What's the appeal of investing in oil stocks?
Oil companies have been a massively successful investment in 2022 due to re-openings post-Covid and the war in Ukraine. But in normal years, they seem like a poor investment unless you have a magic crystal ball that can predict the cycle of oil prices (or black swan supply shocks like pandemics and wars).
Oil prices strongly affect your revenues - you can find the best run and managed firm but if OPEC decides to drastically ramp up production then your revenues will be mediocre. You are exposed to a litany of macro factors and since you're a commodity producer, your earnings growth potential is severely capped by the cyclical nature of the market - if prices are high, the other companies will ramp up prices and soon a supply glut will appear and prices will come back to normal. I know that oil producers are not investing a lot in new rigs right now to appease shareholders so maybe this cycle will be mitigated but it seems like oil stocks are a comparatively poor thing to invest in due to the high risk and limited upside. There's also the headwind of green energy and regulations.
I could only see myself investing in oil stocks due to very low valuations or foolproof knowledge of oil prices in the future. Am I onto something here? If not, how do successful oil and gas PMs invest in the industry?
You hit a lot of things on the head here regarding what has, for the last 10-15 years, been a very poor investment as companies in the space have allocated capital to the wrong places (i.e. production growth + acquisitions vs. optimization of assets + shareholder returns).
Now on the flip side of things playing devil's advocate (and take my thoughts with a grain of salt as I am a professional in the oil and gas industry)....when done properly the oil and gas industry is relatively insulated from the broader macro cycle. There is a large component of headline oil prices that are driven by macro factors (recession, etc.), but oil cannot go to zero in a recession because of it's necessity in the broader economy (i.e. take for instance that during COVID where the entire world was shut down, oil demand went down from ~100 mmbo/d to ~70 mmbo/d; a drop of 30% is nothing to laugh at, but think about how "resilient" an industry has to be to not go to 0 in the face of the largest coordinated shut down in modern history). So in an ideal world you get 1) a flawed, but relatively sufficient macro hedge. 2) the capital allocation strategy over yesteryear has in fact shifted, for a variety of reasons which don't need to be discussed here, but the fact is production growth will be muted moving forward. Core reservoirs are declining, producers are shunning away from over extending, OFS companies are keeping service costs so high that single well economics don't work, etc. Companies may "guide" to production growth (doubtful since the shareholder now hates growth vs. return of capital), but the growth will be muted and likely anyone who underwrites growth is likely going to miss target. Now on a company level, not great obviously, but if you think of oil stocks as a beta play of the commodity, the supply ramp not being there also sets a floor of some extent on the price. Which brings me to my 3rd point in that really oil stocks are, for a generalist investors, a beta play relative to oil prices. You're right that it's no longer 1980 and you just buy a bunch of Exxon and Chevron stock and ride it out. It's more of short- to medium-term bet on oil prices and who's exposed to that the most. If you want to get really granular you can get cute and do some sort of market neutral on basin by basin (i.e. long FANG/short CHRD if you have an opinion that Permian Basin will relatively outperform the Bakken), but I'm guessing that's not what most generalist funds are going to be doing.
So to summarize, in my opinion, the investment thesis on oil stocks are:
1) Macro-hedge
2) Supply side constraints putting a floor on prices
3) Commodity beta
You're not wrong on the energy transition providing headwinds, but without government intervention, the economics of large scale projects haven't proven out yet. Hence the reason most of the alternative energy companies have seen dramatic underperformance in their trading performance.
I'm obviously biased, but I do think there is still a bull case on at least the short and medium term in the oil space.
Very good viewpoint but I do think this is a bit biased other way and is why many people have got into "bull traps" in energy late 2022. Based on the forward curve in Q4, absolutely everyone will be growing this year and that is why companies like HAL had great quarters and outlooks. Energy producers will always grow if they can find infrastructure to serve a future need and currently that need is there as one of the world's largest suppliers has market share up for grabs.
While Russian oil isn't making it's way to western markets as much now, I'm not sure if that will remain the case when the war is over - sooner or later it will end and the market will be flooded with Russian supply as the country retries to finance its rebuilding and make it for lost income. That will just drive prices down and make the NPV of any investments into expanding supply now very negative.
I mean, ya, I am 100% biased although I do think I trend towards not being as biased as some of the old folks in the industry and do see the writing on the wall on the industry.
Will point out that yes, forward curve has shown a "surplus" in the 4Q like you point out, it's really interesting to compare the shape of the forward curve from the summer of last year (when oil was >$110/bbl) to 4Q23 vs. what that same spread looks like now.....I do not remember the specifics of the curve, but the relative slope of the curve from 2Q23 to 4Q23 from that point vs. now has very noticeably flattened....i.e. the front month has come down relative to the backwardation...what that tells me is that yes the markets are pricing in more production relative to today, the absolute variance between the two data points is much lower, and the flatter curve reflects that there is an indication that the supply isn't going to match what was forecasted last summer and in the driver seat of an operator I can tell you we are tapering activity. Remember, futures price is not an indication of what price will be at that future point in time, but rather a measure of supply and demand at that point less adjustments for carry and all that nonsense, so the flattening implies the production the curve priced in months ago hasn't materialized.....rig counts are trending down, inventories are broadly staying flat, and that's ex-China fully re-opening. It's a lot of moving pieces but I do think you can't underwrite demand erosion, and from my vantage point the supply isn't coming as the curve implies.
Important to note that HAL is not an oil company, but an oil field services company. They are at the back of the value chain and their orders are going to be lagged due to contracting. Most operators are on 6/9/12 month rig contracts + completion contracts, so the downside in prices won't be reflected in the near term guidance....what's more interesting imo (despite how much I hate SS research) is the longer term forecasts that they are putting together on the OFS guys like HAL/LBRT/RIG/etc.....they aren't crediting them with much uplift from here, which is another indication I think that shows once this queue of activity rolls off, there will be a cliff fall off of activity.
I agree that if we could, we would on filling the production need. But that goes back to my point of reservoirs are declining in quality and thus rough math suggests it takes ~1.5 2023 wells to replace the productivity of a 2021 well. Costs net neutral would alleviate that, but all the macro nonsense about labor shortages and raw goods supply chain considerations are very much real (still takes ~9 months to procure the steel to get the casing for the wellbores vs. 4 months historically) lends itself to even if activity held constant, productivity overall is lower so you actually need an uptick in activity to just hold constant.
Hey thanks for the detailed writeup. Here are some of my thoughts on the points you laid out:
1. Not a lot of industries (or non-small cap stocks even) go to zero during recessions or macro shocks. You could also extend this argument of being an indispensable commodity to a lot of consumer staples sector/products.
Not sure if you were referring to oil companies or oil as the commodity but oil barrels were -$70 a barrel at one point during the pandemic.
2. I like this point - seems like a great source of dividends provided you got in early at an attractive valuation and can weather the down cycle or somehow get out in time. Not sure if oil stocks are unvalued now though.
3. Why not just invest in oil barrels instead of oil stocks then? The stock comes with idiosyncratic risk like poor management, hefty fines due to noncompliance to regulation, and value destroying acquisitions. I suppose you get the company-associated idiosyncratic reward too but I feel like that needs to be compared to the idiosyncratic and macro risks.
You're right, not a lot of industries go to 0, but a lot of them did halve or 3/4 during COVID, yet oil stayed at 70+%
As far as pricing, the negative day was strange (and I emphasize that was a day or two) because of a weird two day stretch where pipelines and storage were temporarily full. It's well known that the easiest money to ever be made in oil was buying at -$37 and selling literally the next day at +$10....that was a breakdown in the financial markets, not in the physical markets.
The point on buying barrels directly is fair, but is tough to execute in practice. USO is really the only decent WTI proxy ETF in practice, but there is cost decay associated with how they are structured in practice. As a retail investor it is very challenging to just replicate oil without access to the stocks.
For years O&G firms had access to cheap debt which allowed them to become a good leveraged businesses at times. That said when "shale technology" was found the technological curve made it a race to the bottom as you mentioned. O&G did not just do well cause of "high cyclical prices in 2021-2022" they did because the industry took a massive step back saying that the businesses can no longer be so levered and to focus on "cash flow".
So the next investment thesis is now that they are cash producing machines that can continue to buyback their shares as long as they limit capex. OPEC is in the same mentality as well as they cannot handle long-term cost pressures and already forecast the "peak demand" is about 5 years away possibly,
Now tell why tech is a better investment, if you need to spend capex and many of the businesses do not produce cash flow.
I see your points, although as oil prices normalize and regress to the mean I'm not sure if oil companies can continue to be cash producing machines. If you jumped in earlier it might've been worth it but now oil stock prices have jumped tremendously.
Out of curiosity, why don't you think OPEC is stepping in and ramping up production to fill in the gap once occupied by Russia?
I agree that tech is a shit show right now with a lot of deadweight that needs to be pruned, although cash-flow positive tech companies in areas like SaaS can continue to generate a consistent revenues that might even grow in the future, which may make some degree of CapEx worth paying for. In contrast, all oil companies are subject to this boom and bust cycle and there are stronger caps on their revenue generation potential.
Will try to add some context.
OPEC, well actually its OPEC+ currently so they are working together to maintain production. OPEC already had a price war with Russia that ended not well for anyone, and the height of the price war went into covid. Outside of that, Abdulaziz has mentioned in the last three months that OPEC views the next 5 years to be a higher interest rate environment and that because they buy all their goods from the "west" they are experiencing major inflation. So OPEC has to rethink how to balance their books and their view of the world "S/D" for Oil than 10 years ago. This is why OPEC aimed to cut production late last year when Europe collectively shut down industry.
Other producers, this is where I think the "shale revolution" has pushed us into two camps of thinking; first people who think "normal is $50-65" and then people "who think producers should not care unless its 100+ cause that is inflation adjusted etc..". The truth is somewhere in the middle that historically the "regression to the mean" has been when Oil producers can invest in long-term projects and secure the resources to do so. For now various banks think this "regression of normal" is around $75-$80. Fringe plays like the bakken, scoop/stack do not work even at $80 for longer term projects, while something like the eagle ford is totally NGL/condy driven and you need a larger NGL infrastructure in the USA till you can just ramp the production. While the very good rock in the Perm, Delaware works and is the main growth engine currently.
So over time while Oil will still see "boom-bust cycles" the volatility we have seen the last 10 years may not occur again and it could become a more reasonable cash flow yield investment (which truly is what any producer would always prefer).
I could be totally wrong and have a major world recession, or massive bull market start up again. But in this interest rate environment seems not that likely.
I suggest looking up Paul Sankey and his research to hear the mega bull case. Then reading some of Ed Morse thoughts on why we do not need $120 oil.
I think you’re kind of overestimating how much of O&G performance is directly tied to commodity prices. There’s always a risk, sure, but at the same time, many of these names are hedged against lower oil prices (many of them also aren’t) and have breakeven costs that correspond to $40/$50/$60 WTI depending on the basin. So even if oil halves, which is unlikely in the current macro environment, they’re making a profit.
You invest in them right now for sexy FCF yields and dividends driven by a commodity that although is volatile, will ideally outperform vs other industries when inflation is high. Plus spikes in oil will hurt other industries while helping your oil investment.
True, that's the thesis for why oil stock prices are so high but you need to understand where we are in the cycle in order to enter and exit profitably; if you get in too late after oil supply has caught up then you are left holding the bag.
That’s pretty much every industry tho, all go thru cycles that are obvious in hindsight but are really hard to pin down at the time, lotta good theories for pros and cons to invest in the oil sector rn.
ER covering O&G so feel somewhat qualified to answer here. "Green energy" is not a headwind unless it is nuclear. And even that will take 20 years to develop and meaningfully displace Oil demand. There is no other current technology that will replace O&G. That said, regulation is not a headwind either for the industry, imo it keeps supply on the sideline and prolongs the upcycle. The whole ESG bs comes from low interest rates and cheap energy. You can see Biden flip flop on the subject between urging them to produce more and also talking about taxing them higher. I think things remain meh for current players but heightens the risk for new supply to come online.
Second - if you're only a prospect you have only witnessed one of the most anomalous, liquidity-driven bull markets in market history. Most younger investors including myself have only lived through one that favored tech and long duration assets. Everything is cylical and everything will peak and trough, O&G has just been the most recent example of this.
There are 2 types of people who invest in the industry. Tourists and O&G specific. Oil and Gas, your job is to over/under weight compared to the index. So O&G PM's - many of them have a solid understanding of oil supply/demand dynamics across the world. They have a view on how many million barrels China re-opening will bring, what would happen if Ukraine/Russia war called a truce, etc. On top of the broad understanding, they have pretty nuanced understanding of project economics and which basins might outperform others, which companies are levered to those basins, etc. This is where their alpha comes from and take bets on some shale shitco that they understand better than the market (See Josh Young on SandRidge). In broader context there are generalists who play the cycle and outperform SPX cause they aren't married to the oil bull thesis. This is why some generalists were betting on RIG at $2 when some dedicated O&G PM's were missing the forest for the trees. Timing the oil market is not insanely difficult for someone actively managing money
In terms of investing, I think offshore crushes other sectors for the next 12-24 months. But I also understand it is not a "compounder" and this cycle will bust eventually. but I don’t think that will be coming any time soon for offshore, more likely in North America. The r/r for offshore is priced like it could still go bankrupt, but it is stilll in the early innings of the international cycle.
Thanks for sharing your insights, I learned a ton!
Regarding point one, I'm curious why you think nuclear is such a threat when in the Western world it's politically near impossible to build a new reactor. Also, renewables have become cheaper than fossil fuels over the last year or so and with more efficient technology and breakdowns in battery tech it will become cheaper, even factoring in the recent elevated fossil fuel prices. You obviously are much more knowledgeable than an intern like me but do the much better economics nowadays compared to two decades ago for renewables not count as a more pertinent threat?
https://unfccc.int/news/renewable-power-remains-cost-competitive-amid-f…
Regarding point two, how do you think the O&G cycle will shape up in the near future given the macroeconomic factor shifts (persistent inflation, globalization sliding back, etc)?
Lastly, on point three, so the O&G PMs have prepared multiple contingency plans based on various scenarios in advance and revise their view of the oil cycle as events play out? Also how does one become a good tourist O&G investor and beat the dedicated O&G PMs (other than avoiding a bad thesis about the cycle)?
I’ll take this as someone who has spent time in O&G and renewables.
On the first part, yes renewables cost has come way down but there’s still no real battery storage technology that can be used in the scale that will lead to grid stability. So as we add more solar/wind/batteries, all we are doing is making the grid less stable. Look no further to the near collapse of ERCOT in 2021 during Uri (very much multi-factorial but emblematic of broader instability) or what has happened at PJM right before Christmas this past year and more recently. And of course Cali has had their own issues too. More renewables absent storage is a recipe for disaster if it’s replacing fossil gen. Natural gas is an extremely clean burn but because it’s part of the O&G sector (and has a pretty bad GHG effect if flared/vented), it’s been vilified. The reality is that clean-burning natural gas is THE transition fuel but it’ll take time for people to realize that.
Ill have to come back to the macro comments, deserves a better answer than I have time for right now.
On the last part though, others have hit on this but O&G specialists understand the micro and macro of the space. The macro is a directional indicator but it’s easy to have lots of differing views. You can generate some alpha there but understanding recent well results, why a different part of a county vs. another (much deeper than level than why one part of a basin vs another or why a basin vs another basin), intra-basin transport issues, why a mgmt team is better than another, who can be trusted to do good M&A deals, etc is where the money is made. And of course all of this is overlaid with near/long-term valuation indicators and cash return profiles.
Lastly, we are nearing an inflection point in nat gas in particular that’s still a few years away. It’s going to make the back half of the 2020’s really, really interesting for a multitude of reasons.
Upside exposure to the price of crude oil 🛢️
I think the investment case for investing in O&G has been made clear by some of the earlier posts on this thread. Focusing on the "how do successful oil and gas PMs invest in the industry" portion, though: just like any other cyclical sector, you play the cycles and pick winners and losers, and cycle in-and-out of advantaged or dis-advantaged subsectors (E&Ps, Midstream, Refining, OFS; which can be further broken down into more specific sectors with different headwinds and tailwinds).
The volatility in the sector is especially great for L/S funds that can play the quarter and make returns during any part of the cycle. For long-onlys, there will be outflows during long periods of downturns, but your job is to avoid the crashes and position towards countercyclical or defensive subsectors. Refining stocks for example had a great run while prices were down in 2015-2020, and act countercyclical when an oil-crash is supply driven like in 2014-2016.
Lastly, there is A LOT of data on the sector. You can have tremendous, publicly available insight into a company's operations and operating metrics. This can help differentiate companies. From the outside, it looks like all of them are just correlated to an oil price. However, if you can hedge out the commodity beta, you can make a bet that a company is better operated and superior to a rival. A lot of OIl & Gas funds/PMs employ this strategy. Hedging that commodity beta is easier said than done, but can still help reduce the commodity price risk when making investments, allowing you to focus more on how well the business is run as you would in more traditional sectors.
Most accessible hedge to any corporation’s fuel bill.
Get where you're coming from on the oil and gas investing rollercoaster. It's like trying to predict the weather without a forecast. I once dabbled in it, thinking I could outsmart the market. Spoiler alert: I couldn't. The volatility is real, and macro factors? They're the wild cards.
One time, after a deep dive into oil stocks, I found myself in a similar spot. Felt like I needed a crystal ball just to stay ahead. But here's the kicker: met this seasoned investor at a local meet-up who shared a nugget of wisdom. He swore by patience and strategic entry points. Low valuations, he said, can be your best friends for oil and gas investing.
Fast forward, I've learned that successful oil and gas PMs aren't always playing the short game. They're strategic, eyeing those dips, and keeping an ear to the ground. Green energy and regulations might be headwinds, but they're also driving innovation in the sector.
You've hit the nail on the head with the unpredictability of oil prices and the myriad of macro factors at play. It's like trying to navigate through a maze blindfolded sometimes!
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