"To be a great champion, you must believe you are the best. If you’re not, pretend you are.”
- Muhammad Ali
Last night Big Alberta (aka Daryl Jones) gave me the late look that I was to write this Early Look, so this morning I get to take extra creative liberties and subject you all to thoughts on my sector, Energy.
It’s a difficult space to make money in when oil prices aren’t going straight up, a la 2009 and 2010.
Oil and gas companies – particularly the producers (E&Ps) – are highly promotional, as they have to be, in order to raise capital for what has become an incredibly capital-intensive industry. In 2012, capital expenditures from S&P500 companies in the Energy sector were 39% of the index’s total; in 2000, they were only 12% (see Chart below). Someone’s got to foot that bill, as the companies can’t do it on their own – the free cash flow yield of that same group was 0.0% in 2012, and if you back out a few cash cows like ExxonMobil and Royal Dutch Shell, you’ll find that most producers are not self-funding.
Nevertheless, in general, market participants hold the energy sector near-and-dear to their hearts. Investors tend to anchor on recent history, and energy was by far the best performing sector over the last decade (XLE +200%). And the sell-side knows what pays the rent – capital raises – so it’s not too surprising that Energy has the highest percentage of “buy” ratings and lowest percentage of “sell” ratings of all S&P500 sectors.
But is the love deserved? Most E&Ps cannot generate a return greater than their cost of capital (aka “create value”), even with real oil prices near multi-decade highs and interest rates at multi-decade lows. We shudder to think what a serious back up in rates would do to the sector…bankruptcy cycle?
But all is not lost (can’t get too cynical on a Friday)! Among all the wealth destruction so colorfully described by activist investors in recent letters to the shareholders of Chesapeake (Icahn), Sandridge (TPG), Murphy Oil (Loeb), and Hess (Elliott), there are legitimate franchises and investment opportunities in the sector. Over our long-term TAIL duration, we believe that select companies highly-levered to US natural gas prices will generate the best risk-adjusted investment returns in the space.
As we hover around nominal natural gas prices last seen on a consistent basis in the 1990s, it is a non-consensus view, so it needs some defending…
1. Because natural gas is a local commodity, market fundamentals (supply, demand, and inventories) in North America impact prices in North America. It is a remarkably efficient commodity market, and one which we can fundamentally believe in. If we have a warm winter, natural gas prices go down – we get that. We can’t necessarily say the same about global oil markets.
2. In a world characterized by slow growth and tail risk, we think natural gas is a relative safe-haven. If China has a debt crisis or the EU collapses, we will still heat our homes and turn our lights on. US demand for natural gas is inelastic – in 2009 it fell only 1% compared to a 3% drop in US real GDP.
3. Natural gas will continue to take power generation market share away from coal. We estimate the natural gas demand from the power sector was +20% y/y in 2012, largely due to coal-to-gas switching and the retirement of aging coal plants. At least 10% of existing coal-fired capacity is likely to shut down between 2012 – 2015 due to impending emissions regulations.
4. Demand from the industrial sector should grow above GDP as new petrochemical, chemical, fertilizer, and steel plants come take advantage of the energy cost advantage in North America relative to the rest of the world. As one example, Italy’s M&G Group announced last month that it will build the world’s largest single-line PET plant in Corpus Christi, Texas. M&G remarked, “This is the largest PET investment ever in the western world and probably one of the largest investments recently announced in the US in the private sector.”
5. Price is below the marginal cost of dry gas production, which we consider to be $4.50 - $5.00/Mcf, or the price at which producers can generate a positive return on a Haynesville Shale gas well. We do think that we have seen the last of Haynesville Shale production growth.
6. Longer-term, we are optimistic about new sources of natural gas demand: LNG exports and natural gas as legitimate transportation fuel. With the right R&D and policy measures, both are economic and feasible, in our view.
We’re not going to give away the shop here, so if you’d like to discuss ways to invest in the thesis send us an email at . Further, on Wednesday 2/6 we’re going to host a Black Book presentation and conference call for institutional clients on Gulfport Energy Corp. (GPOR). There we have a very non-consensus view. For now, we’ll just say that it’s one of the more promotional companies in the space... Email for details on that call.
Have a great weekend,