No, we do not believe investors should add a new overweight to public energy at this time. Political machinations and virus-induced uncertainty are weighing on oil prices at present, and it seems unlikely that both of these obstacles will soon be lifted. Instead, investors should closely monitor positioning to ensure their current level of energy exposure is intentional.
The oil price collapse has been nothing short of breathtaking. Oil prices dropped to a little more than $30 per barrel on Monday, after starting 2020 in the low $60 range. The roughly 51% decline from its early-January peak represents one of the sharpest contractions in history. In fact, in examining the 40 oil price declines greater than 20% since 1983, the current slide is the fourth most severe. This has left oil prices at the cheapest level since first quarter 2016 and cheaper than roughly 90% of historical prices adjusted for inflation.*
Russia’s decision this past weekend to not support the OPEC-led production cuts removed a key support of oil prices. Since late 2016, Russia coordinated with OPEC member countries to prop up prices by restricting supply, in response to growing US shale production. But Russia viewed the results of coordination as mixed and may view its decision in broader strategic terms, considering its dislike of recent US attempts to stop its Nord Stream 2 gas pipeline to Germany. In response, Saudi Arabia stunned oil markets by both discounting oil prices and announcing its intent to rapidly increase its production.
Oversupply concerns only rubbed salt into the wounds of a market already suffering from weak demand. China has been a key driver of oil demand growth for years, but its economy has slowed to a standstill as COVID-19 fears have mounted. Indeed, manufacturing and non-manufacturing activity fell to record low levels in February. As a result, energy forecasters have lowered oil demand growth expectations, with the US government cutting its 2020 forecast from 1.4 million barrels per day in December to 1.0 million barrels per day in February. Moreover, western government efforts to contain the virus through restrictions on activity look poised to pick up, meaning demand may be more severely curtailed.
Many energy companies are not well positioned to deal with a prolonged period of low energy prices. To be sure, these companies have become more disciplined following the 2015–16 energy commodity downturn, which bankrupted more than 100 producers in North America. But debt levels remain high, particularly in the United States. US energy companies collectively carry net debt that is roughly 2.8 times the amount of EBITDA they generated over the prior year, as opposed to energy companies based in other developed markets, which carry 1.5 times. Still, a significant portion of production is hedged, and capital outlays can be cut.
Market pricing of these companies reflects the heightened level of uncertainty. The MSCI World Energy Index returned -40% year-to-date in USD terms, leaving it trading at just 3.7 times cyclically adjusted cash earnings. That multiple, which normalizes cash earnings to account for cyclical imbalances, is the lowest we’ve observed since data began in 2004. In addition, that pricing is just 31% of the same multiple for its parent benchmark, the MSCI World Index, which is the lowest level that any developed markets sector has traded at historically. No other major equity country, region, or style that we track is priced so cheaply.
Still, we do not believe investors should adopt a new overweight to public energy, beyond our longstanding preference for natural resources equities (NREs) over commodity futures. The helpfulness of valuations for public energy has often been undercut by the volatility of oil. And, it is rare that oil markets are confronted with large twin supply/demand obstacles, as now is the case. To some extent, our current preference for NREs over commodity futures helps mitigate these concerns, given the common underlying exposures, but we are closely monitoring this position.
Instead, investors should monitor how their energy exposure evolves relative to policy to avoid an unintended bet. Investors should also wait for more clarity on the virus’ impact on potential oil demand. Even at that point, and depending on market pricing, investors should probably only buy well managed companies with sustainable debt levels. Ultimately, the success of an overweight to public energy equities today is too dependent on Russian and Saudi politics, as well as COVID-19, for our comfort.
*Oil price observations rely on data from near-month NYMEX WTI Light Sweet Crude Oil contracts, which began trading on the New York Mercantile Exchange in 1983.
Kevin Rosenbaum, Deputy Head of Capital Markets Research