“Over the last 120 years, we estimate it took 17 barrels of oil on average to buy one unit of the S&P 500 Index. Today it requires over 53 barrels.”
In the thirty years we have been investing in global natural resource markets, we cannot remember seeing greater value than we do today in the global oil markets. With both crude and oil-related securities, the price action appears to have completely divorced itself from underlying fundamentals.
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By any measure, oil and oil-related securities are radically undervalued. Over the last 120 years, we estimate it took 17 barrels of oil on average to buy one unit of the S&P 500. Today it requires over 53 barrels. The only time it has taken more was during the parabolic dot-com blow off – incidentally, an excellent time to become an oil investor. At the same time, energy-related equities now make up a mere 4% of the S&P 500 by weight. Not only does this represent the lowest level in at least 20 years (when our records begin), it is 75% below the peak levels reached in 2008 at which point energy stocks made up 16% of the S&P 500.
In particular, the bear market in oil exploration and production companies has created value that can hardly be believed. We analyzed the universe of all US-listed E&P companies with market capitalizations over $100mm and proved reserves that are at least 50% oil. We then compared the current stock price to the net-debt adjusted SEC PV-10 measure from their 2018 10Ks. As you may recall, a company’s PV-10 measures the discounted cash flow of all proved reserves at the prevailing oil and gas prices. Under normal market conditions, E&P stocks trade at a premium to their SEC PV-10, reflecting the expected value of any future reserves not yet “booked” in the reserve statement. However, due to the overwhelming bearishness among energy investors, the average company now trades at a 12% discount to its net-debt adjusted SEC PV-10 per share value.
While we have seen individual companies trade at a discount, we cannot recall a time when the industry average was less than its SEC PV-10 value. We should point out that the price used in most companies’ SEC PV-10 analysis for 2018 was $55 per barrel, not materially higher than today’s price.
We also computed the discounted value of the companies’ proved developed producing reserves (PDPs). This represents the most conservative possible measure of value: a company’s discounted cash flow from currently producing wells only. As you might imagine, it is very unusual for an E&P company to trade at a discount to this most conservative measure. Today, we estimate that twelve of the twenty-nine companies in the universe are trading at a discount to their PV-10 value using only their PDP reserves. Furthermore, the average premium to PDP PV-10 value across the entire industry is now only 7%. Once again, we have never seen anything remotely like this before. Investors often act irrationally at the bottom of long, drawn-out bear markets and we believe that is what we are witnessing today.
While the market can famously stay irrational longer than most investors can stay solvent, what we are experiencing today is truly extreme. An entire industry is nearly priced as though it will simply run off its existing assets. How can this be?
We believe there are simply no buyers left. In past cycles, as energy prices fell and E&P stocks sold off, two groups of investors would begin to accumulate positions: natural resource specialists and value investors. Our analysis tells us that natural resource funds continue to suffer material redemptions as investors look to reallocate capital away from the industry. We estimate that nearly 25% of the industry’s assets under management are flowing out through redemptions each year and this figure shows no sign of abating. As a result, resource fund managers are constantly forced to sell positions to meet redemptions, instead of stepping in to take advantage of the deep value.
Value managers are also suffering net redemptions. After a difficult ten-year period, growth continues to outperform value and investors continue to chase the momentum of the former by selling the latter. In past cycles, value investors could be counted on to buy during extreme bear markets. but today they are either on the sidelines or liquidating positions to meet redemptions as well. In fact, active managers in general are seeing capital being allocated away into passively managed index funds. As we mentioned earlier, energy now makes up its lowest ever weighting in all the major indices. Therefore, as capital gets redirected from actively managed funds towards passive index funds, energy shares end up being liquidated.
There are no natural buyers for natural resource stocks in general and energy stocks in particular. This has allowed the sell-off to be more severe than past cycles and resulted in unprecedented value for those able to invest in this most contrarian space.
In our latest in-depth commentary, WHAT IS HAPPENING TO US SHALE PRODUCTION?, we explore this subject and many others. If you are interested in reading the document, download the full commentary here.
