Are the US oil majors a bargain?

Are the US oil majors a bargain?

Lots of people don’t want to own oil stocks, and that is reasonable.

Of course, it won’t make any difference to the environment if even a large majority of public market investors take fossil fuels out of their portfolios. The industry is not capital constrained, and there are ample sources of private, ethically flexible capital that can supply such needs as it has. As long as demand for oil, gas and coal persists, who owns what financial instrument will not change industry operations.

But if you don’t want to collect dividends from (say) ExxonMobil, I get that. I myself pray that a faster than expected energy transition crushes the fossil fuel industry. So it’s odd for me to bet my savings on that not happening.

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What follows puts all that aside. There has been a shock to the energy market, and we’re all trying to figure it out. One lens on that is analysing equity prices. So here goes.

Despite a big run-up, the big US exploration and production companies still look very cheap, on first blush. Some stats on six of the biggest (these are percentages, except for the first column):

Companies on low double-digit price/earnings ratios with revenues growing at 50 per cent or more are enticing, but remember that commodity stocks’ PE ratios are deceptive. Commodity-extraction groups’ earnings are volatile. The denominator (earnings) rises very quickly when the price of the commodity rises, pushing the ratio down. Often it makes sense to buy them when their PE ratios are high (trench earnings) and sell then when they are low (peak earnings) — the very opposite of most stocks.

The key column to look at, then, is the last: free cash flow yield. This is the amount of distributable cash a company generates, as a percentage of its stock market value. Take Pioneer’s 19 per cent cash flow yield. What that means, in essence, is that at its current level of profitability, it will make enough money to buy itself in just a little over five years. If all that money ends up in investors’ hands, either through dividends or share buybacks and price appreciation, then you can think of buying the stock as an investment where you get all your principal back over five years, and then you get a free option on whatever the company is worth after that.

With free cash flow generation and shareholder value, though, there is many a slip between cup and lip. For example, a company may decide to do an acquisition or an investment project rather than pay a dividend or buy back shares.

Recently, though, American producers have been focusing on returns over investment to such a degree that, with petrol prices rising, politicians are mad about it. From a story last week by my colleague Derek Brower:

Scott Sheffield, chief executive of Pioneer Natural Resources, the shale patch’s biggest oil producer, said in an interview that his shareholders wouldn’t let him spend more [on increased production]. Were any of them willing to budge at $120 crude? “None. Not at all,” he said.

Amos Hochstein, the state department official co-ordinating much of Joe Biden’s energy strategy, told the Financial Times that wasn’t good enough. “They should call their financiers and tell them there’s a war going on,” he said of the shale producers. “The American public is paying the price.”

The good news for investors is that the oil companies don’t seem to care. From a recent note by Credit Suisse analyst William Janela:

We caught up with most of our large-cap E&Ps [exploration and production companies] in recent days and heard a consistent message that there is no appetite to ramp up production in response to bans/sanctions on Russian oil imports . . . companies and shareholders alike are wary of jeopardising the low-growth, FCF/cash return value proposition that’s taken years to materialise and is finally resonating with investors.

American oil companies would rather make more money than produce more oil. At least that is what they are saying and, so far, doing. This is the central plank of a bull case on oil prices (and therefore US oil producers). The other big planks would be:

• Oil is a hedge against inflation.

• Oil companies are in all the value indices. If we are in the middle of a growth-to-value rotation, oil groups will benefit.

• The nightmare in Ukraine is nowhere near over, and the shocks to the oil market will keep rolling in, making stable supply from US majors more valuable.

At this point in the argument, the US oil majors do look very cheap. But the stock market does not tend to leave money lying around. There are two very big uncertainties reflected in the price of the majors. The first is obvious: no one knows how this war plays out.

One strategist at an energy consultancy put the second uncertainty to me as follows:

Does this war accelerate the energy transition, and by how much? If it accelerates it from 30 years to 20 years, I’m buying Conoco. If it accelerates it from 30 to 10, it gets pretty tough [to own these stocks].

The investment proposition for the oil majors depends a lot on what happens in nuclear, wind, solar and energy storage technology.

European markets are worried, rationally

A US recession, we told you on Monday, is a fair possibility, but not anyone’s base case. Europe, though, is a different story. Last month Germany’s central bank warned the country may have already veered into a technical recession (ie, two quarters of negative growth). That was before Russia invaded Ukraine.

Forecasters are split, putting an average one-in-four chance on a eurozone recession in 2022, according to Bloomberg data. Recent projections I’ve seen are playing down recession risk. Here’s one, published on Monday from Pantheon Macroeconomics:

The war in Ukraine will knock 0.6 percentage points off [eurozone] GDP growth this year in our baseline scenario. We have revised down our GDP forecast to 3.2 per cent. In a worst-case scenario, where the war lasts past the end of this year and gas and oil prices rise substantially more, we still do not expect a recession. Fiscal policy should prevent this.

But markets aren’t waiting for forecasts. They’re already braced for something bad. Since Russia’s invasion in late February, the Euro Stoxx 50 is off 6 per cent, versus 3 per cent for the S&P 500. Over the same period, Europe’s main stock volatility index has shot up twice as fast as America’s Vix.

European credit markets are getting jumpy too, as frequent Unhedged correspondent Dec Mullarkey of SLC Management notes. Spreads on European investment-grade bonds, after trading close to US equivalents, have widened. Investors want an extra dollop of yield to make up for the geopolitical risk they’re taking by owning European businesses. I’ve recreated Mullarkey’s key chart below:

Something similar is happening with bank stocks. European banks have long lagged America’s much more profitable banks, but the recent divergence is unusually big:

The most obvious fear is that Russia’s war drags on, sanctions tighten further, Russia cuts off Europe’s gas and a fresh energy crisis erupts. The European Central Bank would have to choose — raise interest rates even as growth stumbles, or hold them steady and let inflation run hot. The risk of slower rate rises helps explain how badly European bank stocks are performing.

Nervous markets are broadly a good sign, though. We aren’t seeing panicked fire sales, nor complacency. Staring down a crisis that could worsen, investors are weighing up the risks. Perhaps it is another indication markets are functioning as they should, despite circumstances that would test even the most level-headed investor. (Ethan Wu)

One good read

The nickel market simply stopped working last week. If you haven’t kept up with this bonkers story, Bloomberg Businessweek has a great rundown stuffed with new reporting.