The black gold makes you antifragile

The black gold makes you antifragile

29 April 2022 from Mikael Syding

The energy sector in the S&P 500 is up 36% so far this year (closing prices 27 April). The second best sector, "Staples", has risen by 2%. As a further comparison, the Nasdaq 100 has fallen 20% since the turn of the year. The energy sector has thus outperformed technology stocks by more than 55 percentage points in four months. Given what has happened in the world in the meantime, it is not very strange. Extremely expensive "innovation companies" suddenly heard about rising interest rates, while Russia's attack on Ukraine caused Europe to fear a sudden shortage of oil and gas for its factories and the heating needs of households.

Energy is the world's most important resource, so when the production or distribution of energy in the desired form does not run smoothly, the marginal buyer quickly becomes eager. The zeal goes on a scale from sticks in the economic wheels to worries about freezing to death. This applies to both the demand for energy products as such, and for energy shares where both profits and multiples typically rise when the price of the underlying raw materials rises.

This year, demand for energy shares has also been given an extra boost by the fact that inflation has raised the price of oil and gas a little extra, while rising interest rates have increased the relative attraction for oil shares with low multiples compared with the technology sector's high or negative profit multiples. This is because when interest rates rise, it becomes more difficult for investors to wait for profits in hyped growth companies that are both uncertain and well into the future. This is especially true compared to the oil sector's low multiples of already safe and sharply rising profits.

Energy, S&P 500 and Nasdaq 100 (in USD)

But perhaps the energy sector has already counted on the future. Maybe it's time to rotate back to the technology sector or any other industry with long-term growth potential? Everyone agrees that we must phase out the use of fossil fuels as soon as possible, so in the long run, are oil stocks threatened with extinction? If the Ukraine war is soon over and if higher interest rates lead to a slowdown in the economy, the supply of oil will increase and demand will decrease at the same time. Then the price that balances supply and demand very well, can fall below 80 dollars per barrel again, ie at the prices that applied in 2014-2021. The analysis and investment company abrdn has it as its minimum outcome for the oil price. And at the other end of the spectrum, the firm's analysts expect a price of WTI oil of $ 180 a barrel, provided the rest of the world implements all planned sanctions against Russia. In such a scenario, many investors wish they had been quicker to exchange more of their expensive and uncertain technology stocks for shares in oil companies.

Energy shares and oil prices (in USD)

Of course, it is true that the price of oil will fall when the war is over and if there is also a recession in large parts of the world. However, one should not forget that Russia's customers have begun a process of freeing themselves from Russian oil and gas. That process does not change just because there is peace. This means increased demand for oil from elsewhere and a structural upward pressure on oil prices. This adds to the pressure from the anti-ESG stamp, which has led to underinvestment in the oil sector and thus a steadily increasing shortage of oil in the world. Of course, Russian oil will leak into the world in the same way that Iran has done. China and India are ready with the hoses, but the change is facing increased friction, which is reflected in higher prices.

WTI - Western Texas Intermediate Oil Price USD / Barrel

When talking about the demand for oil, one should also not forget that it is used for much more than just burning up for heat and transport. Oil is used as a raw material for both food and a variety of building materials and consumer products. Demand does not end or perhaps even decrease from year to year just because the oil is burning up to a lesser extent. Measured over five years, the oil sector has not only fared much worse than the Nasdaq but also worse than the oil price. The latter is probably an effect of ESG rules and the stigma that oil investments bring. As a result, the valuation levels of the oil shares have fallen, despite the fact that the conditions for higher oil prices and lower total production have improved.

Oil shares (USD), oil price (USD) and Vestas Wind

Of course, there is no lack of risks for the energy sector, or more specifically for oil stocks in particular. The central banks seem to have decided to slow down the economy in order to combat high inflation. US consumer prices e.g. increased by 8.5% in the last 12 months, and wages rose by 6%. The Fed is therefore not likely to deviate from its planned 10-15 interest rate hikes unless inflation falls permanently below 4%, or the corporate bond market freezes. It was the latter that caused the Fed to turn around a five-year shift from increases to reductions and QE in the autumn of 2018. No, interest rate increases and the recession are almost given, which will lead to reduced demand for oil on the margin.

On the other hand, there is a long-term structural shortage of oil. In addition, a company like Conoco Phillips is trading at only 1.9 times next year's sales, or 4.2 times EBITDA and P / E 7.2. This could reasonably mean that there is a 30-50% upside for the share price, as long as the oil price does not plummet significantly (WTI = 102 $ / barrel right now). One should also not ignore the market's ability to look a little further than just to the next corner. Even if the oil price falls a little during the beginning of a recession, investors know that there will soon be new stimuli at the same time as investments in new production remain minimal. Incidentally, an unusually hot and dry summer, or a windless autumn, is enough, not to mention a cold winter, for the energy shortage to be reminded again and quickly push the oil up to record levels.

Even in the medium term, you can clearly see how the market trades wind and oil in direct opposite phase, exemplified in the graph with Vestas Wind Systems Price / Earnings of over 100 times the profit in a year despite fairly low Enterprise Value-to-Sales of 1.5 - it is difficult to make a profit in alternative types of energy). The oil shares are a good insurance against all possible negative events, against extreme weather as well as war and inflation. It is no wonder that this antifragile asset is called "black gold".

I’ll quote the film “300” regarding the current investment climate: "You will not like this. It won’t be over quickly", so make sure you position yourself today as you want the money to be placed tomorrow.

Please remember that any forecasts mentioned in this article are not a reliable indicator of future performance.

01/02/2023 14:28:37


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