OH, THE PLACES OIL WILL GO

OH, THE PLACES OIL WILL GO

What Dr. Seuss and the Energy Markets have in Common

A few weeks ago, Dr. Seuss Enterprises announced it would stop publishing six books due them containing racist imagery. This came as a surprise to some, and less so to others. However, what happened next should not have surprised anyone --- demand for Dr. Seuss books skyrocketed. In the days that followed, Dr. Seuss books represented nine of the ten best selling books on Amazon and each of the banned books were sold out in a matter of hours. On Ebay, copies selling for $5 just days earlier were now selling for thousands of dollars. It was yet another example of how reducing, or even threatening to reduce, supply increases demand. Whether it is Dr. Seuss books during a contentious social environment, toilet paper in a pandemic, guns after politicians threaten to ban them, or bank deposits during a financial crisis, if people lose confidence that something will be available in the future, they will buy it now. This is part economics and part human nature.

Dr. Seuss has received a lot of attention recently, but there is a much larger supply/demand story occurring today in the global energy markets. Many think the traditional oil & gas industry is on the verge of extinction and that investors should avoid it at all costs given the rise in alternative energy sources, climate change, and government legislation. Yet, two examples from the past few decades argue otherwise. 

Tobacco: The once indispensable asset

Up until the middle of 20th century, tobacco had been one of the country’s most important commodities. It was also a major part of American culture and our way of life. Look no further than this report from Perspectives on Public Health (link), 

“For more than a century, tobacco companies were thought to be providing a great public service. The military considered it indispensable as a daily ration in World War I and FDR made tobacco a protected crop in World War II to support the effort. The U.S. government had become dependent on the lucrative income from tobacco.” 

Yet, this all changed over the decades that followed WWII as tobacco companies were subjected to massive government fines and regulations, mired in endless lawsuits, prohibited from advertising their products, and eventually deemed as “un-investable” by many. Knowing this, it would be logical to conclude that investors who maintained positions in these companies must have experienced very disappointing returns. Yet, in spite of all these negative headlines, some of the largest tobacco stocks generated returns well in excess of the S&P 500 (e.g., Altria has compounded at 23.5% since the early 1970's vs 10.8% for the S&P 500). How did this happen? Pricing power in the U.S. due to a loyal (addicted) consumer base and consolidation across the industry, coupled with consumption growth in China more than made up for the declining revenues elsewhere. Today, the situation in the energy market is starting to feel strikingly similar.

Fossil fuel consumption may have already peaked in the U.S., but the vast majority of the U.S. auto fleet still consists of internal combustion engines. Meanwhile, due to the sustained low level in commodity prices in recent years and pressure from legislators, oil & gas capital expenditures and production levels have fallen materially.

Source: JP Morgan Guide to the Markets

This combination means that Americans will continue to rely on petroleum for years to come and may have to pay a premium for it due to lower domestic supply. At the same time, China's dependence on fossil fuels is only likely to increase. Today, China's population is roughly four times the size of the U.S., but consumes 60% the amount of oil. While the Chinese have made significant strides towards decarbonizing their economy, electrifying their auto fleet, and reducing their fossil fuel consumption, the fact is that with 1.4 billion people (of which many are rising into the middle class) fossil fuels will have to be a major contributor to a diversified energy base. There is simply no other way to support a nation expected to increase its energy consumption by 25% by 2040 (which means its total consumption will be close to double that of the United States). 

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Sequestration: When worse top lines lead to better bottom lines 

Back in 2013, the U.S. government imposed a sequestration bill that called for an across-the-board reduction in specific parts of the federal budget. The defense industry was squarely in the crosshairs. After it was reported that sequestration would cause overall defense spending to fall by 8-10% (from $702 billion to $646 billion) and that defense contractor spending would fall by 15-16% ($373 billion to $314 billion), Wall Street analysts almost uniformly downgraded the entire sector. The Aerospace Industries Association decried it would become “the second wave that overwhelms our floundering economic boat.” 

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While these dire forecasts were correct in that revenues would fall, the industry did not get decimated. The "second wave" did not "overwhelm the boat". Why? Simple. In anticipation of these draconian cuts, defense contractors made a concerted effort to streamline their operations. They sold divisions, reduced production capacity, and thinned back office operations. After operating with considerable “bloat” for years due to endless years of increased government spending, sequestration forced these businesses to become leaner and more efficient. The result has been that since 2013, the defense contracting ETF (XAR) has annualized at +19.6% vs. the S&P 500 at +15%. 

A similar story has been playing out in the energy sector over the past few years. With oil and gas prices well below levels seen over the prior decade (2000-2010), energy companies have been forced to slash capital expenditures, reduce headcount, streamline operations, and prioritize shareholder returns over generating higher revenues. In 2020, the nine oil majors cut their 2020 budgets by close to $40 billion, which left capital expenditures at a 13 year low. At the same time, the number of petroleum engineers in the U.S. have been falling steadily since 2014 and BCG reports that oil companies across the globe are reinventing the way their operate and allocate capital to favor shareholder value over revenue growth. Said another way, they have been squarely focused on eliminating the bloat, yet most Wall Street analysts are still painting a very bleak future for their stocks. This set up sounds very familiar.

Why this matters

There is little doubt that traditional energy companies still have a number of headwinds. The electrification of our transportation system is real, the effects of climate change are being taken more seriously, and investors are increasingly opposed to investing in this sector. There is also little doubt that these companies are doing everything in their power to adjust to the current reality. If so, the stories of what happened to the tobacco and defense industries show us that these are often the precise moments that provide ideal set ups for surprisingly strong future equity returns.

It is not a popular stance these days given the environmental consequences associated with fossil fuels and more certainly needs to be done to combat climate change, diversify our energy sources, and promote a more sustainable future. However, from a potential return perspective alone, if history is any guide, sectors that go from unloved to disdained to nearly completely disregarded tend to generate stronger returns than many expect. Energy may just be the next example. An added kicker? Energy tends to be one of the few parts of the market that performs well when the dollar weakens and inflation rises, two trends that appear to be strengthening.

Ted this is really good. I’ve been talking for over a year now about the opportunities in declining industries. We haven’t made a move in that direction yet but actively thinking about that as an idea source.

Taylor (Henry) Meyer, CFA

Vice President, Goldman Sachs | Advisor to Institutions, Family Office, Ultra-High Net Worth | Board Trustee

3y

Thoughtful analysis and great analogies to underscore the power of s/d imbalances. Always enjoy your reads, Teddy. Hope you and the family are well!

Thomas A. "MOOSE" Ollquist

Fixed Income Distribution at MFR Securities, Inc.

3y

Well said !

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