Energy stocks have been the number one sector in the market so far in 2022, and this follows upon its number one performance in 2021. What should we make of that and what does it portend for the future? We should probably start with the fact that energy was the worst performing sector in 2020. There are two ways of looking at this. It would be easy for investors to decide that the 2021-2022 performance by energy stocks is simply part of a huge catchup rally that may now have overshot the mark. Energy stocks had fallen to a point where they were dirt cheap, according to this view, and have since recovered to a point where they are fully priced. The other point of view is that something fundamental has changed in the energy market and the rally starting in the middle of 2020 was just the beginning as the market gradually recognized the implications of that change. Deciding which way to look at the two year monster rally is the key to understanding whether energy is still a good buy right now.
The relationship between energy stocks and highly volatile oil prices is less important than it has been over the past decade. Most oil and gas companies have taken advantage of the high prices over the first half of 2022 to repair their balance sheets and reduce financial leverage. This is true of all the stocks mentioned in this article. All can operate profitably and provide solid future shareholder returns at prices around the average price for 2021 which was about $68 per barrel. This is probably in the low end of the band upon which oil companies base their forward expectations. Prices bouncing around $90 per barrel probably don't worry energy company CEOs to nearly the degree that short term volatility seems to worry investors and the market. The underlying assumptions for companies mentioned in this article are roughly based on 2021 oil prices and level of volatility.
On April 20, 2020, the expiring price of WTI futures dropped to negative $37 per barrel so that in theory the futures market was willing to pay you $37 to make a barrel of oil go away. Both long term and short term factors led to that moment of negative oil price. Going into 2020 the dominant long term narrative was that carbon energy was in a secular decline. The major oil companies were pretty much written off as companies in run-off. It wouldn't have been the first industry to suffer that fate. In the 19th century, 90% of American workers were farmers. Today the number involved in farming has fallen to 1%. That's what secular decline looks like. We still have farms, of course, but they are vastly larger in scale. Over a period of 100 years this sort of decline is almost certainly the future of carbon energy, but the question for investors is whether that decline is measured in a few years or a few decades. The chances are very good that carbon energy will still be around and produced by businesses operating on the present model for decades.
By early 2020 the mega-cap oil majors were beleaguered on all sides. Green energy activists were making proposals at annual meetings and seeking seats on their boards. Three actually won seats on the board of ExxonMobil (NYSE:XOM ) in 2021. The oil majors were easy targets for political leaders because of their longstanding denial of climate change. Unfriendly government policies were on the way. Then in February 2020 the COVID pandemic appeared and effectively shut down the economy. The business of major customers like airlines fell radically so that lower prices were compounded by lower volume. The final straw was the OPEC price war in the first half of 2020.
These factors all contributed to the energy crash in April 2020, but in the longer perspective the most serious challenge to the oil majors was the simple impossibility of replacing their reserves. An energy company which can't replace the oil it processes and sells eventually goes out of business. On March 29 I wrote about this problem in detail. The short version is that the four largest international oil majors spent $11.5B from 2010 to 2020 versus $6.5 billion from 2000 to 2010 to find roughly the same $40 billion of reserves. All four failed to maintain their level of reserves, and as a group they replaced only 85%. That strongly suggests that the oil majors are in fact in the early stage of the run-off phase. The ten-year chart below compares the Energy Select Sector Spider (XLE) to both the S&P 500 (SPY) and the tech-heavy Invesco QQQ Trust (QQQ). What it shows is the fact that energy fell steadily behind the broader market with technology stocks being the big winner.
The sharp dip in all three charts shows that by March 2020 most investors had thrown in the towel on energy. I can't recall any predictions at that time that the energy sector would lead the market over the next two years, but that's exactly what it did. Does it make any sense that the energy sector has rallied furiously for two years beating technology and all other industries? Looking closely at the chart you can see that after two years of leading the market, energy is still well below its level in 2014 when oil prices were about where they are right now. What does that mean for investors who are considering energy stocks right now? The chart below shows just how powerfully energy stocks rallied over the past year and seized market leadership while the market as a whole, with downside leadership by tech, was sinking.
So far in 2022 (as I write this line) the Energy Select Spider ETF (XLE) is up about 40% for the year after having been up as much as much as 60% at its June peak. For 2021 it was up 54%. Since its low point in March 2020 the XLE is up 200%. From its low point in November 2020 the percentage weight of energy in the S&P 500 has more than doubled from just under 2% to just over 4.4%. It's worth noting that in historical terms this is still a small number as the market is accepting the new energy story with some hesitancy.
The fact that the energy sector bucked the market down trend carries important information. The immediate support for energy outperformance is that the operating results of oil and gas companies have also outperformed. Recent Wall Street projections have the energy sector providing about 10% of S&P 500 earnings in 2022. It's hitting far over its 4%ish weight. This piece by Factset notes that while S&P 500 earnings were up 6.7% for the first half of 2022 they would have been negative 3.7% without energy.
At the very least the narrative predicting the immediate demise of carbon energy has been shown to be exaggerated. In his 2020 Shareholder Letter, Warren Buffett, a strong supporter of going green rationally, pointed out the difficulties in delivering renewable sources to the large cities which are the major users of energy. Buffett should know, having taken no dividends from Berkshire Hathaway's (BRK.A)(BRK.B) BHE unit while it devotes all of its earnings to constructing the necessary grid for renewables. Buffett's target date for completing this project is 2030 and BHE has a substantial head start when compared with other utilities. The inescapable implication is that while the use of carbon energy will decline in the very long run, the decline will be gradual. Nothing could have put this in focus more clearly than the supply squeeze stemming from the Russian invasion of Ukraine.
The premise of this article is that oil and gas will continue to be the major source of energy for quite a while - long enough for current energy investors to do extremely well. The narrative of carbon energy's secular decline got a couple of decades ahead of itself. The major opportunity lies in the fact that even after a powerful rally the positives in the energy narrative seem not to be fully factored into energy stock prices. Bucking the trend in what increasingly looks like a bear market is a powerful hint that the energy stocks may continue to be leaders in the next bull market.
One of two key questions is how to weigh the several time frames at work with oil and gas and the energy sector. In the longest time frame the energy sector has fallen from a bloated 28% in 1980, when it had been the leader for the long 1970s commodity inflation cycle. That 28% was a clear overshoot, and those who thought that energy stocks only went up were in for a big disappointment. Starting in 1980 most parts of the market did better. In 2000 the weight of energy rallied back to 15% and it tagged that 15% level again in 2010. Since then, while tech led the market, energy stalled and then fell below 2% in November 2020. It is around twice that today. In the long run energy will lose ground to technological innovation, but for the moment it appears to be tech which is overextended while energy makes a comeback.
The important question for investors is whether the 2020 reversal should be viewed as a major turning point. Are we about to see a series of long term highs in energy prices or do current energy prices merely reflect a number of short term factors? The very difficulty of replacing reserves and the relatively modest recent capital expenditures for exploration and production suggest that such a long term turning point was due. The target is not the 28% S&P weighting of 1980 but it might approach the 15% of 2000 and 2010.
What this means is that in the longer perspective, energy stocks are probably cheap. That being said, it's usually wise to be prudent when the price of an asset has recently tripled as the Energy Select Sector ETF has done since April 2020. The present market may be in the process of providing a dip-buying opportunity as energy has succumbed to the general market slide for the past few days. Investors might watch for an opportunity to buy in the course of the present market correction.
The question of what to buy depends to some degree on an investors goals and risk tolerance. The two largest positions in the Energy Select Sector ETF, making up more than 45% of XLE holdings, are ExxonMobil and Chevron. While some investors might be attracted by the diversification of XLE, both Chevron and Exxon have higher yields at 3.6% and 3.7% respectively and appear able to continue increasing their dividends for the foreseeable future. SA Dividend Ratings give CVX an edge with Dividend Safety at B-, Dividend Growth at B+, and Consistency at A+, all three a notch above XOM. Buffett appears to think so too, having established a large position in Chevron, more than $26B per Berkshire's last report.
The downside is that the energy mega-caps have no growth in volume, with recent improvement in metrics being driven by rising oil prices. One should also not forget that the energy mega-caps have been unable to replace their reserves and both have revenue lines reflecting a long term decline. Chevron touches out Exxon again in SA Factor Ratings with an edge in Value as XOM has recently gone up more in price. Chevron also is rated a notch better for Growth. Both receive Quant Rankings of Strong Buy. XOM is ranked #1 of 19 Integrated Oil and Gas Stocks with CVX rated #4, but the difference in the numerical score is 4.99 (out of 5) for Exxon versus 4.98 for Chevron. They are pretty much the same company when it comes to basic statistical measures.
For the oil majors, size is not their friend. Their huge size makes it extremely hard to move the needle by acquisition or successful drilling. It is also worth pointing out that the recent direction of interest rates makes safe Treasury Notes increasingly competitive to dividend yields in the 3.5% area. Before long this may be a factor for all stocks favored by investors as bond substitutes.
For investors more focused on potential capital gains and willing to assume a bit more risk the following two stocks seem more likely to increase earnings and dividends with rising operating volume and profit margins. Both are less constricted by the difficulties of reserve replacement and both have the potential to take a major leap in earnings and cash flow accompanied by an increase in valuation.
Occidental has been written about frequently on this site, and I myself have included it in three articles from various perspectives. The major subjects have had to do with OXY's success in beating out Chevron for the assets of Anadarko and Buffett's persistent buying of OXY shares which some see as prelude to a takeover. The current focus, however, should be on OXY's transformation as a company following the Anadarko acquisition.
Among oil majors, Occidental benefits by being small enough that an acquisition can make a difference. Chevron is almost five times larger and ExxonMobil is six times larger. The acquisition of Anadarko would have had modest impact on Chevron, but for OXY it added about 70% to its reserves. The good luck of rising oil prices shows just how transformative this has been as annual revenues through Q2 2022 are up about 70% from 2013 when oil prices were roughly at the present level.
The more specific developments involve debt and capital structure. The Anadarko acquisition ran up OXY's long term debt from $10.2B to about $39B plus the $9.76B preferred stock held by Berkshire Hathaway. With its market cap as low as $20B for much of 2020 OXY looked frighteningly leveraged. The gusher of cash flow over the last six months has enabled OXY to uptempo its debt reduction to $8B for 2022 so far, bringing net long term debt down to just under $20B. Along with rising market cap that has reduced debt as a percentage of capital (including Berkshire's preferred) to about 33% of enterprise value, bringing credit ratings upgrades. The plan for future debt reduction is to take LTD down to $18B by the end of the year and let debt roll off at maturity in the future.
Along with its $3B scheduled share repurchases, CFO Robert Peterson noted in the Q2 conference call that cash from execution of warrants would be used for share repurchases to mitigate the increase in shares outstanding. Also worth noting is that scheduled capital expenditures for exploration and production for the remainder of 2022 were set at a minuscule $75 million for Q3 and $215 million for the second half. This is a company which has made its large play for reserves and is laser focused on rapid improvement on capital structure and profitability. CEO Vicki Hollub reassures that a rising dividend can continue if oil falls to $40 per barrel. A quick look at metrics for 2021 shows that the new and transformed OXY will be highly profitable at oil prices similar to those in 2021.
A point about OXY which should be mentioned is its Low Carbon Ventures initiative with construction of a carbon capture project scheduled for this fall as reported by SA News. Helped in part by its modest size that puts OXY well out in front of other integrated oil companies. CEO Hollub seems serious about this initiative which could align OXY with the evolution of energy sources in the long run. Hollub is an outstanding no-nonsense CEO who is attentive to details but can also think in terms of the big picture. She survived a war with Chevron to buy the Anadarko assets which have transformed Occidental. Her leadership is one of the reasons to feel comfortable owning it.
Occidental's current SA Quant Rating of Hold does not fully reflect its rapid balance sheet and earnings growth improvement. The better measures are its factor ratings of A for Growth, up from C six months ago, and A+ for profitability. While one shouldn't generally attempt to front run Quant Ratings, prospective investors should note that the stunning improvement in its debt situation thanks to gushing cash flow has taken place over about 18 months with the largest pop in the first six months of 2022. A higher Quant Rating seems likely to follow. While I am agnostic on the subject of Buffett buying the whole company (see this article) I don't rule it out. I own OXY and rate it a Strong Buy.
If you just look at the operating statistics without being told it's an energy company you might imagine that Cheniere is a young tech company with earnings and cash flow just flipping from negative to positive. Revenues have exploded along with long term debt, although debt went down a bit over the past six months thanks to its greatly increased cash flow. The share count has increased as it does with growth companies. Cash flow just turned positive in 2021 and has grown explosively in the first six months so that Cheniere now sells at about 8 1/2 times free cash flow per share. What happened?
The obvious answer is that much higher gas prices happened and without anything major increases in cost, higher revenues dropped to the bottom line. There's much more to Cheniere, however. Cheniere is the largest US company and second largest globally in the transportation and storage of liquid natural gas. The fuel crisis in Europe resulting from the Russian invasion of Ukraine has compelled Europe to rethink its energy policies, and Germany now has six new LNG terminals in the works. Because European gas prices are higher than prices in the US this presents an opportunity for Cheniere.
Excellent recent results clearly don't tell the whole story as Cheniere is seeking FERC approval to expand its LNG plant in Texas. It has no real competitor in production and transportation of LNG, including the specialized ships required. There are no present numbers for the impact this will have on future earnings and cash flow, but the market seems not to fully grasp the possibilities.
Cheniere has an SA Quant Ranking of Hold, which may seem generous given its Factor Ratings of F for valuation, B- for Growth, and C+ for Profitability. As with OXY, however, these Ratings will soon read like ancient history. Most interesting is its Quant Ranking of 29 out of 61 in the Oil And Gas Storage and Transportation Industry. Because of the recent developments with gas supply in Europe it might be more relevant to rank Cheniere 1 out of 1 or possibly 1 out of 2 (globally) in its specialized niche.
Cheniere is more speculative than the other three names, but I rate it a Strong Buy. While I don't own it, I may buy it in a further market pull back.
Energy has been the strongest market sector for the past year and a half. Over a two-year period the value of the Energy Select Sector SPDR ETF rose 200% yet energy remains a small weighting in the S&P 500 given its continuing importance to the economy. All of the stocks suggested above had single digit P/E ratios and single digit price to free cash flow ratios. While there are various risks which hold down the P/E ratios of energy stocks, their valuation seems low given the high probability of good future prospects. The major risks include a deep recession or a sudden and unexpected solution to all the world's major problems. Take the more pessimistic house position on that one. One might throw in the risk that energy costs and shortages continue and high energy prices persist politicians may see successful energy companies as targets for various kinds of taxes.
The energy sector has many companies with various sizes and business models. Chevron and ExxonMobil seem ideal for income seekers. Occidental Petroleum offers capital gains as its large makeover transforms the company. Cheniere is a somewhat higher risk company with quite a bit of debt, but high gas prices have enabled it to begin paying down that debt while the prospect of selling liquid natural gas to Europe offers a high upside. The core case is that Cheniere's business is ideally aligned with the current environment. After the long run-up from 2020, investors might choose to be patient and see if the current market decline will pull the energy sector down a bit more and present a good dip-buying opportunity. Strength despite general market weakness suggests energy may well emerge as a big winner in the next major bull market.
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Disclosure: I/we have a beneficial long position in the shares of OXY either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The companies recommended differ in details making them attractive. I can't reduce to a single reason.