We believe investors should be open-minded about old-fashioned energy for two reasons. First, we have a growing conviction in oil companies’ capital discipline. Second, while commodity prices may rise due to severe underinvestment, they do not need to for the sector to become a massive profit engine for investors. Third, with broad market equity duration risk at records, energy offers a very cheap hedge.
Get our White Papers direct to your inbox: SUBSCRIBE
Consider:
- On March 29th, 2020, we published a study on sector responses in crashes. With oil at negative prices, energy stocks down 61%, and industry consolidation underway, we believed that survivors of the carnage were a “…call option on the eventual resumption of even partially normal human behavior.”
- In April 2020, we published an update noting that with total stimulus exceeding 30% of GDP, despite elevated valuations, stock selection would be key to strong performance.
- In March of 2021, we published a study of the Great Inflation of the 1970s which showed that not only had Energy & Staples been some of the biggest beneficiaries of inflation, but that the market’s valuation structure was such that many popular sectors were priced like long term inflation was impossible. Watch our follow-up presentation on equity duration here and review our piece explaining what does volume in stocks mean today.
- Since then we have written pieces that discussed the bubble in renewable energy companies, a piece explaining that ESG and brutal capital destruction were setting energy up for the virtuous cycle of capital discipline, rising free cash flow, deleveraging, multiple expansion, and healthy dividend yields.
- A piece discussing soaring food prices due to drought and rising energy costs as well as a piece showing that magazine covers were giving their classic contrarian buy signal and showing energy has the lowest weight in the S&P 500’s history.
Fig. 1 below is at the heart of our first point of conviction – oil prices do not need to rise for energy stocks to see explosive growth in profits. When oil peaked at $140/b, the sector generated $53bn in FCF. The energy sector today has generated $35bn in FCF in the trailing 12-months, with oil at an average price of $52. This means, energy stocks are generating ~70% of the FCF despite oil prices being 63% lower than the prior peak.
This is simple and powerful evidence of the importance of capital discipline to overall sector profits.
This is why the KCR team has such deep roots in data-driven behavioral finance. The below chart shows how narrative can trump facts and profits for only so long. The navy blue line is still the energy sector’s FCF. But the light blue line is now the aggregate market cap of energy companies.
Disclaimer
The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital Research, LLC and its affiliates (collectively, “Kailash Capital Research, LLC ”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital Research, LLC . In preparing the information, data, analyses, and opinions presented herein, Kailash Capital Research, LLC has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital Research, LLC , however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital Research, LLC and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital Research, LLC – All rights reserved.
Nothing herein shall limit or restrict the right of affiliates of Kailash Capital Research, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital Research, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital Research, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital Research, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.
September 8, 2021 |
| Authors: Matthew Malgari, Nathan Przybylo, Dr. Sanjeev Bhojraj and John Durkin
September 8, 2021
Authors: Matthew Malgari, Nathan Przybylo, Dr. Sanjeev Bhojraj and John Durkin