Why Energy? A Brief Historical Perspective

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Over the past six months or so, energy has become a much larger weight in our Canadian Equity portfolios.

Using charts from a data visualization software that we use at Cambridge Global Asset Management (“Cambridge”), I want to describe what has attracted us to find good value in the energy sector and how and why we have built our exposure in this sector.

Energy has not been a good place to invest over the past five years. Globally, multiples in the sector compressed as sentiment deteriorated. This was due to both short- and long-term drivers: 1) an increased supply from U.S. shale oil producers (a driver of weak commodity prices), 2) a swing to less business-friendly governments (especially in the U.S. and Canada), 3) region-specific challenges (including decreased investor interest in Canada), 4) concerns about long-term demand, and 5) a new focus on ESG (environmental, social and corporate governance) considerations. After understanding these qualitative factors, we then decided to take a closer look at companies in the Canadian energy sector.

As a reminder, across all of Cambridge’s portfolios, we look for companies that can create value over time (i.e., returns above, or expected to be above, their cost of capital going forward). The best time to buy a business is when the market is not reflecting this opportunity; this is when alpha is generated. We can summarize this process by comparing what premium the market is paying to invested assets (i.e., enterprise value/invested capital, or EV/IC) to the returns the businesses generate (i.e., return on invested capital, or ROIC1). Earlier this year, Stephen Groff (Cambridge Partner and Portfolio Manager) wrote a complementary blog post, delving into how we create portfolios of companies that are high-quality, free cash flow–generating businesses trading at attractive prices, and how we are currently finding several opportunities in the Canadian energy sector.

Energy Sector: Pre-2008

Prior to 2008, energy stocks were trading at high multiples versus history, and they generated solid returns. Oil prices climbed higher based on several factors, including new demand created by China and other high-growth economics coupled with a lack of supply. At the time, the Canadian oil sands was an important source for growth in the supply of oil. The good times were interrupted by the global financial crisis of 2008–2009, during which commodity prices collapsed. Returns and valuations fell, as indicated by the arrow in the chart below2:

Chart 1: S&P/TSX – Energy Sector EV/IC vs. ROIC, 1998–2018

S&P/TSX – Energy Sector EV/IC vs. ROIC, 1998–2018

Source: Cambridge Global Asset Management, November 2019.

Energy Sector: 2010–2014

While commodity prices recovered after the financial crisis and even benefited from geopolitical dynamics in the Middle East, a new challenge emerged. The lack of demand as well as new supply sources kept commodity prices well below prior peaks. In Canada, significant capital continued to be invested in energy projects (some rerouted to unconventional resources) and created a highly inflationary environment within the oil sands sub-sector. Despite the increased price of oil, returns from energy stocks deteriorated because the incremental returns deteriorated, and valuations remained lower than the prior peak, thereby destroying value (see charts 2 and 3 below).

Chart 2: S&P/TSX – Energy Sector EV/IC vs. ROIC, 1998–2018

S&P/TSX – Energy Sector EV/IC vs. ROIC, 1998–2018

Source: Cambridge Global Asset Management, November 2019.

Chart 3: S&P/TSX – Energy Sector EV/IC vs. ROIC, 1998–2018

Energy Sector EV/IC vs. ROIC, 1998–2018

Source: Cambridge Global Asset Management, November 2019.

Energy Sector: 2014–2016

Oil and gas companies had it rough during this period, with industry returns hovering around zero. In late 2014, the energy sector experienced a second oil-price shock when the Saudis announced they would defend market share against U.S. shale producers, flooding the market with supply. Returns and valuations fell further as commodity prices declined, and there was a dramatic reduction activity in order to survive. That said, this shock triggered companies to have more capital discipline (i.e., getting their cost structure and balance sheets in order). – likely by choice (companies are getting smarter since after a certain point, they can’t continue to destroy value) or force (companies have no choice since banks are shrinking their line). Returns started to improve because of this, but valuations continued to decline (see chart below).

Chart 4: S&P/TSX – Energy Sector EV/IC vs. ROIC, 1998–2018

Energy Sector EV/IC vs. ROIC, 1998–2018

Source: Cambridge Global Asset Management, November 2019.

Energy Sector: 2016–2019

The past three years, we’ve seen improved returns for energy companies. As companies started to improve returns, they also began to experience a significant lack of available capital.

Chart 5: S&P/TSX Sectors – EV/IC vs. ROIC, 2018

S&P/TSX Sectors – EV/IC vs. ROIC, 2018

Source: Cambridge Global Asset Management, November 2019.

While we can’t forecast demand, we do know that supply lags capital invested. Capital expenditures and assets are down 50% and 30%, respectively, since 2014 on a global basis (see charts 6, 7 and 8 below), which offers support for energy prices even if demand happens to be weak for a short period of time.

Chart 6: U.S.-listed Energy Stocks’ Total Capital Expenditures, 2003–2018

U.S.-listed Energy Stocks’ Total Capital Expenditures, 2003–2018

Source: Cambridge Global Asset Management, November 2019.

Chart 7: U.S.-listed Energy Stocks’ Total Assets, 2003–2018

U.S.-listed Energy Stocks’ Total Capital Expenditures, 2003–2018

Source: Cambridge Global Asset Management, November 2019.

Chart 8: Canada Energy Net Debt & Equity Issuances, 2000–2019

Canada Energy Net Debt & Equity Issuances, 2000–2019

Source: AllianceBernstein, November 2019.

Energy Sector: The Present Day and Going Forward

Today, the valuation discount in the Canadian energy sector appears to be the best in the past 20 years, even though returns are close to average over that time-frame. This bodes well for incremental returns going forward. There has been a significant decline in capital invested and capital being spent in a commodity industry with relatively short capital cycles, which is why incremental returns will continue to improve. Going forward, it appears the trend will continue as we move into 2020.

Of course, the next step in this analysis is to look within the energy sector for appropriate risk-adjusted opportunities. The ordinal ranking of risks by sub-sector (see chart below) would be oil and gas storage and transportation, then integrated oil and gas, and finally oil and gas exploration and production (E&P).

Chart 9: S&P/TSX – Energy Sub-sector EV/IC vs. ROIC, 2014–2018

S&P/TSX – Energy Sub-sector EV/IC vs. ROIC, 2014–2018

Source: Cambridge Global Asset Management, November 2019.

This ranking is also confirmed operationally; oil and gas storage and transportation tends to be regulated or at least semi-regulated, providing more stable cash flows and returns. Integrated and E&P companies take on much more earnings volatility due to their exposure to commodity prices.

With our preference for downside protection, our first area for analysis has been the oil and gas storage and transportation companies. As you can see in chart below, other than 1998–1999 (the peak of the technology bubble) these companies have not been cheaper in the past 20 years, on average trading at a 30% discount to median, on an EV/IC basis. It’s worth noting here the upside to the equity is significant when looking at EV/IC as the debt portion of the EV calculation is fixed, so all multiples expansion will accrue to equity holders.

Chart 10: S&P/TSX – Oil and Gas Storage & Transportation Sub-sector EV/IC vs. ROIC, 1998–2018

S&P/TSX – Oil and Gas Storage & Transportation Sub-sector EV/IC vs. ROIC, 1998–2018

Source: Cambridge Global Asset Management, November 2019.

While returns have compressed over that time-frame, so have interest rates. Using our bottom-up analysis, we own the companies where we expect returns to improve. We have a portion of our exposure to companies with this quality of returns, limited downside and upside potential from improvement in commodity prices and capital allocation. We also believe there are opportunities in areas that are sensitive to changes in commodity prices. E&P companies specifically are trading at a 40% discount to their historic EV/IC multiples, while earnings are close to the median over the 20 years (see chart below).

Chart 11: S&P/TSX – E&P Sub-sector EV/IC vs. ROIC, 1998–2018

S&P/TSX – E&P Sub-sector EV/IC vs. ROIC, 1998–2018

Source: Cambridge Global Asset Management, November 2019.

While the E&P space offers a compelling hunting ground for investments, business models are quite diverse. Fortunately, without a lot of active investors eyeing the space, we are finding that both high- and low-quality business models are trading at similar valuations, giving us an opportunity to reduce risk in this part of our portfolios while still participating in the upside opportunity we see. Across several of the Cambridge funds, our clients will see more than their historical averages in the energy sector increase in what we believe to be companies that provide the best risk/reward opportunities.

The Canadian energy sector is providing opportunities for investors we have not seen in 20 years. We have been able to build a conservative portfolio exposure to businesses in the sector, through which our clients will benefit from improvement in fundamentals and sentiment. We believe we are doing so while understanding and minimizing the downside risk of investing in the sector where possible.

Brandon Snow, CIO & Portfolio Manager

 

  1. To standardize tax charges, ROIC is calculated on an after-tax basis assuming 20% tax rates for all companies in the data set.
  2. The size of the bubbles in the chart above and others below represents the amount of assets for each data point.

 

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Published December 2, 2019

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