Market Commentary: Energy’s June Pullback is a Buying Opportunity
“The first half of 2022 brought on the combination of macro financial and economic challenges that investors haven’t seen in decades…2022 ranks as the worst start in 50 years for both stocks and bonds with global equities markets down 20% and the Aggregate Bond Index down about 10%.” — Larry Fink, Blackrock’s founder, and CEO, said on the company’s second quarter earnings call.
The energy sector fell into bear market territory in June. Recession fears are roiling markets, pressuring commodity prices, and adding to volatility. Specifically, the S&P 500 was down approximately 8% for the month of June and 20% in the first half. Technically, the S&P 500 energy sector fell into bear market territory in June (a peak decline of 20%) following its 52-week high on June 8. The decline was steep and swift as the sector ended the month down approximately 17%, but energy still gained 32% in the first half. At month end, WTI crude oil and Henry Hub natural gas spot prices were down approximately 6% and 23%, respectively, but also still up for the six months (41%, and 45%, respectively). Relative to their year-to-date peaks, the energy sector ended the month down 22%, while oil and natural gas were lower by 13% and 31%, respectively.
An average bear market correction of 30% would suggest that there is still downside risk in the S&P 500 to ~3350, in our view. The broader market’s valuation seems reasonable based on projected price-to-earnings multiples of approximately 16.9x and 15.2x consensus earnings estimates for FY’22 and FY’23, but this may give investors a false sense of comfort if projected earnings estimates need to be revised lower.
We are more sanguine about the prospects for the energy sector. We believe that oil and gas companies are likely to report strong second quarter results and stick to the playbook that has been working: namely, focus on returns, generate free cash flow, continue to pay down debt, and return cash to shareholders via dividend increases and share buybacks. The physical market for commodities is likely to remain tight, notwithstanding any future volatility. We would continue to overweight energy, dividend paying stocks, and defensive sectors.
In our view, the positive fundamental outlook for energy remains intact with companies poised to generate substantial free cashflow and deliver above-average dividends.
Given the strong increase in crude oil and gas prices, EPS for the S&P 500 Index's energy companies is forecasted to increase by ~243% year-over-year in Q2’22, according to Credit Suisse. This compares to a decrease of about 3% for the S&P 500, excluding energy companies. For the upcoming Q2’22 earnings season, we expect upward earnings revisions to consensus FY’22 and FY’23 estimates for energy companies. In contrast, other sectors’ earnings are likely to be negatively impacted by inflationary pressures and economic slowdown. Inflation in the U.S. has reached a 40-year high with the CPI up 9.1% year-over-year in June. Energy’s likely strong Q2 earnings results and positive outlook could highlight the sector as a bright spot in the stock market and serve as a catalyst to catapult stocks higher in the near-term.
Source for Data: Credit Suisse; Chart: Baidi Wang/Axios
SIGNS OF VOLATILITY PERSIST…BUT DOWN FROM YTD HIGHS
Markets don’t like uncertainty!
Uncertainty equates to risk and manifests as market volatility. Russia’s invasion of Ukraine, coupled with a precarious economy and multiple strains of the Covid virus conspire to heighten market uncertainty and investors’ fear. Consequently, we expect stock market and crude oil price volatility, as measured by the Cboe’s Volatility Index (VIX) and Crude Oil ETF Volatility Index, respectively, to remain elevated, but not excessive by historical standards (please see charts below). As a reminder, the VIX is a measure of constant, 30-day expected volatility of the U.S. stock market based on S&P 500 call and put options, while the OVX is “an estimate of the expected 30-day volatility of crude oil as priced by the United States Oil Fund.”
The VIX index measured 27.29 (as of 7/12/22), which has been trending down slightly from the June average of 28.2 and monthly max of 34.02 on 6/13/22. Notably, the VIX’s year-to-date peak was 36.45 on 3/7/22 and the five-year peak was 82.69, during the beginning of the pandemic on 3/16/20. In comparison, the OVX was 54.4 (as of 7/12/22), which was up from the June average of 47.1 and monthly max of 49.19. Like the VIX, current OVX levels are materially below the year-to-date peak of 78.91 on 3/7/22 and significantly below the five-year peak of 325.15 on 4/21/20.
Five-Year Market Volatility (2018-22)
Source: Cboe Exchange, Inc.
Russia’s revenues Increase while its exports decline. According to the International Energy Agency (IEA), compared to a post-war peak level in April, Russian oil exports in June were 530,000 bpd lower, (7%), but its export revenues were up by $2.3 billion, (13%) to just above $20 billion. No wonder the U.S. and EU are contemplating putting a price cap on Russian oil. It’s a conundrum, the world needs Russian energy, but also wants to punish it for invading Ukraine.
OPEC is at near capacity. The record OPEC+ production cuts are scheduled to be fully phased out in August. The only two countries with meaningful spare capacity are Saudi Arabia and the UAE. If, as planned, Saudi Arabia produces 11 mmbpd in August, its spare capacity will shrink to about 1.2 mmbpd; while if the UAE produces 3.2 mmbpd in August, its spare capacity will fall to less than 1.0 mmbpd (Source: IEA, July OMR). This equates to about 2% of global demand of ~ 100 mmbpd and suggests to us that any supply disruption could cause oil prices to spike.
PERCEPTION VS REALITY
Let’s dispel some misperceptions:
#1: Clean energy zealots are no longer demanding the end of fossil fuels.
The narrative is changing as energy security and affordability move to center stage. Europe is facing an energy crisis (not unlike OPEC’s 1973 oil embargo) as Russia has weaponized its energy. An extraordinarily hot summer only exacerbates the situation! On the one hand, we have the world seeking more oil, natural gas, and coal, and on the other, clean energy zealots still calling for the end of fossil fuels. No wonder oil and gas producers are reluctant to ramp up long term capital investments and produce more if government policies become even more punitive when the crisis passes.
#2: Clean energy has lost momentum.
Senator Joe Manchin of West Virginia created a setback for the green agenda when he indicated that he would not support the administration’s proposed economic legislation to extend clean energy tax credits and tax increases on the wealthy. Earlier in the year, the Senator also derailed the $2 trillion “Build Back Better” plan because of his concerns that it would fuel inflation. Clearly, Manchin is a proponent for fossil fuels, but he also favors decarbonization. According to the Washington Post, “Manchin said on West Virginia local radio that he could support climate spending and tax increases, but only if economic indicators improve in the next month.”
Although we are skeptical that the pursuit of net zero emissions can be met by 2050, decarbonization will continue to progress in the years high. The high cost of traditional energy is making renewables even more competitive and desirable. Fossil fuel companies are investing in new clean energy initiatives, and we do not believe that it’s just lip service. The decarbonization train has left the station.
#3: ESG investing has also lost momentum.
No, it has not. The toothpaste [train] is out of the tube [station], and it can’t be put back. Investors may have soured on using ESG ratings as a guide because of recent poor stock price performance (many ESG funds invested in the same large cap technology companies); however, while companies are seemingly no longer emphasizing ESG on earnings calls, they are certainly not shying away from their commitments to ESG. The jury might still be out on whether ESG investing provides better long-term performance, but we maintain that companies’ focus on the environment, their communities, diversity in the workplace, and corporate governance is a good thing. We are big believers that a company’s value system and culture matter over the long term.
Conclusion: Both traditional energy and clean energy stocks can prosper over the long term.
We continue to believe that traditional energy stocks are in a multi-year upcycle because of constrained supply after years of underinvestment, focus on generating attractive returns and free cash flow, and secular growth in consumption (apart from any potential global recession hiccups). In its July Oil Market Report, the International Energy Agency assumes oil demand will grow by 2.2 mmbpd in FY’22 and 2.0 mmbpd in FY’23. Given this backdrop, we expect that oil prices (as well as prices for natural gas and coal) will continue to allow companies to earn attractive returns on investment.
THE CLEAN ENERGY TRAIN REMAINS ON TRACK
Renewable energy (i.e., wind and solar) are growing rapidly and will continue to garner market share in the power market,
Global governments and private companies continue to support and invest in new technologies such as hydrogen and carbon capture and sequestration (CCS),
And, lest we forget, the major oil companies have earmarked billions of dollars over the next several years to invest in clean technologies.
A BALANCED PORTFOLIO APPROACH
As described above, we have strong conviction that traditional energy companies can prosper in the years ahead and invest in a net zero carbon future. Our two strategies overweight midstream stocks that process, transport, store, and export oil and natural gas because of favorable fundamentals and attractive yields. We are also believers in the long-term potential of clean energy stocks and have exposure to this megatrend via investments in utilities, companies that provide utility scale renewable power under long-term contracts, and selective exposure to pure-play clean energy stocks. Our objective is to provide investors with above average income and attractive risk-adjusted returns. Please see our January 2022 Market Commentary: “The Perceived Demise of Fossil Futures is Premature” for a more detailed discussion on “How to Invest in Clean Energy Stocks.”
In the first half, SAM Partner’s Infrastructure Income Strategy generated a return of 7.5% (net of fees) and bested both its benchmark (+5.8%) and S&P 500 (-20.0%). For the month of June, the strategy posted a return of negative 9.3% versus -9.1% for its benchmark and -8.3% for the S&P 500. SAM Partner’s ESG Infrastructure Income Strategy generated a negative 1.7% return (net of fees) in the first half versus -0.4% for its benchmark. In June, the strategy posted a negative 8.8% return versus -7.1% for its benchmark.
Sam Partners’ Infrastructure Income and ESG Infrastructure Strategies seek to provide sustainable income and growth with capital preservation. This is accomplished by investing in a concentrated portfolio of high-quality clean energy companies, midstream energy companies and utilities that are well positioned to participate in the energy transition to a net zero carbon future. A diversified approach to investments across these sectors should optimize risk-adjusted returns, in our view. Our Infrastructure Income Strategy offers investors a current yield of ~5% and growth potential of ~7%; while the ESG Infrastructure Strategy that is more heavily weighted with clean energy stocks and adheres to strict ESG criteria, offers investors a current yield of ~4%. In a world starved for yield, we believe these Strategies offer a compelling value proposition.