Is it late-cycle? Does a hard landing loom? Or is the US economy on the cusp of re-accelerating, or at least dodging a recession on the way to a prolonged period of steady growth?
Nobody knows, least of all the Fed. If you ask Morgan Stanley’s Mike Wilson, it’s best to avoid answering such questions until there’s more clarity, and one way to exercise caution is via a barbell of defensive growth (so, compelling idiosyncratic growth stories and traditional defensives, including Healthcare) and late-cycle cyclicals.
On the latter (i.e., when it comes to late-cycle cyclicals), he likes Energy. Black gold. Swimming pools, movie stars.
As ever, Wilson’s pitch sounds compelling, trenchant and well-reasoned. With Mike, the problem is never plausibility or analytical rigor. The problem for Wilson (at the index level) in 2023 was basically just that he’s a rational guy analyzing a notoriously irrational asset. Fortunately, his 2022 calls were astoundingly accurate, and let us not forget that he also predicted 2018’s Q4 mini-bear market.
Anyway, here’s Wilson’s short rationale for the Energy preference, along with a handful of the relevant charts:
The sector is historically a late cycle outperformer that is often supported by commodity strength in such backdrops. In today’s environment, oil demand is strong, production cuts have been significant and our commodity strategists see crude prices underpinned around current levels. After underperforming from November of last year into July of this year, the sector’s relative performance has once again turned up though valuation remains quite attractive on both an EV/EBITDA and FCF yield basis. Further, earnings revisions have recently reaccelerated for Energy and for the majority of subgroups within the sector. Free cash flow generation is robust and net debt-to-EBITDA remains low relative to history as investment discipline has been a prominent theme for the space this cycle. Finally, positioning is once again light for the sector as evidenced by hedge fund net exposure levels which have declined this year and are low in a historical context.
Obviously, an outright recession could hurt energy shares given the read-through of a hard landing for demand, but if you think Xi Jinping will ultimately manage to rescue the Chinese economy from the deflationary abyss, and you believe Mohammed Bin Salman and Vladimir Putin will succeed in putting a floor under crude prices, then you can conjure a decent macro case.
I’m admittedly biased. As regular readers are apprised, I’ve been Overweight energy for nearly three years now, with no plans to sell. That, despite my deep misgivings about humanity’s disregard for the biome that’s so generously harbored our species for millennia.
As I put it in “Oblivion,” describing myself, “I’m somewhat unique in being a progressive who acknowledges our species’ dire predicament while simultaneously conceding an almost complete lack of concern. Although some find that juxtaposition distasteful, it puts me at an advantage with various sorts of climate deniers. There isn’t an oil baron or hardline conservative on our withering planet who cares less about this issue than I do. I’m the progressive who knows the planet is dying and loaded up on oil and gas stocks during the first half of 2020.”
H: liked your Beverly Hillbillies reference:)
No coal?
Warren Buffet also believes clean energy transition via a monopoly/cartel is profitable =p
I like energy stocks, was very overweight in 2H21 and ‘22, still overwt in ‘23. Consumption of oil, natgas, coal is not going down, the producers have discipline, investment is getting pulled back, and commodities tend to work during inflation.
At some point, fossil fuel consumption will peak. I think you can look at increasing EV penetration and renewable energy investment and make some educated guesses of when that might be. IEA thinks about 2030; I haven’t done the work and have no idea if that’s reasonable, but feels like it isn’t going to be 2050+. Price might keep revenues going for a while after that, but the stocks will front run the peak.
When I value the stocks, I use negative terminal growth rates, and I look for high FCF and dividend yields.
Basically I think we may be enjoying the autumn of fossil fuel stock investment, but the goodbye will be long and, for a while, profitable.
Hopefully renewable energy will become investable. I’ve looked at solar, wind, etc – repeatedly – and found very little to buy, among US names anyway. Well, there’s one EV name but it seems to fall squarely outside of my “style”.
https://www.independent.co.uk/tech/battery-price-increase-electric-car-lithium-b2414028.html
The IEA’s forecast is more bearish than I’d thought. See IEA report https://iea.blob.core.windows.net/assets/6ff5beb7-a9f9-489f-9d71-fd221b88c66e/Oil2023.pdf
“Growth in world oil demand is set to lose momentum over the 2022-28 forecast period as the energy transition gathers pace, with an overall peak looming on the horizon. Led by continued increases in petrochemical feedstocks, total oil consumption growth will remain narrowly positive through 2028 as usage rises to 105.7 mb/d, 5.9 mb/d above 2022 levels.
Crucially, however, demand for oil from combustible fossil fuels – which excludes biofuels, petrochemical feedstocks and other non-energy uses – is on course to peak at 81.6 mb/d in 2028, the final year of our forecast. Growth is set to reverse after 2023 for gasoline and after 2026 for transport fuels overall. These trends are the result of a pivot towards lower-emission sources triggered by the global energy crisis, as well as policy emphasis on energy efficiency improvements and the rapid growth in electric vehicle (EV) sales.”
The IEA thinks that the OECD’s oil demand may peak this year, while India and China’s demand will continue growing.
On the supply side, Russia’s invasion of Ukraine, sanctions therefor, and dimming opportunities for Western oil companies in Russia and in the Middle East have lit off a push for new sources in non-OPEC+ places where supermajors can still lead – Algeria, Guyana, Nigeria, Azerbaijan, etc. While US production stagnates and OPEC+ restricts supply, very significant increases in production are coming from those fields. Maybe more on the gas side, but offshore oil too.
I can see a scenario in a couple years where this new supply growth collides with slowing-then-peaking demand. Assuming the OPEC+ countries will have failed to develop an economic alternative to oil and gas, which seems highly likely, cartel cohesion may not last.
Hopefully I’ll be out of energy names by then.
Reminder to self: fossil energy is a years-long-trade, but not a buy-and-sit-on.
Reminder to self: you’re never the first, and often among the last, to see things.
I hope that Algeria, etc. (which are already corrupt dictatorships that are jailing dissidents and creating ties with Russia/China), don’t join OPEC+++
I speculate that countries where production is led by Western oil company consortia are less likely to join OPEC while countries where production is directly under the government’s control are more likely.
I find it extremely frustrating that the US energy policy is causing inflation for the Americans and simultaneously enriching the authoritarian, anti-American, dictatorships around the world.
Even though I have made some money on oil stocks- it hardly seems worth it.