The energy market is completely bombed out. If you tried to pitch an energy stock right now, I’m pretty sure no one would listen to you. Personally, I don’t know enough to pick a “winner” small cap energy stock, but I think buying a basket of the majors makes a lot of sense.

I know what you’re thinking: “Oh no… now Dilly D is falling for the value trap of big energy… there’s no hope.”

My thesis comes down to three points:

1. Sector is completely bombed out. No one wants to invest in it. It’s almost toxic. Most people will likely skip this article because they have no interest. Oil prices going negative this year might have been the last straw.
2. Supply is much tighter now. Shale, which was the growing marginal supply, now has rig count come way down. While COVID was a shock to demand this year too, demand likely will come back much faster than supply. This could lead to a price run-up.
3. Oil is not going away. People think oil demand is going away due to electric vehicles, yet they don’t realize the chemicals and plastics we enjoy in everyday life are also derived from oil. Also, I don’t think an EV commercial jet will be made anytime soon… jet fuel will continue to be a large source of demand, not to mention emerging markets.

So the bottom line is that I think as the global economy recovers from COVID, supply will be much tighter than people expect. That tighter supply will lead to higher prices (not calling for anything crazy), and that will result in more focus on the sector again.

I’m not going to comment on how oil is now the lowest % of the S&P ever, because I don’t really think that’s relevant to me. It could be a contrarian indicator, or just a sign that the industries return on capital is only good when prices are high. I also think you can control for the risks in energy through position sizing (I don’t plan on having a big position here, but I also don’t want to have ZERO exposure anymore).

Let me work backwards from my three points.

Imagine a chart of global crude oil demand in your mind… what does it look like? Is it something that flatlines around 2005? Maybe more fuel efficient cars have come and that’s crushed demand?

Up until COVID hit, that would be completely wrong. Yes, so far with COVID, oil demand has been crushed. But I’m not banking on people not flying, not driving to work for long.

With demand so low right now, plus the swath of bankruptcies in shale, US supply has come wayyyy down.

This chart clearly shows the “bubble” that was US shale, which eventually led to an oil collapse in 2014-2016. But now we’re talking about very low levels of supply. We’re talking lows of Great Financial Crisis. The lows of the early 2000s (or pre-Shale Revolution).

US Shale vs. the Majors

The energy sector is consistently called out for not ever generating FCF, but that’s more so related to US shale. I’m speaking more about the majors, where they do actually generate a lot of cash. The majors are also pretty diversified across upstream, midstream and downstream (e.g. chemicals).

But I think FCF in the industry could be much higher if they just stopped spending (re:drilling) every dollar they earn. If you think about having one well, once all the upfront costs are gone and the infrastructure is set up, the costs to keep it going are relatively low. However, you now have a declining asset.

A declining asset generating cash is still worth something. It’s the PV of a declining annuity. I just think the shale industry needs to prove they can generate FCF and have more discipline. I’m not banking on that, so I’m going for the majors.

The majors have the scale, the developed assets, and perhaps need to generate FCF to support the big dividends they’ve handcuffed themselves to. Yes, I still think Exxon should cut its dividend. It’s getting outrageous. But at the end of the day, I may be wrong, but at least I won’t have a ton of downside.

I kind of like this chart. It compares oil price (yellow), XLE price (energy stocks proxy in white), and Baker Hughes Oil rig count (orange). It helps me see “bubble” and then collapse in a classic cycle. For example, if I were to show you a chart of US Housing starts, you could see something very similar around 2005-2006 (around 2.1MM housing starts). Then a collapse and no one wanting to touch housing (around 500k housing starts)… how times change…

Clearly there are risks to this playing out.

The cure for high prices is high prices – meaning as soon as prices go up, shale is coming back.

A second factor is that credit is easy right now. At the time of writing, the yield to worst on the US high yield energy sector is just 6.4%. This was a factor that led to the shale uprising. If credit is too easy, it’s hard for these guys to just STOP F&CK!NG DRILLING. Especially because this was an industry that used to be rewarded solely by increasing production and never really generating FCF.

Obviously, there are a million other reasons why I could be wrong, not the least of which is OPEC. They just announced a small production increase, which seems crazy, but the OPEC countries’ economies are reeling. They need to pump volume at the expense of price sometimes. I still think longer term, they realize what needs to be done and shale (in a way) has already responded.