The energy industry represents a significant portion of the global economy and is essential to modern civilization. The industry is highly capital intensive and prone to volatility caused by commodity price swings, geo-political events and periodic investor panics and speculation.
During the past several months, the marketplace has witnessed yet another major swing in oil prices with the benchmark WTI (West Texas Intermediate) having dropped from roughly $103/barrel, to just under $40/barrel, before recovering to the current $50-$60/barrel price range.
And similar to past periods of speculation and heightened levels of capital spending, supported by high oil prices and cheap credit, the stocks and bonds of energy producers have collapsed. Some of the companies will never recover and several have already sought bankruptcy protection. Nevertheless, taking a long term view, we believe that the recent price collapse presents a significant opportunity for value investors.
That said, we have no idea how long the lower price “deck” will endure, nor when fundamentals will improve. We have been early as evidenced by continued price erosion, but intend to stay the course. Like many cyclical industries, the best opportunities for investing commonly occur when earnings and prospects appear less favorable.
For example, off-shore rig drilling contractor equities can all be bought for a fraction of book value. Book value is a good proxy for “replacement cost” as most of the contractors have recently upgraded their respective fleets.
Market values (stock prices) are depressed versus replacement cost because the daily “rental” rates of the equipment have declined with the price of oil and no longer represent a positive internal rate of return against the original capital cost of the rigs. However, at a purchase price of say 50-cents on the original dollar of capital investment, the prospective return under any recovery scenario becomes a favorable risk-versus-return opportunity.
Investing after a capital spending boom can be advantageous because earnings will need to recover industry-wide before another round of capital outlays is required. The suppression of capital expenditure, as we saw after the real estate crisis of 2008/2009, can result in stronger players reaping benefits when capacity constraints become evident.
Given the potential for a prolonged downturn, balance sheet strength is an important factor in our analysis. Additionally, with respect to oil and gas exploration/production companies, equipment suppliers and service providers, those that can manage their variable cost structure to a less robust environment will benefit the most.
This “boom-bust” industry group is tailor-made for value investing. A value investor takes a long term view as to the earnings power of individual companies over the entire cycle (peak-to-trough) and chooses appropriate entry and/or exit points depending on price. While appearing to be a contrarian strategy in the short-run, effective application requires a multi-year viewpoint consistent with the required planning period for such a capital intensive industry.