early 2018 it was in the 1.5-2.25 x range, but since then it has declined continuously to 0.8x. If XEG.TO was trading at a more typical value of 1.75, it would be at US$7 instead of US$3.35. The pessimism toward the sector is evident from its performance relative to WTI, which implies significant multiple contraction. An extrapolation of the downtrends evident over the past 5 years suggests that if the XOP:WTI & XEG.TO:WTI ratios continue declining at present rates, XOP & XEG.TO will both hit $0 in another 2.5 years. As hated as the sector may be that seems unlikely, so at some point the relentless declines will have to flatten out and perhaps even reverse. The declines observed over the past 5 years are associated with a broad range of factors that have been discussed here ad nauseum, including: Oversupply Fears - the 'drill baby drill' attitude of the shale cowboys - corporate forecasts of continued shale production growth - EIA forecasts of shale growth - OPEC wrangling & noncompliance, Russia sh*t-disturbing - Iran and Venezuela on the sidelines, but for how long? - more recently, BP & the IEA forecasting earlier peak demand - expectations that ICEs will be replaced by EVs at an accelerated pace ESG Considerations - increasing regulation & taxation of the sector is applauded in many quarters - numerous high-profile institutions divesting holdings in oil & gas - many entities actively campaigning against the sector - cult-like anti-hydrocarbon behaviour by some - their new religion - media presenting biased information (renewables are free, hydrocarbons are evil) - unrealistic but widely held belief that hydrocarbons are a dead-end - unsexy & so 'last century'; upcoming fund managers have zero interest in sector - investors shamed for investing in the space (please don't tell my mom I work in the oilpatch - she thinks I'm a piano player in a whorehouse) Financial Considerations - sector has a long & shameful record of value destruction - chronic market underperformance - long-term stock downtrends, no sign of a reversal - trading has replaced investing - minimal new money coming into sector - diminishing existing investor base worried about throwing good money after bad - opportunity cost of holding oil & gas when tech has been booming - value investing completely out of style So what has to happen to turn things around? Supply is ubiquitous, and oversupply concerns already existed long before demand was slammed by covid. The only way the market will give any respect to the sector is if the current nonchalance toward the supply / demand situation is replaced by concern. In order for that to happen, some or all of the following need to occur: - the market needs to realize that there is limited new supply on the horizon from major new projects - the market needs to see that despite the wishful thinking of many, demand isn't going to fall off a cliff - OPEC+ needs to remain disciplined - shale players need to show some self-restraint, which clearly goes against their DNA - since shale managements can't really be trusted, funding for shale needs to dry up and remain scarce as oil prices recover - oilsands producers also need to show some restraint with new development. Unlike some here, I don't view E&P management teams as a bunch of idiots. I've worked in the industry long enough to know that there are a lot of sharp & ethical people in key decision-making roles. These people are driven by whatever will reward them professionally and financially. Financial incentives have historically been based on factors that are under management's direct control, with a primary focus on production targets and costs. This has resulted in decisions that are absolutely logical at the individual level, but suicidal collectively. The only way to change the behaviour of E&P management teams is to modify the incentives. This ultimately needs to come directly from the Board of Directors, and indirectly from shareholders. Compensation schemes should be based on profitability & returns, not production levels. Once debt is at manageable levels, shareholders should be rewarded via dividends & share buybacks, and improvements in key per-share metrics - not punished by the pursuit of uneconomic endeavours such as acquisitions at market highs, and investment in marginal or sub-economic assets. This is a drum that people like Eric Nuttal (love him or hate him, he's right about this) have been beating for some time now. The problem is that not enough institutions / shareholders have taken up the cause. Although there has been significantly more talk of this over the past couple of years, it will only count if E&P companies show they can actually walk the talk, instead of rapidly forgetting their near-death experiences at the first sign of an uptick in oil prices, and carrying on as before. Could it happen?? |
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Msg # | Subject | Author | Recs | Date Posted |
292713 | Re: Could the sector turn around? | rdesroch | 1 | 10/14/2020 4:00:34 PM |
292745 | Re: Could the sector turn around? | sfsorrow | 24 | 10/14/2020 8:18:11 PM |
293025 | Re: Could the sector turn around? | Hombre77 | 12 | 10/16/2020 4:43:36 PM |