The Dividend Cafe - The Energy Famine Has Become a Feast

Episode Date: January 28, 2022

I understand it may seem odd to devote a Dividend Cafe to the particular subject of the Energy sector in a week of surreal market volatility and media obsession over the Fed. But in fairness, I write about the Fed almost every week, plus four days a week in The DC Today, and the entire subject of monetary theory underlies all that we do in capital allocation at The Bahnsen Group. Our nuanced views on the role the Fed currently has in financial markets are known, and to co-opt my planned Dividend Cafe subject yet again to cover the thrilling story of the Fed moving interest rates exactly how we knew they would, is not going to happen. But the Fed was not the only story (non-story) this week. Markets are in a pattern of daily incoherence as traders, algorithms, novice investors, speculators, and other such inconveniences work through the challenges of a paradigm shift. What the futures say at night has nothing to do with what they will say in the morning which has nothing to do with what they will say at the open which is fully disconnected from intra-day activity which then leads to a totally unpredictable market close. Then, rinse and repeat. So I’ve written about our low opinion of “shiny object” investing, and the avoidance of such has a lot to do with the way our January has (thus far!!??) gone. But the energy sector is up +18% this month as of press time in a YTD market that has a Nasdaq down -15% and S&P 500 down -10%. We need to look at that. Is Energy becoming a new “shiny object”? Is the sector a trade or a long-term opportunity? What aspects of energy investing appeal to us right now? Where do environmental, political, and macroeconomic concerns fit in? These subjects all deserve their own Dividend Cafe, and that day is today. So jump on into the Dividend Cafe … Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to another edition of the Dividend Cafe. I am extremely excited about this week's Dividend Cafe because I am successfully resisting the temptation to want to talk more and more about market volatility and shiny objects and all the things that have been in the market. But I really do feel that me writing about it every day in DC today, dedicating last week's Dividend Cafe to it, not to mention pretty much everything that's come out of my mouth about this subject for well over 20 years, I think ought to be enough for now.

So, yes, a lot of volatility, a lot of incoherence, and a lot of erratic stuff going on in the markets. And yet, I really think that we are wise to stick to our plan this week to discuss the subject of energy. stick to our plan this week to discuss the subject of energy. And so the energy sector is a topic that's near and dear to my heart and has been for quite some time. It's been a big source of client portfolio activity for good and for bad for a long time. And I want to unpack where I believe we are in the U.S. energy sector and what that means to investors. The energy sector has traditionally been a large part of the S&P 500. It's been a large part of the American economy. There have been times when one of the largest energy companies in the sector was one of the largest companies in the world and in our country, of course. And yet the entire energy sector put together now has become a very, very, very small part of the market.

And much of that has to do with a lot of changes that have taken place over the last decade that I'm going to unpack for us here today. But what we do know is that when I mentioned this market volatility we're dealing with, and for some people what feels like market distress, The NASDAQ being down, as I'm sitting here recording, about 15% since the year started. And the energy sector being up about 17% or 18%. That is a massive delta. A 30% plus difference between energy sector performance and the overall market. Even the S&P is down about 10. And one of the things that sticks out to me about this is not just the absolute return difference, what a huge delta you see in what's a short period of time. It's only been a few weeks.

It could reverse. It doesn't have a whole lot of relevance other than this month that obviously the numbers shine very differently. But what sticks out to me is that there have been eight times since the financial crisis that the S&P has gone down between 10% and 20%. Oh, excuse me. In one case with COVID, even more than 20. Okay. And in the eighth time being what we're dealing with right now. Okay. So seven out of seven times, the S&P went down over 10%. Energy did worse than the market, whatever the market was down, whether it was one of its 10% declines or the COVID case, the 34%, you had two different roughly 20% declines, one in December of 2018 and one in the summer of 2011.

In all of those cases, energy did worse than the S&P. And yet right now, this is the first time since quantitative easing began, since the financial crisis ended, that the relative performance of energy is not just better than the market, but massively better. Well, is this a changing of the guard? I don't want to understate the technical strength in the sector. Over 80% of the constituents in the energy sector are at all time relative highs to the S&P. It's a pretty amazing experience. And as I talked about in our year in review paper a few weeks ago, energy was the top performing sector last year, somewhere around up 50% on the year. And now it started off this year ferociously. And we know the oil price is a big part of it.

Oil is indeed up substantially here in the year. Last year, oil went from roughly 50 to roughly 70 and now has gone into the mid 80s. So you have big percentage movements higher, no surprise related to supply, demand and balances. In this case, an undersupply relative to growing demand. When oil prices collapse, it's usually also a supply, demand and balance, but inverted where you have excessive supply and collapsing demand. Well, this is not the entire story of the energy sector, just simply going higher with oil prices. You do get slightly better margins when you're a producer selling oil when it costs more,

but volumes are a huge part of what are necessary to drive profitability in the energy sector. Confidence in the continuation of higher volumes, confidence potentially in the continuation of higher prices. And then for the midstream sector, meaning not those that are producing oil, but that are in the business of transporting oil for those producers, moving it from one place to another destination. It's a space we're heavily invested in at Bonson Group. You need high volumes and the expectation that there will be growth behind those volumes, new projects, new opportunity to store and transport oil and gas. So I want to do a quick kind of look back as to what has happened. And I divide it up into two events or two eras, all within the last seven years that I think had a similar conclusion, but a totally different causation. Okay, a similar conclusion,

totally different causation. And the biggest issue I'm referring to by way of causation. Okay, a similar conclusion, but totally different causation. And the biggest issue I'm referring to by way of causation is the lack of capital, that a sort of capital constrained dynamic entered the oil and gas energy sector. And that is an industry that is desperately in need of capital because of its capex intensity. Capital expenditures in oil and gas, much like real estate, much like industrials, is very expensive. It costs a lot of money for the capital expenditures that are needed. And yet, for the capital expenditures that are needed. And yet, you ran into a buzzsaw as an energy investor when the capital train stopped running. And what happened in 2015 is that companies, both upstream and midstream, that had become very dependent on access to capital, whether it was debt or equity, had a very low cost to capital, had plenty of access to capital. And that capital was used

to fund new growth and new growth was used to collateralize new capital. And it was this positive feedback loop everyone was loving. And this can often happen in positive feedback loops when one kind of domino goes astray, it leads everything else astray. And oil prices dropped significantly. And then you had a lot of pressures on margins, which disincentivized growth projects, took away capital. By losing capital, it really took away future growth projects. And there was sort of a negative feedback loop. It really took away future growth projects. And there was sort of a negative feedback loop. It cascaded around the whole sector.

And again, this is applicable in both upstream and midstream. And so that forced a couple of years that I am going to argue will prove in history to be some of the most fruitful years imaginable for the energy sector, even if they were quite difficult at the time. It forced new levels of governance as to the way some of these companies were set up. I write about it at DividendCafe.com today, the economic relationship between the general partners and the limited partners at a lot of these pipeline companies. Incentives weren't totally aligned. Some of the practices were not good governance. They were getting away with it until they couldn't.

And the cost of capital became inhibitive. And there's this thing called incentive distribution rights that pretty much have now gone away. That used to be a big problem, in my opinion. You had companies that were over-levered, that had inadequate debt to income ratios and debt to asset ratios. In a lot of cases, they were giving out more than the cash flow of the business. It's not sustainable. So credit quality deteriorated, fiscal decisions became quite foolish, governance was astray, and the industry lost confidence

in the willingness to fund much of the United States energy sector. And those things had to get rectified and rectified they did. And not only did you end up getting a lot more fiscal discipline, a lot more capital allocation, wisdom, but you got it at a time when you had a now very friendly administration in the White House, majority rule in the Congress. You were able to get a lot more projects approved that had previously not been approved. And so things were seemingly headed to a better position for what had been very difficult for a number of those years as they kind of had to write some of the wrongs and,

and deal with the fact that capital markets as a market mechanism, as a market function had largely cut off the industry. When you need equity to fund projects and then you're losing your growth trajectory, you then have much higher priced projects because your cost of capital has skyrocketed. And then that leads you to have to cancel projects. Well, that leads you to a lower growth expectation, which leads you to less access to capital. And this was happening over and over again, these kind of spiraling negative feedback loops. And so growth expectations became very minimal.

Cost of capital became high. Profit margins became low. And in a lot of cases, just survival of some of the individual companies was at stake. But as those things improved, as decisions started being made better, as some of the weak companies went away, you had this palpable feeling of improvement. And you had an administration that was now friendly from a political standpoint and regulatory standpoint. And yet we then go into phase two of what I'm referring to about capital constraint. And that was this just avalanche of what is often referred to as the ESG movement. support the fossil fuel industry, of activists preaching out against any banks that would be lending to oil and gas companies, Hollywood celebrities having their opinions about

the green safety of some of these companies. And so between politicians and celebrities and think tanks, and especially capital allocators, the perfect storm of awful for the energy industry in terms of their access to capital. Originally, it was markets cutting them off. They righted a lot of that chip. And then it was sort of the culture cutting them off. And you think, well, this can't really get worse. And then we have this thing called COVID. So now all of a sudden, supplies are through the roof and demand goes to nothing as the whole world shuts down. and the world starts to reopen, but there's a long road to hoe in front where the one positive factor that had been contributing to the energy sector over the last several years was a friendly administration

from a policy and regulation standpoint, and that goes away. You have a new election, and now there's kind of intensified antagonism towards the oil and gas industry in the new political environment you really kind of couldn't make it up you really couldn't make it up the um successive conflicts of access to capital markets combined with the change administration combined with the the covid moment. And then what happens? It becomes the top performing sector last year.

Well, counterintuitively, a lot of the reason it was the top performing sector was because of all these problems that they got so priced in and they attracted new capital because the expected rate of return got beat up by all the antagonists, so successfully pushing down the current market pricing. And so it allowed for a big opportunity, and opportunity draws investors in. A lot of those investors were richly rewarded for that. But you also had a lot of innovations in American capital markets. Now, mind you, private equity and private credit coming into oil and gas has been an overwhelming positive for their ability to navigate the difficulty in accessing capital. But it has come at a higher cost to capital than public markets.

I've read studies that say it's roughly about a one and a half percent per year premium. Well, you're talking about industry. There's many tens of billions of dollars of debt and equity capital regularly going into new projects. A one and a half percent delta is a significant amount of money and the capital cost. So there is still a price to be paid for this sort of capital censorship, but they have navigated and found ways through non-bank lenders and non-traditional lenders and investors that have read to new forms of access to capital. So what do we think happens from here? I believe that the returns now draw more capital in. And just as negative returns facilitated no capital flows at a point in

which people were using ESG, using other arguments to avoid funding the sector. The arguments that natural gas is actually a much cleaner fossil fuel, that the energy needs of the world were going to be met somewhere. And if they were not being met by the cleaner American gas industry, would be met by the dirtier coal industry or the dirtier Chinese gas and oil access or Russian gas and oil. Those seem to have fallen on deaf ears before. But a cyber attack on a pipeline last year, $6 natural gas prices, $4 gas tank at the pump, right now $87 oil. And all of a sudden, some of the sort of virtuous arguments against investment oil and gas have flipped. And I believe there are plenty of true believers that do not think there should be funding into a cleaner oil and gas sector.

gas sector. I'm one who believes in reducing carbon emissions and believes that that ought to come and be presented in a way that's realistic and viable and feasible and has to take into account the real alternatives and the opportunity cost. And so regardless of one's own environmental take on it, my view is that the environmental take that has largely served as a headwind. I don't know that there will be the same aversion going forward that there has been. I believe there will be a massive aversion and certain pension funds and certain virtue signalers, certain politicos, certain celebrities, that doesn't go away. But I don't think that the cultural moment stays in tandem with the economic moment quite to the degree it has the last several years. Because I think a lot of the marriage between the economic censorship and the cultural moment was a marriage of convenience. It's very easy to

be opposed to investing in something that is performing terribly. And when it's performing very well, it sort of changes. And then people become receptive to some more rational or counterintuitive environmental arguments or whatever the case may be. So this is much more of a descriptive commentary than prescriptive. It's not really a secret what I personally believe ought to be the policy framework, but that's not my point. My point is what I think it will be. And I think that there will still be plenty of aversion, which still adds plenty of risk premia to the sector.

plenty of aversion, which still adds plenty of risk premia to the sector. But I do not believe that there will be a total inaccessibility of capital in the oil and gas space. I don't think we can afford it. I don't think it's functional or manageable. And I think it creates a bit more normalcy and opportunity. Ironically, some of the stuff that we love so much, invested in heavily, done so well in, it's now almost like price to a point where we want to trim it down a little bit just from a valuation standpoint. And that is kind of the tug of war that goes on here. And some people hate something enough that they bid it way down. And then the people that love it bid it back up. Somewhere in there, you get a market. You don't just get a culture war.

You don't just get social tension, ideological disagreement, environmental debate. You get a market. And that's what we're here to talk about. And I think that the market for the energy space is still to be determined by fundamentals. We will not make a decision about investments on anything other than the free cash flows, the fiscal stewardship, the return of capital to shareholders through a growing stream of dividends, balance sheet, of dividends, balance sheet, sustainability. Those things are how we would adjudicate any other sector. And we want to do the same in energy and be more discriminating. There cannot be a love affair or a vendetta against any particular aspect of the market for a fiduciary asset manager.

against any particular aspect of the market for a fiduciary asset manager. And from a moral standpoint, that opens up a different can of worms and different conversation. But our viewpoint is that there's simply no question. There's no denying that people need gas to heat their homes. So we are not talking about having gas or not having gas. We're talking about how responsible we want to fund the gas operations that help bring heating to American homes and fuel for airplanes and automobiles and other aspects of our society. I've tried over the years to talk. I don't even get into this Dividend Cafe this week. So you're actually getting a little bonus feature right now on the podcast and video that didn't make it in the written commentary.

If we understood how much natural gas liquids played into cosmetics, into plastics, into bags, into consumer products, into household items, we wouldn't just be thinking about dirty automobiles with this topic. It's a significant part of American life. We have a responsibility to do this with right stewardship. I believe there is a successful path to reducing carbon emissions. We've seen our carbon emissions be able to decline from better investment, better technology. But I also believe that we cannot hold it up to a nirvana standard that simply is not going to happen. So all of that creates an investable opportunity. Those prices reflect that a lot of new capitalists come back in the space. A lot of value has now been recognized. It's not as cheap as it was. There's certain elements we continue to think are opportunistic. The midstream side is at the top of that list. We still think there's beautiful yield spreads. Enough people were probably burned in that space that there's a limitation to the

investors coming back in. That is not a negative. That is an opportunity for an investor to take advantage of it because all things find their real value through time. That's all we're talking about with energy space is finding real value, investing in it. And that's our job here at the Bonson Group. I hope this has been helpful. I hope it's been kind of a little 10-year rundown. I didn't want to complicate it by going back into the 60s, 70s, past conversations about totally inadequate supply, where we go into the future, people believing that we'll have an oil or gas-free society in a few years. Just in the realistic here and now, the moment where we've been in recent years and where we're going,

we want to responsibly steward client capital in the right direction. And this includes energy space. And hopefully I've explained why, even where some of the policy decisions we may disagree with have not hurt the industry's ability to continue functioning. And on the margin, they can always compress it by controlling volumes. But even those things seem to be self-correcting over time as people and voters and taxpayers and consumers demand lower prices that can only come about from higher supply.

That's my take on the energy sector in the United States. I hope it's been helpful for you. I hope you've enjoyed listening to and watching the Dividend Cafe. And we look forward to coming back to you next week. I'll be back in the California office. And who knows what the week in the market will bring. We expect it'll be exciting. Thanks for listening to the Dividend Cafe. Thank you. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary and does not constitute investment advice.

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