Despite a few isolated misses, generally favorable third quarter 2019 energy sector operating and financial results provided a boost to investor confidence and a modest degree of support to equities heading into the end of the year. Since April, energy equity weakness has reflected a sense of investor unease associated with U.S. China trade war uncertainty and the continual rise in lower 48 production volumes which have driven U.S. shale market share gains at OPEC’s expense. Facing this environment, management teams, sector wide, have moved to embrace the ideals of capital discipline by reigning in spending and pursuing cost efficiencies where possible in an effort to enhance equity appeal. In 2020, we see these measures driving intra-sector relative performance ultimately rewarding those best able to achieve what we believe is the trifecta of shareholder friendly capital allocation: 1) growth within cash, 2) cash return to shareholders, and 3) the prudent use/reduction of leverage.
As we near the end of 2019, we thought it would be appropriate to address the key themes driving current energy sector investor sentiment and provide our view of the potential impact to equity performance into 2020.
OPEC’s decision to deepen existing production cuts by 500,000 barrels per day (bbls/d) through March 2020 suggests a floor on global crude oil prices and beneficial de-risking of energy equity prices.In a move to pre-empt potential crude oil price weakness during the first half 2020, OPEC’s quota alliance announced that it would deepen existing volume cuts by an additional 500,000 bbls/d starting January 1st 2020. Importantly, the cut announcement came with stern language by Saudi Energy Minister Abdulaziz bin-Salman that any future quota extension beyond March 2020, the expiration date of the existing quota, would require full member compliance. For market watchers, tough Saudi language and the deepening of existing cuts came as a welcome surprise given that most forecasts projected a simple roll-forward of existing cut levels. From our perspective, reduced OPEC volumes and moderating U.S. shale development activity will serve to tighten supplies into the second half of 2020 when rising seasonal demand trends combine with consumption growth from incremental refining capacity additions coming online in the middle east. By our numbers, crude oil markets will likely require the restoration of incremental OPEC crude oil volumes as we approach the end of 2020. In this environment we see NYMEX WTI crude likely rangebound between $50 to $60 in the coming year. At this price level sector cash flow generation should prove adequate to support industry activity and healthy returns for most of the upstream sector, which in turn should perpetuate sector financial health and restore investor confidence along the way.
As in 2019, we believe a rangebound commodity price environment will prompt companies across the value chain to embrace the ideals of shareholder friendly capital allocation.While the U.S. continues to grow in its role as a primary supplier of energy to the global market, rangebound commodity prices are incenting a shift in corporate behavior to broaden the appeal of industry equities. Companies across the energy value chain continue to make great strides in lowering their costs structure, reducing capital expenditures and de-leveraging to adapt to a rangebound price environment. As such they are beginning to show signs of positive free cash flow generation, and as a result, to our team are becoming more investable through the commodity price cycle. Though the trend is industry wide, we anticipate varying degrees of sub-sector performance will continue to reflect the company as well as sub-sector progress toward the ability to deliver on these important ideals.
Sub-sector performance bifurcation will likely persist into 2020 as those companies benefiting from the business integration, competitive cost structures and financial flexibility should be rewarded with premium multiples relative to less advantaged peers.
Integrated Companies –As in 2019, we anticipate that investors seeking energy exposure in 2020 will continue to favor integrated energy companies given the attractiveness afforded by relatively low leverage, asset integration, and economies of scale. In our view, no other sub-sector of energy equities provides the benefit of both cyclical defensibility and the potential for attractive cash return. In the coming year we will be paying particular attention to company cash generation levels relative to aggregate outflows associated with capital spending and cash return to investors. While current global crude pricing suggests these priorities will be approximately balanced, any weakness in pricing and/or corresponding rise in sector leverage could detract from sector appeal. Among our favorites, Chevron (NYSE: CVX) looks particularly attractive. While the company recently announced a sizeable write down of certain natural gas related assets, the company’s reiteration of focus toward the short cycle Permian asset base and optimized capital spending approach across the broader upstream portfolio should deliver attractive growth and returns on a go forward basis relative to peers in the sector.
Exploration & Production (E&P) Companies –As with integrated energy companies, we expect that E&P company relative performance will accrue to those companies best able to balance capital allocation priorities that ultimately benefit the shareholder. E&P companies are increasingly being called upon to focus on shareholder returns which in turn is prompting management teams to moderate capital spending and emphasize a focus on cash returns (dividends and share repurchases). Looking ahead, we will be assessing the sustainability of further well productivity gains and cost efficiencies which historically have propelled operating and financial results. While further cost savings appear probable, productivity gains will likely to be harder to come by given the technical limitations to wellbore length and proppant load size, and the degradation to per well recoveries associated with tightness in well-space proximities. Similarly, we anticipate further depletion of tier 1 acreage also known as sweet spot exhaustion will also likely challenge further productivity improvements. Ultimately, companies that have the scale, low base decline and financial resources to return capital to investors at lower commodity prices will continue to garner market favor. One such company, EOG Resources (EOG) recently articulated a payout ratio target (X) which we believe reflects attentiveness to investor demands for cash returns. Should other E&Ps follow EOG’s lead, sector companies could see an improvement in investor favor. As a sector, we believe current valuations are compelling with the group (based on the XOP) trading at 5.8x on an enterprise value to one year forward EBITDA estimate (EV/EBITDA), versus the 5-year historical average of 7.8x, representing a 25% discount.
Oilfield Services –Throughout 2019, moderating upstream capital spending pressured drilling and completion activity which in turn negatively impacted oilfield service company operating and financial results. While we do believe activity levels will ultimately rise in the coming year, the magnitude and pace of industry spending increase remains uncertain. As such we generally remain cautious on many of this sector’s companies going forward. Still, in some instances, we believe the valuations are too compelling to ignore, particularly in companies that have streamlined operating capacity to align with current upstream sector business opportunity. One such case is Schlumberger (NYSE: SLB). Schlumberger is a well-diversified oilfield service company trading at a 10.5x EV/EBITDA, or a 20% discount relative to its historical 5-year average of 13.2x EV/EBITDA. Given the company’s international footprint, cost cutting initiatives and focus on returns, we believe this is unwarranted.
Midstream –Though the midstream sector posted improved third quarter operating and financial results, fears associated with U.S. production growth sustainability, corporate governance issues, and an early start to year-end tax loss selling have weighed heavily on investor sentiment in the fourth quarter. Still, the last several years of steady hydrocarbon volume growth and generally stable commodity prices have allowed much of the sector to fortify balance sheets and redirect cash in a shareholder friendly manner. In fact, we would argue that the sector today is more financially resilient, fiscally self-reliant, and more capable of delivering returns to shareholders than at any time in the last five years. Thus, we argue that the reward to risk of midstream investment has greatly improved, and thus is deserving of continued investor commitment. At the current valuation level, U.S. midstream sector screens quite attractively. On 2020 consensus EBITDA estimates, the Alerian MLP infrastructure index current EV to EBITDA multiple is 9.8x which is more than a 1x turn discount below the sector’s historical 5-year average of 11.1x.
Refining –Since the dawn of the shale boom era, the refining sector has enjoyed an abundance of competitively priced U.S. feedstock, which in turn has enabled most of the sector’s companies with the ability to deliver healthy shareholder returns. Going forward, we see varying degrees of opportunity. The recent divergence in pricing between sweet and heavy/sour crude associated with IMO 2020 market dynamics should present a near term tailwind for complex refiners capable of running a diet of heavy sour feedstock. Alternatively, the narrowing of regional U.S. crude pricing differentials due to the recent additions of takeaway capacity out of the Permian basin could present headwinds for those refiners traditionally sourcing barrels from price advantaged inland markets. In terms of valuation, the refining sector appears appropriately valued given the risks and opportunities evident in today’s marketplace.
The popularity of renewable energy technologies will continue to captivate the broader market interest despite the dearth of investable renewable companies that make up the sub-sector. Renewable capacity growth will continue to provide upstream and midstream natural gas companies with expansion opportunity, as coal generation continues to cede base-load market share.As an investment theme, the trend toward decarbonization is driving material growth in renewable energy projects around the world. Unfortunately for investors however, the rising level of capital investment associated with this growth hasn’t necessarily translated to a commensurate level of investment opportunity. In each of the last 5 years, the total capital invested in renewable energy capacity has exceeded the comparable number directed toward traditional energy grid resources, approximately $200bn per year. Yet, by our numbers, pure play public companies comprising the renewable energy value chain (generation, transmission, distribution) total just over 60, representing an aggregate market capitalization of approximately $45bn dollars. Of course, that figure declines meaningfully when screening for size and liquidity and even further when screening profitability. Still, we believe the sector is worthy of coverage and investment given the favorable outlook for continued growth and unique opportunities afforded by particular niche businesses. Over time, we expect renewable energy exposure rise as sector investability tracks industry expansion higher.
Where do we see opportunity?We see the most attractive opportunity in companies participating in the dramatic growth in solar rooftop expansion and those that are driving progress in grid-scale storage solutions. Additionally, we see opportunities for distributed generation, given the need for localized power generation in parts of the country where fire risk (CA) necessitates the curtailment of power transmission. Wind power should also present opportunity as should geothermal power project development. As always, these companies will be required to navigate the difficult challenges to company level project returns that come with extreme competition, declining pricing, as well as the gradual roll-down of beneficial sector subsidies and investment tax credits (ITCs).
With an acknowledgement that headwinds to renewable energy do exist, we broadly see a gradual progression in renewable dependency driving a need for baseload power gen capacity at least until grid scale storage (battery) solutions resolve the current power dispatch dilemma. With decarbonization trends pressuring traditional coal fired power generation, natural gas will likely continue to gain power generation market share. Often referred to as renewable energy companion fuel, natural gas infrastructure build-out opportunity will continue to advance on rising demand for the fuel as it displaces coal usage and provides the necessary backstop to the dispatchability of renewable energy. In sum, we believe this sector represents an important, growing component of the broader energy sector, and as a consequence we will incorporate equities to the extent that relative investment merit warrants.
Summary–While there has been significant turbulence in the energy industry over the past few years, we believe 2020 is looking bright for companies that can meet the new energy investor criteria of: 1) living within cash flows, 2) generating positive free cash flow with some growth at lower commodity prices, 3) returning capital to shareholders and 4) maintaining a strong balance sheet. Despite select energy companies making transformational changes in their business models, valuations for these companies remain depressed. We believe this is unwarranted and provides an attractive entry point into energy stocks going into 2020.