Attracting Capital Back to Energy: Q&A and Clarifications
Navigating The Energy Crisis Era
This week I will aim to address some of the many questions I have received following a series of posts over the past month on attracting capital back to traditional energy and following back-to-back appearances this past week on Twitter Spaces with super star hosts George Noble (No Bull - Market Talk) and @chigrl (Tracy Shuchart). You can find links to recordings of the Twitter Spaces appearances below.
What if ROCE declines next year due to lower oil prices? Does that mean the long-term ROCE upcycle is over?
Oil prices could well decline in 2023 resulting in lower earnings, cash flows, and ROCE. There is little question that especially if we tip into a recession scenario that extends beyond Europe and includes the United States or other important regions it is quite possible 2023 could be a down year for traditional energy profitability.
My focus with Super-Spiked remains on the longer-term capital allocation and ROCE cycle and the recognition that structurally (as opposed to cyclically) tight energy markets require an extended CAPEX cycle that has barely started. I expect year-to-year and quarter-to-quarter volatility to be high, consistent with the SuperVol framework I have been articulating. A down year (or several quarters) is not only possible, but inevitable, especially when energy market tightness is being resolved through demand destruction pricing as opposed to robust CAPEX.
I continue to encourage companies and investors to think about how to navigate an inevitably Super Vol macro backdrop in the context of what is a messy energy transition and structurally tight energy markets. What actions should you be taking now or in the future, especially relative to others that either think this entire rally was a Russia-Ukraine-driven blip or that are in the "always bullish, all the time" mode?
How do you assess whether structural ROCE is sill in a long-term uptrend when short-term volatility is high?
A key metric I will be looking at to assess the health of the structural ROCE cycle is the relationship between ROCE and oil prices. Are changes in ROCE outperforming, underperforming, or about in-line with changes to underlying commodity prices?
Exhibit 1 shows annual median ROCE for the traditional energy sector during the Super-Spike era versus WTI oil prices. You can see ROCE improved dramatically over 2002-2006 as oil prices rose faster than CAPEX and costs. This began to change for the worse in 2007 as I have previously discussed, with the erosion continuing beyond the period shown until 2020. Check out the 2008 ROCE erosion versus 2006, despite a circa $35/bbl oil price jump. Or how about 2012 versus 2002 where oil prices had increased 4X but ROCE was unchanged…yikes!
Exhibit 2 is similar to Exhibit 1 but is quarterly data for Q12015-Q32022. The regression line is for 2015-2019. I have actually taken out the 2020 COVID year to add clarity (it does not change any conclusions). As you can see the data points starting in 4Q2021 are decently "above" the regression line, indicating improving underlying profitability relative to oil prices.
All data in Exhibits 1 and 2 use "reported" net income. Some large write-downs in 1Q2022 is the reason that data point looks weaker than 4Q2021. On a quarter-to-quarter basis, the data can get noisy at times, which is a reason to consider using "adjusted" earnings for shorter time horizons.
In addition to the ROCE regression line versus oil price, I also take into account other metrics like industry CAPEX and reinvestment rates as discussed last week (here). Long-term ROCE upcycles are much more likely to be over AFTER, not before, CAPEX and reinvestment rates have risen meaningfully (Exhibits 3 and 4).
Why do you imply energy equities are inexpensive? Shouldn’t multiples be lower on above-normal earnings?
Yeah, of course. Trading multiples like P/E, EV/EBITDA, and free cash yield will appear "cheap" when at above-normal portions of the cycle and "expensive" when at the trough of the cycle.
A valuation framework to calculate intrinsic value has several components:
An estimation of "normalized", or through cycle, earnings/cash flow/ROCE;
An increment/decrement for earnings/cash flow that are above/below normalized earnings for the forecast period (typically the next several years);
A judgement on whether transient cash flows deserve 1X, <1X, or >1X credit; i.e., will temporarily cash flows be spent wisely (>1X), poorly (<1X), or returned to investors (=1X);
A terminal value calculation relative to normalized earnings/cash flow that takes into account going concern or liquidation value, as appropriate, beyond the normalized year used.
The framework gets short-handed into a P/E or EV/EBITDA multiple or free cash flow yield on near-term earnings by most analysts/investors. Rather than expand on these points in this post, it's probably worthy a fuller, stand-alone post. The point being that when I look at energy equities, it is through the lens of a normalized earnings driven framework that takes into account cyclicality. Multiples are just a short-hand Street convention we all use and one does need to consider cycle positioning.
When will volatility decrease?
Ummm...never? Why would you want it to? The constraints of the energy business at cycle extremes, which I will simplistically define as full or empty inventories and spare capacity suggest high levels of volatility at the ends of the cycle and as we approach those extremes. It is only in the moments energy markets are somewhere in the middle that you might have a chance at lower volatility.
Small swings in supply and demand—even in structurally looser markets—can drive energy commodity prices to extremes relatively quickly. I personally spend zero energy hoping a lower volatility environment will magically materialize. It is in fact the inherent volatility in the sector that drives the opportunities for portfolio management, be it as a company or an investor.
What if there is peace with Russia-Ukraine? Won't energy equities trade off in that scenario?
Let's hope there is peace. War is bad. Peace is good. I suspect peace headlines would contribute to instinctive downside volatility for energy commodities and equities. But the impact of war on near-term Russia oil supply has heretofore been generally over-estimated by most. The bigger challenge in my view is the likelihood that diminished capital flows into Russia negatively impact its long-term oil supply growth.
In my view, the days of year-in, year-out 1% per annum crude oil growth from Russia are in the past. Long-term growth I would peg at between flat on the upside and a decline of 1%-2% per annum over the long run as potential capital starvation negatively impacts long-term growth.
How does shale maturity impact sector ROCE?
In my view, this question is better addressed at the company specific level. There are signs that Tier 1 (i.e., the best acreage) inventory depletion is becoming a thing for some companies. A smart, new friend described it best: "The (institutional investor) knives are out" on assessing shale acreage for individual companies. This happens to be an individual that knows what they are talking about when it comes to evaluating shale acreage.
A few implications:
Overall shale oil growth is likely to be slower than seen over 2015-2019;
Individual companies are likely to react to depleting inventory by engaging in M&A; and to be clear, not all M&A means inventory depletion is at hand for a buying company;
ROCE may well be lower for companies with maturing Tier 1 shale inventory.
At the sector level, slowing shale growth is likely to extend the period of above-normal ROCE at the sector level as the market searches for new areas to invest.
If shale is maturing, what areas will help meet future demand?
Canada's oil sands region is the obvious, no brainer, what are we waiting for answer to US shale oil questions. The only thing standing in the way of Canada's oil sands is "climate only" ideology and non-sensical nationally determined contributions (NDCs) to CO2 reductions that has the current Canadian federal government trying to limit oil sands production to meet a particularly mis-guided climate objective.
To be clear, it is NDC accounting that I find non-sensical, not the need for the world to reduce its carbon intensity. It makes zero sense, in my humble opinion, to include domestic oil and gas production in a country's NDC. Canada is not an especially large country in terms of population. I am not even sure why anyone would really care if Canadian consumers, of all the countries in the world, switch to electric vehicles or fuel efficient hybrids or not. Canada should be exempt as a friendly hydrocarbon producer that the world will desperately need for many, many, many decades to come. Let’s start a movement: #FreeCanadaFromMis-GuidedClimateNDCAccountingIsanity
What would a Fed pivot mean for Energy? Wouldn't it be bearish for the Energy sector as the world returns to the good ole days of Tech leadership?
I don't think I need a disclosure that I am an energy analyst, not a Fed expert. That said, one can observe that whenever the market "feels" a Fed pivot on interest rates is coming, the stock market darling sectors of the past decade have bounced. Super-Spiked is not going to suddenly get into reading Fed tea leaves. Instead, I'll just offer a few relevant observations:
The Fed can't print barrels or Mcfs or MWhs.
There is no indication that the United States or broader world can again go back to a "QE unlimited" paradigm.
Globalization, labor, inflation, and geopolitics all appear to be in the midst of structural changes not seen in decades and in some cases since the end of World War II.
The Fed can pivot or not pivot...not sure I really care and I won't be losing any sleep over it. I remain focused on where we are in the long-term capital allocation and ROCE cycle for traditional energy.
Are environmentalists to blame for the messy energy transition?
No. Environmentalists exist to advocate for the environment—that is their place in this world—to promote clean air, clean water, biodiversity, and, now, to minimize the risks of excessive carbon emissions. Like any group, there are elements that are not worthy of listening to, in this case those in the de-growth, anti-capitalism, pro-socialism wing of the movement. But make no mistake, environmentalists are not the reason, in my view, that we are in the midst of a messy energy transition. Rather it is a mixture of politicians pursuing poor policy choices coupled with business leaders that have not done their homework on the implications of some of the promises they have made and policies they have supported.
As an example, I believe Munich Re's deeply disturbing decision to exit the oil and gas reinsurance space starting in 2023 in the name of achieving a “Paris aligned net zero by 2050” goal is the fault of the leaders of Munich Re that made that choice. Yes, I suspect there are many people in the climate community that agreed with and even encouraged the decision. But it was not an NGO that made the final call. It was the business executives leading Munich Re. This is but one example.
The cleaner air and reduced water pollution we enjoy in the United States is in large part thanks to the environmental community. Historically, our environmental goals and achievements have been in harmony with strong long-term economic growth. Looking at our economic track record, the United States is the greatest country in the history of the world. And we have tackled many environmental challenges along the way.
Climate is the first environmental cause where the policy choices being proposed by politicians and being supported, either directly or indirectly, by many businesses is contributing to the challenging energy and economic landscape we face today. Even if many of those poor policy choices and business decisions were at the behest of environmentalists, it is the politicians and business leaders at fault for their enactment. Full stop.
Aren’t politicians and ESG warriors to blame for insufficient energy CAPEX?
No. In what will undoubtedly be one of the least popular perspectives I will have to offer Super-Spiked readers, I do not believe western world politicians or the ESG community is the reason industry CAPEX is at or near trough levels.
I will keep this brief since I have discussed it previously, but it is the 15-year ROCE downturn and the especially poor profitability of 2011-2020 that is the reason industry CAPEX is low. Investors have screamed: "Stop wasting our money. I will not support you any more, as you were."
Are western world politicians helping? No, of course not. But the unfortunate and often misleading rhetoric you hear from Washington politicians is not the reason CAPEX is at or near trough levels. Poor ROCE over 2011-2020 is the reason. 2022 is merely the 2nd year of improvement and the first year of above-normal ROCE. Industry still has some wood to chop to fully earn back the trust of investors.
What about the rise of ESG and anti-fossil fuel divestment efforts? Again, the virtue signaling part of ESG and especially the anti-fossil fuel element is nothing that I support. But I also believe it has had no discernible impact on industry CAPEX. Investors prefer dividends and stock buybacks because they don't, yet, trust management teams to wisely spend money based on the 2011-2020 track record.
Whether that is fair or not is not the point of this section. It is to merely recognize that I do not believe ESG is the reason for why industry CAPEX is near trough. I believe ESG is in need of reform and adjustment. I am vehemently against fossil fuel divestment and exclusion efforts, as I noted in the Munich Re example. But that is a different matter and, in my view, not the reason for current restrained industry spending.
What are three policies you would like to see changed?
Replace ICE vehicle bans with banning any vehicle that doesn't at a minimum achieve real world fuel economy of at last 30 mpg by 2030 escalating to 50+ mpg by 2050. Actual US mpg remains stuck in the low 20s. It's perhaps the most meaningful opportunity to materially lower gasoline demand without crushing economic growth. There are not any great reasons to not do it, especially for those in the ban ICE vehicles camp.
Improve climate accounting by reorienting national determined contributions away from domestic sources of energy toward consumer-based outcomes. In other words, stop penalizing energy supply which is critical to human prosperity. Instead figure out how you can motivate new technologies that give consumers low-emission alternatives that are at least as good as current higher emission choices.
Publicly acknowledge that we cannot run a grid on 100% renewable power anytime soon, if ever, and that we are at an opportune time to figure out how we can incentivize and ensure we have robust growth in reliable, dispatchable, zero carbon nuclear power.
Twitter Spaces: No Bull - Market Talk with George Noble
Apple Podcasts: (here)
Spotify: (here)
Twitter Spaces: @chigrl (Tracy Shuchart)
For best results, listen to this one on your iPhone or Android device. You can listen on a web browser as well.
⚡️On a personal note…
It is the holiday season and hopefully all Super-Spiked subscribers are going to take at least some down time to spend with family and friends. The holidays are also an excellent time to catch-up on reading. Over the course of a given year, I try to read about two books per month and 25 in total. Below are some that I particularly enjoyed reading over the past year or so. To paraphrase a common Twitter tag line, reading a book and being glad I read it does NOT mean I necessarily agree with some or all of the views expressed therein. Please try to remember this as you read the list.
An obvious example of that principle is my reading of Thomas Malthus’ classic from 1798. For those of you that are in “we must take urgent action to address the climate crisis” mode, is there not something you might want to learn from the Malthus history?
For those on the side of “my primary policy suggestion is to be against whatever progressives want”, I recommend reading David Victor whose books Fixing the Climate and Making Climate Policy Work provide excellent templates, in my view, on bridging the gap between the benefits of markets and areas where government policy is needed to address negative externalities. It’s not light reading but it is highly informative. And I have met Dr. Victor who happens to be a nice and engaging individual.
I liked the contrast between Saul Grifith’s “Electrify Everything” and Meredith Angwin’s “You might want to better understand how the grid actually works before electrifying everything”. Read these two back-to-back if you can. Start with Mr. Griffith’s.
Every person on Earth should read Dr Vaclav Smil. It should be required reading in high schools and colleges around the world.
Everyone, left and right, takes population growth as a given. Darrell Bricker’s Empty Planet, which I might call bizarro Malthus, takes doom and gloom in the opposite direction: not enough people!?!
Finally, for all my readers that grew up in the Tri-State Area and are plus or minus 5 years of my age (low 50s), none of you will have forgotten Crazy Eddie and his insane commercials. Retail Gangster is for you. And seriously, everyone should watch the ad compilation below…great memories!
Favorite books I have read over the past year or so
Energy & Climate
Numbers Don’t Lie: 71 Stories to Help Us Understand the Modern World by Vaclav Smil
Electrify: An Optimist's Playbook for Our Clean Energy Future by Saul Griffith
Shorting The Grid: The Hidden Fragility of our Electric Grid by Meredith Angwin
California Burning: The Fall of Pacific Gas & Electric—And What It Mean’s for America’s Power Grid by Katherine Blum
Fixing The Climate: Strategies for an Uncertain World by Charles Sabel and David Victor
Population
An Essay on the Principle of Population by Thomas Malthus
Empty Planet: The Shock of Global Population Decline by Darrell Bricker and John Ibbotson
Financial/Business Crime
Ponzi's Scheme: The True Story of a Financial Legend by Michael Zuckoff
Retail Gangster: The Insane, Real-Life Story of Crazy Eddie by Gary Weiss
Geopolitics
The Accidental Superpower: The Next Generation of American Preeminence and the Coming Global Disorder by Peter Zeihan
The Absent Superpower: The Shale Revolution and a World Without America by Peter Zeihan
Disunited Nations: The Scramble for Power in an Ungoverned World by Peter Zeihan
Frozen Order: A True Story of Money Laundering, Murder, and Surviving Vladimir Putin’s Wrath by Bill Browder
Pandemia: How Coronavirus Hysteria Took Over Our Government, Rights, and Lives by Alex Berenson
Business & Investing
No Rules Rules: Netflix and the Culture of Reinvention by Reed Hastings and Erin Meyer
The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by Will Thorndike
Narrative and Numbers: The Value of Stories in Business by Aswath Damodaran
⚖️ Disclaimer
I certify that these are my personal, strongly held views at the time of this post. My views are my own and not attributable to any affiliation, past or present. This is not an investment newsletter and there is no financial advice explicitly or implicitly provided here. My views can and will change in the future as warranted by updated analyses and developments. Some of my comments are made in jest for entertainment purposes; I sincerely mean no offense to anyone that takes issue.
Regards,
Arjun
Thanks for your sharing your work. Have you in the past written about 'why' ROCEs were lower in the period ending in '19?
Incredible article, again. Agree 100% on increasing ICE efficiency, this should be a no brainer. Being from Canada also a huge fan of #FreeCanadaFromMis-GuidedClimateNDCAccountingIsanity. LOL