Monday Market Musings 020923
Long-Term Energy Value

Looking for long-term energy recovery

Report out this week:
Investment Strategy Focus for September 2023

• Buying opportunity in US government bonds: the Fed probably reached its terminal rate and should hold its target rate steady at 5.5% until Q1 2024. The recent sell-off in US Treasury bonds offers long-term investors a good entry point. We favour US Treasury Inflation Protected bonds (TIPS) given elevated real yields.

• Recent US dollar movements are exaggerated: we still expect the Fed to start cutting its benchmark interest rate in late Q1 next year as economic momentum softens. Cumulative rate cuts from peak to trough should be much bigger for the Fed than for most other central banks. This should be a key driver of US dollar weakness, once the uncertainty around the Fed’s interest rate path reduces.

• Small stock market correction in August, but no breakdown in the upwards trends in Euro, Japanese, US and Latin American stock markets. We maintain our Positive stance on global stocks, favouring the Eurozone, UK, Japan and Latin America on a regional basis.

• Healthcare sector is a key quality defensive sector that has consistently outperformed other defensive sectors, and benefits from the ageing population megatrend. We continue to rate Healthcare as Positive.

Summary

• OPEC+ cuts global oil supply

• US oil inventories at a seasonal low

• Brent crude oil breaks out above $88/barrel

• Oil majors perform well, led by ExxonMobil and ConocoPhillips

• Value to be found especially in European/UK majors

• Even more potential value in oil & gas small-caps

• Don’t overlook US Master Limited Partnerships (MLPs) to play energy infrastructure

Focus on Energy

As we approach the latter part of 2023, we are presented with a resurgent oil price as global demand remains steady, while supply is cut by OPEC+ producers Saudi Arabia and Russia - both producers have pledged to maintain current quota cuts into October, at a time when OPEC+ oil production is at its lowest since mid-2021.

At the same time, US oil inventories have dipped to a seasonal low, at the lower end of its 5-year seasonal range.

With global oil demand forecast to rise in 2023 and again in 2024 despite the rise in take-up of electric vehicles (due in large part to demand growth from emerging economies), Brent crude oil prices have reacted to this news by rising back above $88/barrel.

Brent crude oil rallies, diesel prices follow

Source: tradingview.com

Integrated Oil profits boosted by high refining margins

The large integrated oil companies such as BP, Shell, TotalEnergies and ExxonMobil all benefit from higher oil prices in the upstream operations (getting oil out of the ground), but also from historically elevated refining margins (the profit from refining crude oil into finished oil-based products).

This results in higher operating margins, free cash flow and return on equity for the “Seven Sisters”, reflected in a rebound in the Oil & Gas sector.

US, European Oil & Gas sectors rebound

Source: tradingview.com

Needless to say, these oil companies are still cheap relative to their respective regional stock markets in P/E terms, and also offer a bullish combination of strong free cash flows, rising dividends (UK majors offering a near-5% yield, more from European majors like ENI) and share buybacks, and falling debt levels.

Of the Majors, best momentum in Europe and the US

The large integrated oil companies with the best momentum are to be found in Europe (TTE TotalEnergies, ENI) and in the US (XOM ExxonMobil)

Leading European oil majors

Source: tradingview.com

The two UK oil majors BP and Shell have trailed not only their European peers, but also US peers such as ExxonMobil and ConocoPhillips:

BP and Shell trail XOM and COP

Source: tradingview.com

This is today reflected in a huge valuation gap between the US and UK majors: while XOM and COP both trade at P/E multiples of 12-13x on forward earnings, BP and Shell trade at only 6.6x and 7.4x respectively. The same is true for European peers such as TotalEnergies and ENI, which trade at 6-7x P/E.

Outside the majors, best value in small-caps

Of course, UK and Eurozone energy policy has been haphazard at best over the recent past, which does not help sentiment towards the Energy sector. The UK windfall tax imposed in 2022 on North Sea oil production by UK companies is an excellent example of the political damage done to the domestic oil sector.

In addition, this valuation gap between UK, Europe and the US is true more generally, not just in the Oil & Gas companies. This highlights global investors’ preference for the US - hardly surprising after such impressive outperformance versus the rest of the world over the last 10+ years.

The UK in particular continues to suffer from investor neglect - not only from international investors, but even from domestic institutional investors who have increasingly diversified their pension fund portfolios away from domestic UK stocks towards international stock exposure in recent years.

Keep and eye also on gas prices, which have renormalised quickly this year after 2022’s enormous price spikes. Note that in the case of European gas prices in particular, that they remain 2 times the average level from pre-2020. So gas producers should continue to be solidly profitable, even if they are unlikely to benefit from a 2022-like windfall in future.

Gas prices also rising from summer lows

Source: tradingview.com

Remember that winter gas demand will depend to a large extent on heating demand, which in turn will be a result of winter temperatures - recall that we in Europe “got lucky” last winter, as average temperatures remained far higher than normal. There is no saying that we will be similarly lucky this coming winter, which may then lead to higher gas demand and higher gas prices.

I still like exposure to extremely cheap UK oil & gas small-caps that are producing in safe geopolitical regimes and which are paying high dividends - SQZ Serica Energy is one such company which remains extremely cheap, with a 8% forecast dividend yield. Yes it is more exposed to UK natural gas, and is thus exposed to the UK windfall tax, but I would argue that this is quite clearly priced into the stock at these low valuations.

More information on Serica can be found on the company website.

Serica Energy starts to rebound

Source: tradingview.com

US energy infrastructure another interesting exposure

One way to gain exposure to US energy without necessarily taking the price risk of crude oil and natural gas is to buy an US energy infrastructure ETF. Master Limited Partnerships are infrastructure companies that own oil and gas pipelines to transport the oil and gas from wells (e.g. onshore shale oil and gas wells) to refineries and utilities, and are paid based on the volume transported with correspondingly little exposure to energy prices.

This can be bought via London-listed UCITS ETFs such as the MLPS Invesco Morningstar US Energy Infrastructure MLP UCITS ETF, a strong performer of late:

US Energy Infrastructure ETF: powerful returns

Source: tradingview.com

Bonne chance!

Edmund