Metaverse Meets Universe: The Coming Return of Terminal Value to Traditional Energy
Attracting Capital Flow Back to Traditional Energy, Post #2
This is the second post in my series that focuses on attracting capital flows back to traditional energy, which is critically needed if the world is to evolve to a healthier energy evolution era from the current messy energy transition quagmire. The topic of "terminal value" gets at the idea that investors will only support new CAPEX in traditional energy if they believe the sector has (1) earned the right to spend via sustained improvement in ROCE (return on capital employed, i.e., profitability) and (2) that the long-term outlook for oil and natural gas demand warrants investment in new supply. Right now, investors appear to be heavily discounting the idea that either profits or demand will prove sustainable over the long-run; i.e., there appears to be little if any "terminal value" being attributed to traditional energy equities at this time. I believe this will change in coming months, quarters, and years.
I recently had the pleasure of joining Michael Gayed's Lead-Lag Live on Twitter Spaces (here). Midway through I was making an impassioned plea for recognition that energy is used everywhere and in everything. As a good host, Mr. Gayed sought to bring some levity to our discussion by noting that the metaverse is perhaps the only area that does not need energy. While I recognized the light-hearted nature of his comment, I couldn't let the joking comment slide. The metaverse will of course be using fossil fuels! The metaverse is nothing more than computing power at its core and there is zero chance the metaverse will be much less than 80% fueled by fossil fuel resources for many decades to come. Whether you like that fact or not is simply not relevant. Facts don't care about your feelings as they say.
Energy is everything and everywhere. It is life. It is luxury. It is necessities. It is protection. It is food. It is buildings. It is cars. It is computers and iPhones and iPads and AI and bots and algorithms and yes, it is the metaverse. It is books, clothes, trucks, ships, cranes, legos, syringes, puzzles, crayons, lights, cans, beer, bourbon, wine, and both Scotch and Irish whiskey. This list doesn't even scratch the surface. Energy is needed for everything.
Yet we take it for granted and only notice when it’s either too expensive or, worse, not there at all. If iPhones are sold out, most people will either wait the weeks or months for the order to get filled or buy an alternative smart phone. Same thing with cars. And cereal. And beer and basically every product or service. This is not true for energy. It is famously inelastic and requires exceptionally high prices simply to motivate a change in behavior, which isn't always possible. If there is a gasoline shortage, a person might be able to walk from their home to a local store. But it's not reasonable to think someone would walk 35 miles to work every day. Energy is the one thing that you cannot live without, not even for 5 minutes.
At this moment, the world is essentially structurally short deliverable crude oil, refined products, and natural gas/LNG relative to what is being demanded. Deliverable is the key word: we are no where near the point of resource exhaustion. I have never been a believer that "peak supply" has ever been near...certainly not within my career or overall lifetime. Every 20 or 30 years or so, however, demand outstrips deliverable supply and we have a new cycle. This is where we are today.
But this post is not about counting barrels or Mcfs but is instead focused on what I expect will be a growing recognition that the assumed terminal value in traditional energy equities should not be zero. It's about recognizing that an actual "energy transition" is not anywhere on the horizon even as I fully support the idea of continuing to find ways to reduce negative environmental and climate impacts from existing energy sources while motivating the development of new technologies. We need a major CAPEX cycle in traditional energy and that won't happen when investors believe the business is going away soon. Currently, energy equities are being valued as if we are at "peak" earnings with significant doubt being placed on earnings and cash flow streams beyond the next several years. In my view, an assumed "zero" long-term value is too low, certainly for the top two quartiles of companies that can earn returns on capital above or equal to cost of capital.
What do you need to believe that terminal value for the top two ROCE quartiles should not be zero?
(1) Oil and natural gas demand will be higher in 2030 versus 2019, with a reasonable downside case of flat demand driven by a lack of supply growth.
(2) Recognition that "energy transition" is at best an aspirational phraseology to motivate investment in new technologies and substitution away from traditional energy in coming decades. It is at worst a code phrase for anti-capitalist, “climate only” ideology, though I'd argue that grouping is relegated to left-wing extremists and is not the intended mainstream usage by folks working in good faith to mitigate unabated carbon emissions.
Clearly point #2 is closely related to point #1.
(3) ROCE will be equal to or exceed cost of capital.
I have written extensively about my views on the ROCE cycle in prior posts and would refer readers to my ROCE Deep Dive series which you can find listed on the right side of my website (here). I haven't written as much in Super-Spiked about my long-term crude oil and natural gas demand views, though have detailed as recently as last week's post my expectation for 2030 oil demand to rise to 107 million (mn) b/d from 100 mn b/d in 2019, with a reasonable downside case of 100 mn b/d in the event supply growth disappoints. The nature of why demand could disappoint is meaningful. If oil demand were to instead disappoint due to unexpected efficiency gains or other substitution effects then it would make more sense for investors to not give credit for terminal value.
Who else besides investors should care about terminal value for traditional energy?
It is increasingly obvious that a major new CAPEX cycle is needed for all facets of traditional energy supply: crude oil, refined products, natural gas/LNG, pipelines, other infrastructure, oilfield services, methane monitoring equipment and technologies, and related businesses. The following groups should be in favor a major CAPEX cycle:
Politicians, policy makers, and academics interested in reducing inevitable human suffering from a prolonged and self-inflicted energy crisis era.
Any business person anywhere in the world that sells any product or service that people or businesses use.
Environmentalists and climate activists interested in ensuring we don’t go backwards on environmental and climate progress due to insufficient traditional energy.
My apologies for any groups I may have forgotten or didn't explicitly list. Everyone on Earth that is alive today or will be born in coming years should care that we have a traditional energy CAPEX cycle.
What will drive a new CAPEX cycle in traditional energy?
Investors gain confidence in sustained profitability improvements.
Investors gain confidence that oil and natural gas demand will not be rolling over anytime soon.
Emergence of government policies that support, or at least don’t explicitly hinder, oil and gas development in key regions.
What are some of the more interesting areas for CAPEX?
Canadian oil sands
Canadian natural gas/liquefied natural gas (LNG)
US LNG
Alaska oil
Permian Basin oil
Latin America oil in the event of favorable changes in government and/or fiscal terms: Venezuela, Brazil, Mexico, Argentina
Deepwater exploration
This is not a complete list and I welcome feedback on areas I have undoubtedly missed or why the areas I picked are in fact not interesting.
🌅 Potential for terminal value recovery…in pictures
This section will use ExxonMobil ($XOM) as a proxy for the energy sector. This should not be interpreted as a “buy” recommendation of $XOM shares. The point of this series to recognize that if we are to move to a healthier energy evolution era, a reduction in the cost of capital of traditional energy equities is almost certainly a prerequisite to a new capital spending cycle that is clearly desperately needed. In this post, I am using an inexpensive relative and absolute P/E multiple and a high free cash yield for $XOM as a proxy for a high cost of capital for the traditional energy sector.
1. $XOM: Massive earnings, modest market cap
3Q2022 marked the first quarter in about 10 years where $XOM’s net income exceeded Microsoft’s ($MSFT) and all other FAANG companies, trailing only Apple ($AAPL) among the group that have been the stock market darlings over the past several years (Exhibits 1 and 2). Yet, the disparity in $XOM’s market capitalization versus FAANG names remains substantial, even as it has passed Netflix ($NFLX) and Meta Platforms ($META, formerly Facebook), two companies with a fraction of $XOM’s profitability.
2. $XOM heavily discounted on relative P/E versus $SPX…
Exhibit 3 looks at $XOM’s relative P/E versus the S&P 500 ($SPX) since 1990. $XOM’s relative P/E averaged 87% over 1990-2014 and 76% during the 2002-2014 Super-Spike period that I believe is most comparable to the current era. Currently, $XOM trades at 48% of the $SPX, suggesting the market believes XOM is at some mixture of peak earnings or has only limited visibility on the duration of improved results.
3. …and versus $MSFT
Exhibit 4 is similar to Exhibit 3 but compares $XOM to $MSFT. $XOM’s relative P/E versus $MSFT averaged 77% over 1990-2014 and 70% from 2002-2014. Currently, it is at a 36% relative P/E.
4. Absolute P/E for $XOM well below $MSFT, $AAPL, and $SPX
Exhibit 5 show the evolution of the absolute P/E multiple for $XOM, $SPX, $MSFT, and $AAPL since 2000. $XOM today trades at a trailing 12 months P/E of just 6.9X versus 17.3X for the $SPX and over 22X for $AAPL and $MSFT.
5. $XOM free cash yield also inexpensive versus FAANG leaders
Exhibit 6 looks at free cash yield, where, unsurprisingly, $XOM also trades inexpensively to FAANG peers (in contrast to P/E, a higher free cash yield corresponds to a less expensive valuation and higher cost of capital). Although it has improved from an extreme 15% cash yield, the market is still assuming a liquidation in $XOM by 2030, which is consistent with an assumed peaking of crude oil and natural gas demand by that time frame. I do not believe crude oil or natural gas demand is on-track for a permanent peak and subsequent decline by 2030.
☠️ Some caveats on terminal value expansion
This post is intended as a broad-based generalization of what I expect for the sector (using $XOM as a proxy). Not every company will be deserving of “terminal value” credit, even as a rising tide for traditional energy will likely lift most boats.
Which companies would be less deserving of terminal value expansion?
Companies with a short inventory/asset life or have execution disappointments.
Companies where return on capital is below cost-of-capital, in particular when WTI oil prices are $60-$70/bbl or higher (note: the appropriate WTI oil price needed for a cost of capital return could change in the future based on changes to industry cost curves).
Companies expanding into new areas where competitive advantage has not been demonstrated. To be clear, expansion could be a good decision; I just wouldn’t expect advance credit to be given and it could well weigh on valuation (i.e., raise cost of capital), as we may be seeing with the European Super Majors.
⚡️On a personal note…
This post was inspired by The Babylon Bee.
God Develops Ultra-Realistic Metaverse Where People Can Talk, Learn, And Work With Other People, Calling It 'Universe'
EARTH - In a bold announcement to all of His children, God unveiled the creation of an ultra-realistic metaverse where people can talk, learn, and work with other people, stating this unique new metaverse will be called "Universe."
"This is more realistic than any virtual reality I've experienced before," said reality enthusiast Miles Kann while walking through one of the Universe's city parks in real-time. "I can literally smell the fresh air, touch the cool grass, and interact with other players in incredible ways."
Another early adopter of God's Universe demonstrated how detailed and immersive the player-to-player interaction was as she showed off her humble home, complete with husband, children, and dog. She thanked God for providing her with a sense of purpose and fulfillment unmatched by any competing product.
Critics were quick to point out possible bugs in the Universe, listing wars, injustices, violence, and disease, and suggested God either label it "Early Access" or reboot altogether. These criticisms, however, were countered by God's supporters who were well-versed in the instruction manual, stating a truly realistic Universe must come with the full experience of joy and pain, choice and accountability, life and death, but that the end game was worth it.
According to witnesses, Meta's Mark Zuckerberg screamed in terror at the frightening, immutable reality of God's Universe.
⚖️ 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.
📘Appendix: Definitions and Clarifications
Exhibit 1-6 are priced as of the November 9, 2022 close. For the P-E and free cash flow yield exhibits, trailing 12 months data is used. All underlying data is from Bloomberg.
Terminal value definition per Investopedia (here):
Terminal value is the value of an asset, business, or project beyond the forecasted period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. Terminal value often comprises a large percentage of the total assessed value.
Hi Arjun,
Thanks for another excellent column. I clearly remembered that many Wall Street analysts put out sell rating on XOM in 2020, One of their main arguments was that XOM spent too much on CapEx, which was also a point raised Engine #1 in the spring of 2021. The idea that investing counter-cyclically seemed to be lost to those analysts. One deep impression your articles have given to me is to look at the ROCE of an energy company. According to this chart published on Seek Alpha, the ROCE of XOM on twelve-trailing-month basis was already 36.7% as of the end of 3Q2022 (https://static.seekingalpha.com/uploads/2022/11/8/48844541-16679307177203414_origin.png). XOM's counter-cyclical investment is one of the important factor for such a high ROCE. But given your experience, how high do you think XOM's ROCE can go?
Thanks Arjun.