Disclosure: The following represents my opinions only. I am long BTE.TO, CMMC.TO, CS.TO, and WCP.TO (Image credit to Clyde Thomas on Unsplash)
If you were starting to think that stocks only go up, I’m sure that last week was a stark reminder that they don’t. The market has become a little jittery about rising bond yields and what that could mean for stocks, which has brought volatility up a bit. There are myriad variations and permutations of the expected effects of, and response to, rising bond yields, but in the end the most important question comes down to what the Fed does if it sees bond yields rising “too high, too fast”. If you google “yield curve control” you’ll get yourself a tutorial on the Fed might do in order to keep rates low enough for them to hit their target inflation rate (or higher) for “a while”. Personally, I think the Fed is committed to seeing inflation run above target, but is likely to pull the yield curve control lever only when “forced” to do so by the market. I’m not sure what that looks like (likely some form of market turbulence), or when/if it happens, so in the meantime all I can do is look at what I own and try to think rationally about how I’m positioned in light of what I think the future holds during the Great Restart. Markets have been hot, but the world isn’t even out of covid purgatory yet, so I think things could get hotter. That doesn’t mean there won’t be corrections along the way, but we are fresh out of a full-blown market meltdown and the U.S. is only just about to get the next stimulus/relief package passed, never mind the infrastructure bill(s) that will follow. We could very well be heading into a Roaring Twenties redux, one hundred years later. I guess we’ll see.
Back in December, I’d written about staying the course and being an “ox” when it came to my outlook for 2021. That included staying long energy and materials, which has served me well. I find that it’s a lot easier to make money by focusing on value in sectors or specific stocks that aren’t well-owned or popular and then just remaining patient until the crowd shows up. It’s so much harder to find value in the same names/sectors that everyone else is poring over. A year ago, you could say that materials and energy companies across the board were out of favour, trading at fractions of their underlying asset values and longer-term highs. As it stands today, I think that copper is a little more popular than I would like (i.e., could be prone to correction/consolidation), the market is just starting to come around on nickel, gold has pretty much washed out (I’m looking for gold to have a nice bounce after testing the $1700/oz level, perhaps as soon as this week or next), silver and lithium are holding up well, gas is still attractive, but oil has me the most excited for the big win potential. You know, oil; that stuff that is the foundation of modern society as we know it, that almost nobody owns and everybody loves to hate? It might be a bit overbought in the short term, but I’m getting really optimistic on oil looking through to the end of 2021 and beyond.
Today, the energy sector represents just ~3% of the S&P index and, as Jim in our office likes to say, “there are portfolio managers out there right now who think oil stocks are just something that only old guys own… and that all they do is go down”. There’s good reason for that. Generally speaking, if you haven’t owned an oil stock for the last six or seven years, you haven’t missed much, other than a feeling of eternal disappointment. In late 2014, the U.S. shale production boom — driven by the preceding four years of $90/barrel average prices and nearly unlimited access to capital — finally caught up with the oil market as supply growth overran demand. Oil was left for dead; taken for granted as eternally available and plentiful. Only the largest companies were left with any level of market respect or ownership, while the small-to-mid caps were avoided like the plague. Fast forward to today and the general narrative is that oil is evil, still plentiful, and something to be shunned by investors until it quietly fades into the twilight. Look no further than all of the funds that have proudly touted their divestments from oil stocks over the last few years… at decadal lows, by the way. What a tough decision it must have been to kick something into the ditch in the name of virtue when it was already there. The market today is behaving like the world is going electric tomorrow, which it is not, and therein lies oil’s great revenge.
I’m not some kind of pro-oil nut as a matter of practice. Just because my background in in oil and gas doesn’t mean I’m not a big fan of a low carbon future. The push for green energy is both admirable and practical, even necessary, but I think that the market is completely out of touch with reality when it comes to how fast we can shift away from oil. The consequences of the last six years of upstream underinvestment are about to come home to roost. Capital inflows into the sector have been all but cut off for years, and producers are now focused on debt repayment and return of capital to shareholders, as opposed to production growth at all costs. That is a profound and real shift in thinking. The weak companies are gone and buried for the most part, and the free cash flow generation potential of the remaining companies is already starting to look impressive. Only the strong survived the valley that the oil market just went through and if the market wants to keep letting energy stocks trade with free cash flow yields of 15-20%+ at current prices, I’m quite okay with owning them, especially given that I think oil is heading higher over the next 6-12-18-24 months. There may be violent dips and rallies along the way, but at this point, I’m flat-out a buyer of oil stocks on dips if those dips aren’t caused by something that dents my thesis. I’ll likely steer clear of oilsands, but everything else is fair game for me.
Look, trying to get to some kind of “net zero” economy is going to be like launching a rocket into orbit. Once you get to orbit, it feels a bit like perpetual motion and the required energy input is low, but boy does it ever take a lot of rocket fuel (energy) to get you there. Oil is that rocket fuel for the world’s transition to a green economy (i.e., we have to use the energy we’ve got to build the energy system of the future), so if “going green” is the plan, then oil is going to just as necessary as copper or lithium to get there in the near term, full stop.
Now consider that the price of oil, at around US$60 for WTI right now, is about $10/barrel over what would be considered “life support pricing” for most of the industry despite whatever brave face individual companies might put on. When I was commenting on oil just three months ago (when Brent was at $48) I said, “with some bold forecasters calling for $60 Brent in H2 2021”. Well, here we are just three months later and Brent is $64/barrel. Let that sink in a bit. When I wrote that, it seemed very optimistic, so now that I’m seeing articles wondering about a return to $100 oil, you have to wonder a little about what’s coming. We absolutely need this fuel to even try to launch our green rocket… and the price of it just went up so fast that my head is spinning… and the market has finally started to notice. Sure, there are some inventories to work through out there, but demand was 100 million barrels per day pre-Covid and it’s going right back to 100 million barrels per day by what, Q4 give or take? If the idea is that electric cars are somehow going to meaningfully dent oil demand in the short term, I beg to differ.
All of the electric cars ever produced in the world total up to about 1% of the global one-billion-vehicle automobile fleet. Yes, that number is growing, but the sales of these cars are still limited to only the most affluent of the world’s population and most EV drivers are not people who are driving 200 miles a day or more. Also keep in mind that developing economies represent the source of oil demand growth that is projected to continue until 2030, give or take. These are countries where people have bigger fish to fry than spending 5 or 10+ years of wages buying electric cars in regions with unreliable electricity grids… their hierarchy of needs is based on more tangible, immediate concerns. Yes, oil will slowly be displaced from the global transportation fuel equation, but slowly is the operative word. Despite reports of oil’s demise, it is most certainly not “dead”… and if you thought it was dead, I think it’s about to claw its way back out of the grave.
Not convinced? You could look at the chart of just about any oil company right now and you’ll see why I’m writing about this today. Remember that market that no one thought anyone would come back to? Well, they’re back. Plot a one-year chart on any oil stock and it will likely have at least doubled off its lows. The stocks have done so well recently that the market signal is hard to ignore. Most of these stocks are coming out of absolutely-dead-to-the-market lows. The charts may look overbought/extended on a one-year basis, but try pulling up a 10-year, or 15-year chart on your favourite oil stock that you thought you would never want to own again. A feeling of unease or optimism may set in soon after; depending on whether or not you own oil stocks. I suggest looking at those long term charts because when you are in the fog of market disinterest, it’s hard to imagine the market thinking any way other than the current way. Charts tell stories about past mindsets and they are important reminders that market narratives change over time, sometimes over longer cycles than you’d think if all you do is look at short-term charts. It’s seems almost ludicrous to think of people wanting to own oil stocks because of their impressive dividend yields and share buybacks, right? And yet, the free cash flow yields showing up in broker reports don’t lie. Hmmmmm. Decisions, decisions. I’ve got one foot in the proverbial oil pool through a handful of names, but I’m being patient as I see potential near term risks to the oil price via currency markets, jet fuel demand, inventory levels, and OPEC+ (their next meeting is on March 4th). If oil keeps ripping, yay. If not, I’ve got my shopping list ready if it falters.
I talked to a friend of mine recently about my oil view and he was fairly lukewarm on the concept, which has only emboldened me in my thinking, because the numbers look really good for a lot of these companies already and people still doubt the sector. Sometimes I find it’s best not to overthink simple ideas, so I don’t. A little over a year ago (pre-covid), this was all I had to say about a couple of my favourite copper stocks… both are up ~300% since that time:
“Copper Mountain (CMMC.TO, last at $0.75)
Capstone Mining (CS.TO, last at $0.77)
These are part of my copper basket. Both are producers, both are cheap on NAV and projected earnings/cash flow metrics. I don’t have a lot to say on them other than the fact that if copper goes higher, these stocks should obviously benefit. Both have moved up off their lows and I’ll stick with them as long as the charts look friendly.“
I’d say the same about oil stocks today. If oil goes up, the oil stocks should follow suit. Really insightful right? Short term, I don’t know what oil does, but if I can have half my stock in the boat now with the idea of buying the other half if the stocks come back and have a look at their 50- or 100-day moving averages, then I’m good either way. This hasn’t been a hard sell for me after consistently seeing projected free cash flow yields of 15-20+% on the industry comp sheets. Almost all of the mid-to-small cap oils are trading a healthy discounts to NAV and historically low earnings/cash flow multiples relative to their long-term ranges (that was exactly the set up on copper last August, right before the copper stocks doubled/tripled). That doesn’t mean that I think the oil stocks are going to keep rallying straight up tomorrow, but I don’t rule out the idea that they could. I don’t think that a year ago when it was trading at $2.50/lb, many people thought that copper would be over $4/lb a year later (“props” to Frank in our office for being one of them), and yet here we are.
Looking at a one-year Copper Mountain Mining chart right now is certain to invoke emotions depending on whether or not you owned it. On paper, oil stocks today are as attractive to me as copper stocks like Copper Mountain were a year ago, and while I still very much keep a candle burning for copper, I think the easiest money has been made (for now), so I’ve rotated some of my copper exposure into my favourite small-to-mid cap oils, which is a basket of maybe ten names spanning a range of jurisdictions and market caps. They say a picture is worth a thousand words. They also say that charts don’t lie. Follow my thinking from the following series of charts on Copper Mountain (CMMC.TO, last at $3.15) and Baytex Energy (BTE.TO, last at $1.23). I’d argue that Baytex is kind of like the Copper Mountain of the oil industry. At current prices, the debt that might have been of concern a year ago looks a lot less daunting now and BTE’s discount to NAV, strong cash flow potential, and stabilizing-to-positive outlook make it into a very levered option on the oil price… the same way Copper Mountain was a levered option on the copper price six or seven months ago. Look at the charts below to see what kind of Kool-Aid I’ve been drinking lately:
One more bit of food for thought can be found in the Whitecap Resources chart (WCP.TO, last at $5.69). If I had a dog, it could draw the grey support/resistance line that I’ve drawn on the chart below. While WCP might look extended on a 1-year chart, I think the 10-year chart shows just how much headroom there is if the stock can clear the critical $6 level. This is something that I’ll be keeping a close eye on in the days, weeks, and months ahead because I think that if WCP can move through the $6 level definitively, the chart suggests it could be going to have a look at the $9-10 range before I have to think about it too much again. At the current share price, with its ~1.5-cent monthly dividend, WCP has about a 3.2% yield, and management is regarded as one of the best teams in the business.
By now, this note has run far longer than my initial intentions, so I’m going to saw it off here. Regardless of what oil and oil stocks do, I think I’m going to enjoy reading this in six months. It is just so easy to avoid oil right now given the absolute lack of interest in the sector, but the numbers don’t lie and the charts are universally encouraging. I do think that oil may be extended in the short term, but that’s why I’m looking to be a buyer on dips at this point in time. When the world restarts and we start building our green energy machine as part of the Great Restart, it’s all going to be built on the back of oil — and that’s something that makes a person wonder like me wonder if oil is really dead after all…
Time will tell.