When to Take Profit in O&G Producers, Again?

[a_aron1011]

Hi all,

As usual, I am writing this to (a) bounce around ideas and (b) have something written down to check my own self-selective biases and to evaluate my track record as an investor EOY.

I was long in O&G for 2020 (bought XOM at around $32*), rode the Delta Wave in 2021, saw a possibility of making a few extra percentages during Omicron. So I exited O&G, shorted them, exited the shorts and then re-entered on the long side. As oil equities have risen around 10-30% YTD, I am again faced with the question: "what now?"

• *As WTI rose, the risk curve of investing in oil equities shift leftward. To maintain my risk appetite and return, I started transitioning to more levered bets on oil (so XOM to OXY, PDS, OVV). The downside of this is that these names are more sensitive to WTI movement both ups and downs, within a range.

Valuation-wise, O&G equities are still quite attractive compared to where WTI is. Depending on the stickers and where WTI will be in the next 6 months (as long as it stays btw $65-75/bbl), I think o&g equities have another 10-50% run from here. If bad comes to worse, it's still likely that o&g will yield between 10-30% FCF for 2022, absent a recession.

WTI price-wise, $90/bbl WTI, if adjusted for inflation, is actually only equal to about $72 in 2010. Expenses associated with energy consumption as a percentage of GDP per capita (60k today vs. 48k in 2010) are also not outrageous. Unlike most of the oil bulls, I expect the break-even price will rise with inflation as costs of labor and new equipment rise, at least in the short term. If break-even rises to $65/bbl, that $90 WTI doesn't seem so outrageous anymore.

Supply-demand imbalance, there is a considerable consensus among heads of commodity traders of the big banks (with a vocal minority of opposing views) that we're still in the early innings of an energy supercycle. Also, the IEA recently published their report pushing back their previous timeline of when supply will outstrip demand. FWIW, the above views are the market's views.

• I continue to have a middle-of-the-road view btw the two extremes presented by the mega bulls and bears of oil. Conservatively, I think it's safe to say that WTI will continue to stay rangebound btw $65-75/bbl for 2022. However, I expect US shales will become a significant player again and supply will start outstripping demand in 2H2022.
• As such, I have and continue to position my portfolio toward O&G servicers and equipment. Historically, the servicers' profitability lagged the producers by about 18 months. At this point, I am fairly confident that this pattern will repeat this time, absent a recession.

Mass-psychology wise, I continue to think we're in the very early innings of mass euphoria in O&G. There is little to no pumping of O&G in r/wallstreetbets or r/stocks. When there is mentioning, it's usually household names like XOM or CVX. I joke that I will know that we reach peak euphoria when retail starts peddling pre-revenue O&G names. I don't invest based on the assumption that others will become irrational, but it informs my decision of when to take profit.

In conclusion, depending on what happens between now and EOY, I plan to take profit in the O&G producers sometime in 2H2022.

O&G moves fast and things can change in the blink of an eye. As usual, I reserve the option to change my thesis as events unfold (will update if I do).

I receive a lot of counterarguments/pushbacks for my shorts during the Omicron Wave. But I think that made me a better investor. So, call me out.

 

[martaaa]

@a_aron1011 You reach peak O&G euphoria when Putin invades Ukraine. Russia is one of the biggest O&G producers of the world. Ukraine is one of the most important transit countries for O&G with its pipelines.

 

[ericbunic]

@martaaa

You reach peak O&G euphoria when Putin invades Ukraine.

I disagree. You will reach peak O&G when the US somehow is able to co-opt Russia and complete an encirclement of China. Then, the US, with Russia's giddy support, will be able to weaponize oil prices and really punish China and get its hydrocarbon-starved economy to kow tow to the US led world order. Globalization as we know it today may collapse as cross-oceanic trade becomes untenable due to sky high oil prices. This actually helps the US now that it is the #1 global producer.

Not saying any of this will happen or that it even has a high likelihood, just that this is my peak O&G scenario.

 

[a_aron1011]

@ericbunic I think we need to distinguish btw the possible scenarios that can lead to O&G euphoria and how we know we're in the euphoria stage.

For me as an investor, the primary criteria of how I know that O&G has reached euphoria is that stock prices have exceeded even the most optimistic valuation for the next 5+ years (sound similar to SPAC and IPO "projection" for their tech stocks, right?). On the other hand, I have no idea the pathway of how O&G euphoria would/could happen.

 

[ericbunic]

@a_aron1011

For me as an investor, the primary criteria of how I know that O&G has reached euphoria is that stock prices have exceeded even the most optimistic valuation for the next 5+ years

You know, I still remember looking at valuations of homebuilders like DR Horton around 2005. Their multiples were very low then, around 6. Profits were, of course, absolutely amazing, but investors did not push multiples any higher. Then, the collapse occurred.

I see this sector doing something similar. The public will never get excited about this industry. It's like the comparison you made with Big Tobacco, except hydrocarbons are a necessary evil and actually have a net positive utility (well, depending upon who you talk to lol).

So, euphoria will be demonstrated not by public perception of the industry, no FAANG or CANDIE acronym for this sector lol, just cold hard cash, and a dump truck to haul it around.

 

[a_aron1011]

@ericbunic

You know, I still remember looking at valuations of homebuilders like DR Horton around 2005. Their multiples were very low then, around 6. Profits were, of course, absolutely amazing, but investors did not push multiples any higher. Then, the collapse occurred.

I see this sector doing something similar. The public will never get excited about this industry. It's like the comparison you made with Big Tobacco, except hydrocarbons are a necessary evil and actually have a net positive utility (well, depending upon who you talk to lol).

Good point.

 

[a_aron1011]

@ericbunic Just following up that I think we're inching closer to mass euphoria. Retail in r/stocks has been posting daily about oil equities.

 

[ericbunic]

@a_aron1011 I think the recent weeks have demonstrated that oil is primarily political in nature.

Before, the thesis was primarily that of inflation. Now, you have a geopolitical nightmare in Europe with the US reaping the rewards of its ungodly pursuit of a Russian proxy war.

 

[a_aron1011]

@ericbunic Yeah, the Russian proxy war is the black swan that benefited Western oil equities. Usually, black swan kills me, not help.

 

[resjudicata]

@ericbunic I think homebuilders are in a similar place

 

[rnstaplesattnet]

@ericbunic I mean, DR Horton still has a PE of 6.5 or something lol. Just the nature of the business.

 

[ericbunic]

@rnstaplesattnet Nature of oil too. Old, crotchety businesses people don't get excited over. =)

 

[nabila]

@a_aron1011 I’ll sell the Russia invasion peak and the rebuy the following dip.

 

[resjudicata]

@a_aron1011 I’ve been long oil since 2020 as well and don’t have plans to exit my position anytime soon. Oil super cycles last quite a long time and we are just getting started in my view. The fundamental backdrop is incredibly constructive, and it’s quite possible oil prices stay elevated above $70-80 for a few years if not more. Given the capital discipline US producers have exhibited, they are literally printing money at the moment and probably have the most attractive free cash flow yields of any sector at the moment.

 

[rawrr]

@a_aron1011 Investments are low, demand is rising and supply is low.

Prices are going to continue to rise.

 

[a_aron1011]

@rawrr Essentially the consensus view.

 

[jeanjacq]

@rawrr Yup this. Gas done it, oils doing it, having a stock that does both double bubble.

 

[german777]

@a_aron1011 Oil will be expensive at least till end of summer, other events will cause a variation as well- my thought.

 

[ddc9255]

@a_aron1011

If bad comes to worse, it's still likely that o&g will yield between 10-30% FCF for 2022, absent a recession.

Herein lies the premise of your entire thesis. If you're betting on crude producers, you're essentially betting on a continued trend of secular economic growth. I don't have a view of O&G producers, but that seems a little ambitious given the circumstances. Add to that the fact that, as you've mentioned, production costs will continue to rise and essentially you're left betting that these companies will sustain pricing power to maintain margins and offset this.

*As WTI rose, the risk curve of investing in oil equities shift leftward. To maintain my risk appetite and return, I started transitioning to more levered bets on oil (so XOM to OXY, PDS, OVV).

Very good on you to realize this. A company like XOM operates across the entire vertical, not just upstream. This begs the next question (which you also alluded to), which segment of the vertical will relatively outperform in 2022? I tend to agree with you, and believe that midstream will likely do relatively well in an unstable economic environment.



All of this is to say I think you'd be smart to begin taking some profit on pure O&G upstream. If you're invested in vertically diversified, I would likely hold through this cycle.

 

[resjudicata]

@ddc9255 Would Alerian MLP ETF be a good bet for Midstreams? I've not much knowledge of investing in MLPs/oil but know some mid stream companies like GLP and Sunoco - would like to avoid the forms from direct MLP unit buying though.