It is an old wisdom that during a recession cyclical equities in general and energy stocks in special are suffering pretty much. When the economy slows down, the supply and demand imbalance pushes energy prices down, too. Stocks of these “commodity businesses” come under pressure in unison. But is it the same now? Or could we even be in for a surprise to the upside?
In all the last business cycles it was clear that energy companies would decline after the peak in economic activity. When an economy slides into contraction mode, obviously there is no growth and hence no need for more commodities like energy, but less.
This is usually accompanied by the pro-cyclical behavior of many commodity businesses. During bad days, there is barely any money to be made. Some companies even go bust. When the boom comes again, producer spending goes up accordingly.
What sounds logical at first glance has led in the past to the well-known boom-and-bust cycles. Energy companies were regular victims of the arising overcapacities at the top they created before due to overspending on overoptimism, putting prices of the resources under pressure when demand fell off a cliff.
There are several forms of energy companies. Energy is not energy. Among the most hated and most discussed are oil companies, especially due to massively higher prices at the gas pump this year for many. This is the subsegment we are focussing on today, because it is not only hated that much, but also because it is currently and further is expected to be the biggest source of energy for decades to come.
The obvious question at the moment is whether we will see once again falling stock prices of oil companies? Are prices sustainable at these levels as inflation is so high that consumers only focus on basic necessities and industrial demand is in jeopardy? Will the current recession break the prices of oil stocks again?
It is not a hard guess that the economies in many parts of the world are on a descending branch.
We want to evaluate today, whether we should not brace ourselves for even higher oil prices and thus benefit from higher stock quotations of oil producers as well. Or we could at least let them pay parts of our higher energy bills by collecting juicy dividends.
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Energy: Demand and supply status quo
For many people, energy is a natural thing. It is just there. Whether in the form of electricity to plug in different sorts of gadgets, as natural gas to heat the home or in liquid forms to fill the tank of a car with a combustion engine.
Life is heavily dependent on energy. Our whole modern lifestyle is build on the soil of energy.
Without energy, life like it happens today would not be possible.
I don’t think I’m going too far out on a limb here.
While working on this article, I found a quote from the former Chief Economic Advisor of the UK Coal Authority from 1950–1970, E. F. Schumacher, who was a German-born, but British economist. He predicted the rise of the oil cartel OPEC and said:
“There is no substitute for energy. The whole edifice of modern life is built upon it. Although energy can be bought and sold like any other commodity, it is not ‘just another commodity,’ but the precondition of all commodities, a basic factor equally with air, water and earth.”Economist Ernst Friedrich Schumacher in 1964
Although coal and oil were by far the two big dominant sources for energy production back then (see the chart below) and
unreliables renewables were unknown, I pretty much think that he nailed it. Energy is so common and out of the question that most people never think about it. At least they did not until recent events and rising prices.
I would even go as far out as saying that most people do no even know that energy is the basic material or “precondition”, as Schumacher said, that is the foundation for nearly everything we have today.
By the way, this is the rest of the chart from above – from 1960 until today:
Coal and oil are still used for 55% of energy consumption (95k TWh of a total of nearly 180k TWh). Taking natural gas into this group, we get around 77%. This should not be underestimated.
All this while the total amount of energy doubled since 1980, i.e. since the end of the first of the two charts (compare the left axes).
It is way more than just electricity, heating and transportation. In my article titled “How to beat the bear market – inflation, stagflation, recession” (see here), I included a graphic from Visual Capitalist that showed what a barrel of oil is used for.
Oil is everywhere. You need it for asphalted roads the same way as you need it for everyday products like light bulbs, tires, all sorts of plastics you find everywhere (unfortunately in a growing amount in fast-fashion clothing – so much for caring for the environment) or packaging material like foils.
Here is a nice picture with everyday-stuff that needs oil to be made:
In this short overview, I just wanted to show you where oil is used in our everyday lives and why it is so closely tied to our modern lifestyles. Maybe one day, a clever guy will find out how to substitute it. Until now, I would say, living without it is wishful thinking of theorists.
The alternative would be to sit in wooden tiny houses in forests collecting berries and edible fungus…
Try it out without oil! You will hit the limits very likely, soon.
I think you see the point. It is way more than just electricity, heating and transportation, though these would already be enough reasons.
And you need oil practically for most other resources to be dug out of the ground for on-site work, but also transport and further processing.
Now that we have looked at the past and the current status quo, it would be interesting to have an idea about the future. Sure, predictions are difficult, especially regarding what is to come, but it is not me doing them.
The oil heavyweights BP plc (ISIN: GB0007980591, Ticker: BP) and Exxon Mobil (ISIN: US30231G1022, Ticker: XOM) regularly publish their most current outlooks.
Sure, these are their maybe not totally unbiased reports, but they are respected and even often cited by third-parties, nonetheless.
Both assume different scenarios until 2050 and show how different parameters could likely develop. Among them are the used sources, the expected consumption by type of user and also by geography.
What they show in every scenario is that total energy needs will at a not too distant point in time reverse due to higher efficiency. I am somewhat skeptical of that…
Also, the outlooks tell that especially coal demand will be replaced primarily by wind and solar. The not easily determinable variable is how quick. But it seems to be a foregone conclusion.
It is out of the question that politics want to steer the wheel in that direction.
Here you see the projections of Exxon until 2050:
There are also other guesstimates, but it is important to look at the total numbers and at the relative ones. On the left hand side of the graphic we see that Exxon assumes demand for oil still to grow, though slowing down in pace. The biggest change seems to be between coal vs. wind and solar. Also percentage-wise on the right hand side, oil seems to keep its first place, at least on par with natural gas.
As you know from my prior articles, I am not a fan of predicting demand. Demand is moving way faster than supply. It is possible that the outlooks show completely different demand lines and bars in the next editions.
Demand predictions can be manipulated more easily, i.e. assumed in one’s favor.
There is little hard substance to predict demand for the next ten years. We don’t even need to try to guess what will be in 30 years.
But what won’t likely change so fast or at all, is the supply-side. We have a solid base of facts and figures to get the probable direction of supply right, despite all the bashing.
The good news is that many oil companies are also nat gas producers which is supposed to be an area of growth and a source for the “transition”.
Next, let’s dive somewhat deeper into the sector and the supply situation, because that is were we can draw our conclusions from.
The powers are shifting again to OPEC (+)
OPEC or in full the Organisation of the Petroleum Exporting Countries, headquartered in Vienna, Austria (thought neither Austria, nor any other European country has ever been a member), is an entity of oil producing countries that formed in 1960 during a meeting in Bagdad, Iraq.
The first headquarter was in Geneva, Switzerland from 1960–1965. OPEC’s main objective in the post-WWII-world was to reclaim sovereignty over its oil reserves and also its production, which was in the hands of the big Western oil corporations. The rapidly decolonizing world saw many expropriations and nationalizations “in the interest of the national development” of those countries.
Here is the definition of the goals of OPEC itself from their website:
OPEC’s objective is to co-ordinate and unify petroleum policies among Member Countries, in order to secure fair and stable prices for petroleum producers; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on capital to those investing in the industry.OPEC website, see here
Among the five founding member states were Saudi-Arabia, Kuwait, Iran, Iraq and Venezuela. Later on, more countries joined, some left temporarily like Indonesia (until now for a second time), others like Qatar in 2019 left for good. Today, the organization consists of 13 members. The latest to join was Congo a few years ago in 2018.
During the 1960s, OPEC adopted a ‘Declaratory Statement of Petroleum Policy in Member Countries’ in 1968, with the emphasis on the “right of all countries to exercise permanent sovereignty over heir natural resources in the interest of their national development” (see here).
I think it is crucial to understand this. OPEC was created to defend the interests of its member states.
Interestingly, many of the world’s biggest oil producers do not belong to OPEC, and never have, like the USA, Canada, Brazil, Mexiko, China, Norway and Russia.
|production in 2021
(million barrels per day)
|United Arab Emirates
Note that “only” five of the 13 members are found in the top 10. In total, OPEC’s production in 2021 was around 35% of world oil production which was a more than 30 year low. It has throughout history hovered more around the 40% mark.
OPEC controls around 80% of total world oil reserves and has regularly been responsible for around 40% of total world oil production. Here is a chart showing the development over the last decades:
Undoubtedly the major driving force inside of OPEC is the kingdom of Saudi-Arabia. Venezuela has the comparatively higher (and highest in total) reserves, but lower quality heavy oil and production is only a fraction of what Saudi-Arabia brings up to the surface.
After some conflicts and wars between members (Iraq and Iran 1980–1988 or Iraq and Kuwait 1990–1991), new emerging places of production like Norway or the UK as well as the fracking boom of the last decade in the USA, and thus losing some of its power, OPEC is likely about to make a comeback.
Here is why I think so.
It was also Saudi-Arabia that had a deal with the USA. Upon request, the Saudis would adjust production to move the price of oil in the “right” direction. In return, the Saudis were protected by the biggest military and received arms and weapons.
This is my observation of the last months. The current US administration seems to have angered the Saudis and thus broken their decades-long relationship. Thus, this mighty “swing-producer” could make decisions that are against what Western countries would like to see, as higher energy costs were the main driving force behind the currently high inflation rates, not seen since the early 1980’s.
Unsurprisingly, OPEC announced a big cut to production in the last weeks:
This was 20x the amount that was expected and around 2% of total world supply!
The US administration tries to resist and counteract by releasing oil from its strategic oil reserve (see here).
But, as usual when politicians try to “fix a problem”, they only have short-term answers and always prefer to take on the symptoms, never the real causes.
Thus, expect the release of the reserve to be only of cosmetic nature. Rather sooner than later, they will need to buy back what has been released before, which will cause additional demand. Or do you seriously think the whole reserve will be thrown out? Even if so, what then?
Funny for me, the administration announced to refill the reserve as soon as oil falls into the low 70’s USD – what if the price doesn’t fall under 80 USD?
Shortly before having this Weekly finished, I read the following:
We, as Saudi Arabia, decided to be the maturer guys. It is my profound duty to make it clear to the world that losing emergency stock may become painful in the months to come. Running out of capacity has a much dearer cost than what people can imagine.Prince Abdulaziz bin Salman, the Kingdom’s oil minister
A very clear warning and shot in the air in the direction of the US.
What I also find interesting is that in their energy outlook, BP in all their scenarios is expecting again a higher share of OPEC-countries in oil production:
To be honest, I don’t understand the dip into 2030.
With the politics we have in the West, it would be not surprising to see OPEC gaining not only more share than expected, but also quicker than expected.
Exxon only confirms to me that the powers will shift away from the West with this graphic (focus on the dark green columns):
What should not be forgotten is that OPEC more or less has extended into OPEC+.
This includes many other big oil producers like Russia, Mexico, Kazakhstan, Malaysia, Azerbaijan and Oman, among others (see here). In total, the non-OPEC part brings in another 11 nations, hence making OPEC + a group of 24 members. They came together in 2016:
[…] to institutionalize a framework for cooperation between OPEC and non-OPEC producing countries on a regular and sustainable basis.OPEC, 171st meeting (see here)
Together, they control 90% of worldwide oil reserves. Here is what OPEC+ produced since 2020, for a first impression:
Though the individual columns do not seem to be correct, as Saudi-Arabia definitely is producing more than 4–5 million barrels of oil per day, the total numbers seem to be correct.
The combined share is close to 50% of world oil production. With their just announced cut, it is fair to say that OPEC+ made a bold statement. They don’t want to see lower prices again. The organization is returning to its roots.
This new “OPEC+ put” (a put option is an insurance against falling prices) with a higher share in production will put a floor on the price of oil, as long as supply is not massively increased elsewhere, which I don’t know where it should come from, as the leading politicians of the USA and Canada want to lower production rather than increasing it.
It may be a bold statement from me at the moment, but I think that with the developments we see, energy is going to become a defensive sector rather than the known highly cyclical one.
Energy and especially oil are everywhere and needed to sustain our modern lifestyles which are build upon it.
Additionally, OPEC+ is far more active and becoming the deciding factor again.
Next, let’s look at oil stocks and some fundamentals of the underlying businesses – my main job. But nonetheless, it is important to get the “big picture” right, hence the longer intro with OPEC and the seemingly shifting mood.
Is oil becoming the new tobacco?
Once been closer to the defensive healthcare sector and having a positive standing during the last century, tobacco with time became the bad guy. With the exception maybe of the “defense” industry, no other group of stocks became more hated than tobacco.
What happened was that the tobacco sector consolidated into a few major players that had nearly no competition and high pricing power. The business was unattractive for new entrants due to the scale and brands of the industry leaders. Because of having standardized products with no inventions needed, investment requirements were low, too.
This made tobacco companies cash generating machines. On top of that, due to being everyday products for many people, the stocks were among the most favored ones during stock market corrections. Reliable cash flows lead to reliable dividends.
What might sound strange at first glance and is far from being a perfect direct comparison, could indeed be the path for oil stocks down the road, though I think that it was already expectable over the last years, as the big players started to keep their investing budgets rather tight.
Here, again, a quote from OPEC to stress what is needed in the energy sector:
[…] It emphasized the importance of continued investments for an industry that needs regular and predictable investments to provide the necessary supply in the medium- and longer-terms.171st OPEC meeting in 2016 (see here)
The key words are “continued investments”.
Of course, it might seem a bit exaggerated to assume that oil stocks will become the next tobacco. But at least over the near- and medium-term this thought experiment is not so crazy, as it might seem.
Let me explain.
Due to rather high costs and investments, it is unlikely that new entrants from nowhere suddenly appear on the surface. The industry is already consolidated, but there is room for more takeovers to come.
In the past, oil stocks have been lousy businesses. During boom times they made big revenues, but margins and capital returns were weak. This was due to their pro-cyclical behavior. When money came in, most companies immediately used it for investments into more capacity and new projects. This obviously led to overcapacities that were corrected during the following painful crashes.
But after the last boom cycle, something not seen before happened. The businesses started to invest less, not more, even up until now.
Profitability of oil stocks reached all-time highs recently.
Also due to pressure from shareholders, the companies shifted their focusses on profitably and cash flows, not growth, no matter what.
Here is an overview of the free cash flow numbers (what is left in cash inflows after investments) of the big Western oil producers during the last two peaks 2008 and 2013 (the respective fiscal years of the companies) in comparison to now:
|2008 free cash flow margin
|2013 free cash flow margin
|current free cash flow margin
You can see that the companies have way more free cash flow left, although:
- oil prices are not at record levels; indeed currently they are even at their lowest point of the three periods
- revenues and operating cash flows are not at record levels
- however, efficiency is
This is because the companies started to focus on the most profitable projects and ditched others that did not fit into the frame. Also, capital expenditures (CAPEX) are kept rather tight and so far are not rising. I already showed this graphic in my article “How to beat the bear market – inflation, stagflation, recession” (see here):
Unfortunately, the data only goes until 2020. This was when the oil price crashed even under zero for a day, but bounced back sharply to multi-year highs. However, as you can see, this is a trend that has been a long time in the making.
Energy companies are investing less into their businesses and paying out more to their shareholders.
They are not doing this because they are evil. The overall political circumstances led to that development.
But after the oil crash, with rising prices and better business results, the companies did not increase their spending. Instead, they focussed on debt repayments and higher shareholder returns.
First, over the last ten years, CAPEX went down massively (shorter column = less spent, negative axis):
Second, the companies paid down lots of debt:
Third, overall cash flow from financing activities (including debt repayments and shareholder returns):
This chart only goes until the end of 2021. 2022 was so far a continuation of the trends above.
Now that we have seen that oil companies are producing record amounts of free cash flow and shareholder returns, as well as repaired their balance sheets, the next question is about valuations.
|Enterprise Value to Free Cash Flow
(last twelve months)
We see on a debt-adjusted basis that the US peers have higher multiples and lower dividend yields. These are the biggest of the group and US companies regularly get higher valuation multiples.
I would not see all those stocks as overall cheap and screaming buys like they have been prior to 2022. It is rather unlikely for them to get multiples way in excess of 15x+, because this “dirty sector” under the current circumstances will likely have a valuation discount.
But from the perspective of being now defensive businesses, so far they did a good job!
This could with a not so low chance make oil stocks the new hated tobacco – stable and boring, but needed in our everyday lives!
A few bonus points to support oil stocks
As an interesting quasi-bonus, there have been recent developments that at the minimum could also provide another “put” under the share prices of oil companies and at best even lift them further up.
1. Backed by the two prominent investors Peter Thiel and Bill Ackman, the company Strive Asset Management launched an anti-ESG fund. Their goal: To invest primarily in oil stocks! Among the biggest holdings are Exxon Mobil and Chevron (see here).
Their reasoning is that due to political pressure money has been allocated not where it is best used, but where politics just want it to be. It is no secret that politics is not a good capital allocator…
I can imagine more of such “rational” vehicles to come.
2. Where I really had to laugh at was a chart from the International Energy Agency (IEA). Not known for being pro-oil or fossil fuels in general, they showed the following chart in their latest report on p. 87:
In all seriousness, are they trying to brainwash people with this chart that stocks of
unreliables renewables are good investments, because they “have risen”.
This could be the topic for an own whole article.
The mania and ESG-investing crowd has driven prices up dramatically for stocks that fit in this basket – until something happened that had to happen necessarily when a mania ends.
Those stocks rose over the last decade while with oil stocks coupled with a buy and hold strategy, you obviously would not have earned much, except dividends. This is true so far. But it is also true that not only did the valuations reach unsustainably and absurdly high levels at their peak. Also many companies in this sector are very lousy businesses from a fundamental perspective.
Just take the example of wind energy and its producers. The market leader is Vestas Wind Systems (ISIN: DK0061539921, Ticker: VWS) with a market share of around 20%. Over the last three years, its free cash flow margins have not been higher than 3%. Currently, they are even negative due to cost pressures. And this already includes a high-margin service business.
At its peak in 2021, Vestas had an EV / FCF multiple of over 100x. The stock price halved until now. The valuation is still very extreme. Cash flows are expected to stay negative until further notice. No one with common sense and free of ideology would invest in such a company…
Another example and ESG-darling is Tomra Systems (ISIN: NO0012470089, Ticker: TOM). The company from Norway is the market leader with a 70% market share (!) for bottle returning systems or “reverse vending” as they call it. You can click through their presentation of the last capital markets day here.
It also seemed infallible until recently. The stock is down nearly 50% from the beginning of the year. At its top (highest share price), Tomra had an EV / FCF multiple of over 60x. Currently the multiple is even double of that, also due to cost pressure and a suffering business. Cash flows have fallen faster than the share price.
I am excited to see the chart of the IEA from above next year!
3. One of the most crucial topics currently seems to be the one of energy independence. This alone could make oil and gas stocks – at least for a certain amount of time – “ESG-friendly”.
You think this is spinnery? Then take this one:
This point could be very well supported by the fact that “old-school”-oil companies are also adapting and investing in projects like wind parks, solar farms or charging stations for electric cars. At some point, this could make them “renewables-companies” or something like “next-generation energy”-companies.
Nothing is impossible. At least, better have it in the back of your mind.
Be ahead of the curve. This is where the big gains are made. Not by chasing a train that already left the station.
4. My fourth and last bonus point is the ongoing sector-rotation, I described in length in my article: “How to beat the bear market – inflation, stagflation, recession” (see here).
I think taking all points from today into account plus the first disappointing results from Big Tech companies Alphabet (ISIN: US02079K3059; Ticker: GOOGL), Microsoft (ISIN: US5949181045; Ticker: MSFT) and Meta Platforms (ISIN: US30303M1027; Ticker: META), there is a good chance that the rotation keeps on going.
At first, I didn’t want this article to become this long. But while writing, I collected more and more information that confirmed my already strong belief that energy stocks are one of the sectors for the next months, maybe even years to be invested. The former infallible tech stocks are crumbling before our eyes, yet many are still buying the dips. Good luck on that one!
Energy is the basis for nearly everything we have. Companies learnt from the past and are restrictive with their expenditures. Supply is unlikely to rise in the near- to medium-term. Also, demand should keep up rather on a stable basis, though I don’t like to predict demand due to its fast-moving nature and being more prone to manipulation.
Plus, it seams that OPEC+ is striking back again and thus putting a floor under the price of oil.
You need to look at fundamentals. From this perspective, the lights for energy in general and oil stocks in special are on green (excuse this pun).
However, I am not that much attracted by the oil Supermajors.
The company I described in detail in my research report from 24 September 2022, currently has a nice performance of +21% since my publication (at the closing of 26 October 2022).
It hasn’t paid out a dividend since, but in the next days they will announce their Q3 results and probably also the next payout. At the publication of my report, the company had a dividend yield of around 8%. I expect the current one to be somewhere between 6–7% on an annualized basis – at current oil prices.
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