Jan. 25, 2022

Energy: Rough Past.
Brighter Future?

Guest: Eric Chenoweth, CFA, Senior Investment Analyst at Scout Investments

In this episode of Markets in Focus

Energy has seen its weight decline meaningfully across broader market indices over the past 10 years. But it was the best-performing sector in 2021 and many analysts are optimistic heading into 2022. Eric Chenoweth, CFA, senior investment analyst on the mid-cap equity team at Scout Investments, joins Matt Orton, CFA, Chief Market Strategist at Carillon Tower Advisers, to explore what accounted for energy’s outperformance in 2021 and whether those drivers are sustainable.

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Matt Orton:
Energy has been the worst-performing sector over the past five years by a pretty wide margin. And over the past 10 years, the energy sector has also decreased meaningfully in weight across the broader market indices, and it now makes up just under 3% of the S&P 500. Challenging fundamentals and ESG headwinds have both contributed to the decline, but we're finally starting to see some renewed interest in the space. Energy is the best-performing sector year to date in 2021, and many analysts are optimistic heading into 2022, especially given the outlook for elevated inflation and a strong demand backdrop as the world hopefully continues to reopen.

But given the big moves this year has all the juice already been squeezed? And how should we think about investing across the market cap continuum? Here to break down the opportunity set and help us dive deeper into the energy trade is Eric Chenoweth, Senior Research Analyst at Scout Investments who works on their Mid Cap Equity team. This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights. Eric, thanks for joining us today.

Eric Chenoweth:
Thanks for having me.

Matt Orton:
Absolutely, and I think a good place to start might be looking at the drivers of energy outperformance so far this year in 2021. After years of pretty massive underperformance, we saw a sharp change over the last 12 months. Maybe you can break down what you think is responsible for this and do you think these drivers are sustainable?

Eric Chenoweth:
Great. To understand the outperformance in 2021, you have to first kind of go back and appreciate what took place in 2020 and what a truly horrible year that was in contrast with this year. And when we started 2020, the year started out looking pretty normal, oil was in the 60s, the companies were kind of all doing their status quo. One of the things we noticed though, was that inventory levels, both for crude oil and refined products were elevated versus historical levels and that can sometimes pose a risk, especially if demand doesn't live up to expectations. And, as I think we all know, as the year progressed into March demand certainly did not live up to expectations as COVID fears gripped the world. And we had lockdowns and travel bans, and that all led to a very unprecedented thing to happen and that was in April of 2020, the WTI (West Texas Intermediate) crude oil future price turned negative for the first time ever.

And I think if you have to point to a spot in time, that's the big wake-up call. OPEC (The Organization of the Petroleum Exporting Countries) had been haggling amongst itself, Russia and the Saudis were not getting along particularly well. U.S. oil and gas producers were still kind of thinking they should grow production at fairly reasonable rates every year. And when they got hit with that negative price, everything changed. The OPEC cartel came together in a way I've never seen, now the Saudis and the Russians have been working together ever since then. And the U.S. oil and gas companies really, really came down and looked at what was happening with them and their balance sheets and their business models and they slashed production. They shut in production. They cut spending down to the bone and began to really, really look at what they need to do to sustain themselves going forward.

And on top of all this, there were some fairly unprecedented market currents. And one of those was the ESG movement and in particular, the divestment movement. And you'll probably remember seeing in the headlines in the summer, in the fall of last year, probably more than we had seen them in the past, pension plans and endowments and sovereign wealth funds all announcing that they were going to exit investing in oil and gas and conventional energy altogether. And they did that fairly aggressively heading into the fall of last year, even as the share prices were already very depressed from what had happened with COVID and the negative oil price outcome earlier in the year.

And then, to add one more log to the fire, I guess, to your points on the introduction there, the U.S. oil and gas industry, they had given some pretty terrible returns to shareholders for quite a long time. So those who had sat around and waited all these years were facing some fairly steep unrealized losses in the fall. And a lot of those unrealized losses became realized, they sold out, and that, plus the ESG pressure, led to some of the most negative sentiment that I've ever seen in the space. And that all kind of came to a head in October and then one weekend in November, we had what a lot of people recall as Vaccine Monday, and the markets kind of eased up and realized that that maybe there would be a light at the end of the tunnel for COVID. That really ushered in a lot of the fundamentals that we've been able to see play out in 2021 — from very low stock prices to slowly grinding improvements in demand — that have all helped these companies see their share prices higher this year.

Matt Orton:
Perfect. And maybe just to dive into that a little bit, so when you look at what some of the tailwinds could be for these companies, do you think having elevated oil prices is going to be necessary or do you think kind of the de-leveraging and cleaning up of corporate balance sheets might be helpful enough as long as we stay at a moderate level of energy prices?

Eric Chenoweth:
That's a good question. I think the growing consensus is that oil prices in the 60 to 80 range would be very welcome. And when I look at the valuations that seems to ring true. The companies I think have now fully embraced the discipline that they were forced to embrace in 2020, that means cleaner balance sheets and sustaining cleaner balance sheets. And if you do that and you drill far less than you did in the past, an oil price in the 60 to 80 range leads to very attractive free cash flow yields on the current prices where they trade, which is quite a bit higher than where they traded a year ago, but you still see very, very healthy free cash flow yields that should attract and keep investors interested in the companies.

Matt Orton:
Okay. That's definitely some helpful context and then maybe one other point that you'd mentioned before was that of the divestment movement and some of the ESG concerns, and obviously ESG is a growing focus of a lot of professional investors and individuals going forward. And what do you think the impact of increased ESG focus might be going forward, especially if there's continued divestment? You've heard some folks like Larry Fink already speculating that we're going to need to have a bad bank structure as energy companies spin off some assets. Do you think this is longer term down the future? Could it impact returns going forward, or do you think energy can weather that storm?

Eric Chenoweth:
I think the industry's always upheld a long list of environmental standards, but what the ESG movement's done is added CO2 and methane to that list. And while that might sound like just two extra gases to add to a long list of pollutants that they've always thought about, they have a large impact, a large financial impact, and a very big impact on how they need to behave going forward. It's clearly going to require the industry to change on a number of different fronts. You noted the potential to lose access to credit or equity markets or to have reduced access. That's something now that that management teams in boardrooms have to think about. And on the same note, investors need to factor that in to how much they're willing to pay for these companies.

And I think the other thing that's going to happen some companies definitely need to sell assets. Other companies have to have less investment in their upstream assets, but all of them are going to have to have more investment in various mitigation strategies to deal with methane. And methane is something they can deal with sooner than later and then eventually they're going to chip away at CO2 and we'll see, it's going to be a foot race, I think, to your point, it's going to be a foot race to see if the industry can chip away at CO2 faster than the regulations require them to do it or if the regulations come in more quickly and force them more into the asset sale camp sooner.

Matt Orton:
Right. And so when you talk about kind of the investment that it's going to take, is this already being factored in by investors? Are there potential opportunities and companies that might deal some of the items that are needed for investment in these mitigation strategies? I mean, how do you look at the opportunity set?

Eric Chenoweth:
So, we think it's pretty large and the short answer is yes, it's happening literally right now. Today, I read about a project in Australia that was green-lit, and there are some press releases out there you can read about it, that's going to sequester about 1.7 million tons of CO2 underground on an existing conventional oil and gas site. So, those projects are happening, but it's going to have to be much bigger than that. And I think when you look out five, 10 years, you can see an industry shaping up that could be in five years, a $50 billion industry, maybe $100 billion industry in 10 years. So there's certainly a lot of potential there and I think it really has come on radars just in the last year or so. And there are plenty of investment opportunities out there. And I think it's still very early days on who ends up winning in that space.

Matt Orton:
Right. And hopefully some of that investment might help ease some of the pressures on the divestment side, too, that we've seen pick up. And maybe expanding on this part of the conversation, when you look at opportunities across the broad investment landscape for energy companies, where are you finding some of the best opportunities as we head into 2022?

Eric Chenoweth:
Sure. So I think it's going to touch a lot of different industries and our team sees that pretty much everywhere. Within oil and gas, there are some companies doing very creative things with carbon dioxide capture and actually re-injecting that to produce more oil in a way it might actually lead to a negative CO2 barrel, as it were. This is still very early innings, but you see things like that and that's hopeful for the industry. I think as you branch out, all across the industrials, whether you look at chemicals or cement or any sort of manufacturing, there's a lot of work being done to kind of compound and reduce your carbon footprint. One of the really interesting areas that we've been involved with is in renewable diesel. You've heard about ethanol. That's something that people are familiar with. But with renewable diesel you can actually use things like used cooking oil. Now there are companies that have giant fleets of trucks that collect the cooking oil from fast food restaurants all over the country and are processing that into a diesel fuel that's actually incredibly clean-burning and is a negative CO2 fuel.

So there's big opportunities in places like that, because that has a feedback loop. If you start to clean up the fleet that hauls the used cooking oil, and whether it's running electric or running on its own renewable diesel, you can start to compound the CO2 emissions cuts throughout your ecosystem, and you get some pretty impressive reductions in your CO2 footprint. So there are a lot of places to invest out there and I think we'll see these little incremental gains start to compound and add up over time.

Matt Orton:
And there are some of these investment opportunities and as you look across the market capitalization range, renewable diesel might be a pretty niche market. So is that more of a small-cap, a micro-cap investment type opportunity? I guess how do you break down maybe your preferred areas to invest in energy across the capitalization range? Obviously as a midcap manager you're very familiar with the midcap space, but maybe you can help our listeners think about or contextualize the different sorts of opportunities you might have across the range of cap.

Eric Chenoweth:
Sure. The case of renewable diesel, that's actually a midcap company now. So that's an exciting market. I think, broadly speaking and if we look at oil and gas in particular where there's going to be a lot of action, there's just too many small companies, even after the rallies and the share prices, there's just too many small companies and the way the industry works it just doesn't make sense anymore like it used to. So there needs to be a lot of consolidation. Either they need to consolidate together or sell out to a larger player. The challenge with that is when you look at the very large energy companies today, the largest integrated companies, they're getting the most pressure right now from their shareholders on their scope 2 and scope 3 emissions, which are the indirect emissions that they have a harder time influencing. Really the only way to change your scope 3 emissions and then some of your scope 2 emissions quickly is to divest, to sell assets, to sell some of your upstream assets that might be your biggest offenders on the pollution side.

There are likely to be sellers as well, so that doesn’t leave a lot of buyers. You might think there's private equity firms or someone out there, but private equities they report largely to endowments and foundations and pension plans who have very strong ESG mandates. And frankly, from what it looks like a lot of the private equity money wants to exit the space as well. So you have a lot of sellers, a lot of consolidation needs, but not a lot of buyers. I think that that for now, anyway, points an arrow at middle and larger middle-sized companies to roll these opportunities up over time assuming it all makes sense, both economically and operationally. And you've seen a lot of that in the last year. You've seen a lot of that happen and the prices have been fairly compelling to very compelling. You see a lot of no-premium deals to where they trade in the market. And a lot of the deals that take place that their asset sales are very, very attractive free cash flow yields.

We saw some, in the last year that were over 20% free cash flow yields, where they were sold from major integrated companies to midcap companies. So this is all going to work itself out over time, I think and lead to a much leaner and smaller industry and provide some opportunities to those companies that have the skillset to operate and integrate well.

Matt Orton:
Makes a ton of sense. And I also want to touch on the I-word, inflation, because I think it is relevant to the discussion because I think one of the theses you hear thrown around in the general market prognostication is we see increased inflation. That energy could be, or historically speaking tends to outperform in these sorts of environments. And I'm curious to get your thoughts, given your long tenure in the energy sector, do you think that's appropriate and are there any type of historical analogs we can draw to the environment we're in now or is it really, truly unique as you're assessing investment opportunities?

Eric Chenoweth:
That's a great question. I'm going to go roundabout on you, but come back to it. I think what this reminds me most of what we've seen right now, it reminds me a lot of 2008 and '09. And the quick answer to that is in the summer of 2008 everything looked great. The world was consuming a little over 88 million barrels a day of oil, and then Lehman (Lehman Brothers) hit in October. In just one month we went down to 80 million barrels a day. So we had a 10% contraction demand, you know not quite as bad as what we had with COVID, but very similar. The industry went through the same process that we saw now, where they were slashing and burning costs and spending. And then when demand finally came back in 2009, you saw the very sharp market reactions like you saw this year, you know these kind of, some of the smaller companies doubling and tripling, just like you saw this year.

So the 2008 and '09 market action and some of the reasoning behind it seems to rhyme pretty strongly. However, I think that's where the similarity ends, and to your point, this time we have much higher inflation out the back end, and it looks to be something that could be sustainable, at least for this next upcoming year. And when we talk to oil and gas companies they see their cost rising 10 to 20% this next year, but the commodity price has enough room for them. And if the commodity price can keep up then they should do just fine. I think that the challenge for what they bring to other industries, which has investing applications is not just on the oil side, but on the natural gas side, because that really feeds into everything that we spend money on in day-to-day life, whether it's heating our home or the plastic in our cars or the clothes that we wear, or the food that we eat, because most of our fertilizer comes from natural gas feed stock.

And this is a big challenge. I think we're very fortunate in the U.S. to have very low gas prices relative to the rest of the world, but when you look overseas you see natural gas prices in the 30’s, dollars per Mcf (thousand cubic feet) versus $4 here in the U.S. So the rest of the world is facing a very, very extreme input cost shock that looks very likely to linger through the next year and possibly into 2023. That does pose a pretty big inflationary shock and typically when you see that oil and gas has done well. I mean, if you go back to the '70s, there's a clear case to be made that when you look at the '70s energy was one of the only sectors that had positive, real returns, as shocking as that is to think about. I don't see the current situation as extreme as the '70s, but I do think that for at least a number of years here, we have some visible inflationary shocks.

To think about how that would extend out multiple years really comes down to two key factors, but they're both related to one thing which is supply of energy. That is OPEC. OPEC+ now is very unified. If they can keep that sort of unification they should have an influence on the oil price and be able to keep it in that range we talked about earlier and also keep it in a range that would essentially ensure a decent profit level for energy, regardless of the inflation environment, which would make it kind of a unique space to invest in that scenario.

The other factor is the U.S. and the U.S. producers. We've had two years now of very low capital investment in oil and gas. We spend a little under $300 billion – this is globally, a globally CapEx (capital expenditures) – $300 billion in 2020. We're a little over $300 billion this year and probably going to be that next year. That'll get you to three years of fairly low investment versus like a $400 to $600 billion – what you would consider a normal maintenance level to kind of keep things flat. So, we're underinvesting in oil and gas. I think the world expects that to happen. If you look at a lot of what the big agencies are forecasting, to hit net zero targets we need to invest more at like a $350 billion oil and gas level, but the problem is we haven't yet really upped the investment on the renewable side to the degree that we need to, to compensate for that underinvestment on the oil and gas side.

So to kind of sum that all up a bit more clearly, I'd say we just aren't investing enough in energy of any kind given what demand's likely to do as we come out of COVID. And that's likely to support at least inflation in energy and in some of the inputs into fertilizers and plastics and some of those sorts of raw material input costs. So I do think we'll probably be facing a bit more energy price inflation than we've gotten used to in the 2010s. The 2010s were kind of a very nice and calm time in hindsight, I think.

Matt Orton:
Yeah that's some incredibly helpful context. And I think we've got time for one more point, and I'd be remiss if I didn't address some of the potential headwinds to the energy sector, whether it's going to be increased regulation, EVs (Electric Vehicles), expensive investments going to what you were just discussing. Maybe you can just touch on some of those headwinds and how that might impact your outlook.

Eric Chenoweth:
It's important if you're looking at energy investments to know there's always plenty of potential headwinds, as we've learned over the last decade and last 100 years, probably. I think near-term it’s still COVID variants. You know, we've been reminded of that lately with omicron. And I think that's what we have to think about near term. How does this play out on demand? I think very long term, one of the issues we have to think about is the OPEC cartel. It looks like it's gaining share and getting stronger, you know that can always change, but that's something that'll be a big driving force in the marketplace on the supply side. And then on the demand side, they're just an enormous level of uncertainty. We talked about EVs and we can talk more about those in just a second, but it's that uncertainty that makes it very hard for a boardroom or a management team or an investor to underwrite a long-term investment in any sort of energy project.

Some of these large projects have 20- or 30-year payback periods if you're building an LNG (Liquefied Natural Gas) facility, for example. And it's very hard to do that when you just don't know if the demand is going to be there, if the policy is going to support that. It's a very, very trying time, and that raises the cost of capital in all these sorts of things. It's hard to find funding for these projects. And then in the meantime you're watching EVs, and EVs are really starting to ramp as a percent of sales every year, especially in some countries like China and parts of Europe. And that is a crucial unknown when we think about if we want to invest in some of these projects and companies.

Matt Orton:
Absolutely. I think that that's some really important context to take away from all of this. And Eric, I think where we're out of time for our podcast today, but I want to thank you. This has been a really interesting conversation. It's a subject that is top of mind, and I think will be going forward for probably the better part of 2022. So I appreciate your time and I've enjoyed this and thank you very much to our listeners, until next time take care. Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insights at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts Spotify or your favorite podcast app. Until next time, I'm Matt Orton.


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