This year saw the biggest decline in production of crude in 50 years. This supply collapse combined with a demand recovery triggered by significant fiscal stimulus economic should see higher oil prices in the near term. How should one play this? Buy oil? Buy an integrated oil play? Or, what is typically most exposed, exploration and production names? We believe the latter.
This supply and oil price shock has created a significant degree of rationalisation within the US energy exploration sector. ‘Significant’ is probably an understatement – Deloitte believe we have lost over 100,000 jobs in the US E&P this year. This compares with 3,000 jobs in the 2014 to 2019 period following the Saudi Arabian price war. This amount of destruction is unheard of.
The surviving public companies in the exploration space are the strongest entities and are in a much stronger position to generate cash, pay down debt and return capital to shareholders. This provides a significant downside buffer separate to near term oil price movements, while also providing upside to rising commodity prices – a cornerstone of the Collective Finance – Inflation Series.
Playing E&P in single names has obvious risks. However, there is a smarter way with the SPDR Oil & Exploration ETF ($XOP). Different to most ETFs, the XOP is equally weighted and you are exposed to 41 larger exploration names in the US. This ETF, XOP, traded as high as $170 in 2018 when oil was at $68. XOP currently trades at $60 – with some commodity strategists saying that by the end of 2021 we will have recovered 2018 crude price levels.
If this were to materialise we believe there would be 100% upside in the XOP. We would use any weakness to add on a 2 year view.
Energy Sector Is Deeply Out Of Favour
The production collapse in the oil and everything “old industry” has left the energy sector in the doldrums. This sort of production collapses are normal in recessionary periods per Chart 2, however never of this magnitude. The energy sector is now at its lowest weightings in the S&P 500 in the last 20 years.
Was November 2020 the inflection point for its medium term revival? Major integrated oil companies had their largest monthly moves in history and yet the share prices haven’t hit their 200 day moving averages.
“Revenge Of The Old Economy”
One should not write off the energy sector yet – the collapse in production may not be met with collapsing demand meaning the outlook for energy prices could be a lot stronger than one thinks. In addition, the weak dollar could put upward pressure on commodities and oil. The Federal Reserve does not seem concerned about the dollar weakening as it cranks up the money supply (see previous post).
Stimulus packages and government spending will support the whole commodity sector including energy. Goldman Sachs are expecting demand for crude to reach pre crisis levels by 2022. They believe the energy transition will itself increase demand for commodities, from copper to crude oil, as all this new infrastructure is put in place. Their head of commodity research, Jeff Currie, is terming this the “revenge of the old economy”.
Smart Implementation? SPDR Oil & Gas Exploration & Production ETF ($XOP)
The best leverage to rising commodity prices is the companies that take the material out of the ground like mining and exploration companies. Within energy, the energy & production sector is now a value play rather than a growth play. Investors will want to see management control supply, pay down debt and pay dividends – not big capital expenditure and production programs – as we know in 10 years time the terminal value of such is on the wane.
The XOP is an ETF that holds 41 oil & gas E&P names in an equal weighting. It has an annual expense ratio of 0.35% and assets of $2bn. The average company in the ETF trades at 0.7x price to book and the ETF dividend yield of 2.5%.
Even before we get to rising oil prices, there is a lot of levers for the companies to pull themselves. On our screening the market cap to cash flow of the average E&P name (50 largest by revenue) is 3x and Net Debt to EBITDA is around 2.5x. This means plenty of scope for companies to put cash flow towards debt paydown and/or shareholder returns – a very smart way to create shareholder value versus adding to production projects.
Get ready for more stimulus and activity. This will involve fossil fuel demand as we have not fully transitioned to alternative energy. The current supply shock is a 50 year storm and oil prices are set to rebound further. If the commodity strategists are right, XOP could return to its 2018 highs with company management supporting with some prudent capital allocation and shareholder returns along the way. 100% upside.
The main oil majors making up XOP:
- Occidental Petroleum Corporation
- Devon Energy Corporation
- Diamondback Energy, Inc.
- Marathon Oil Corporation
- WPX Energy, Inc.
- Parsley Energy, Inc.
- Concho Resources Inc.
- Marathon Petroleum Corporation
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