Crude Thoughts on Oil Investments

While certainly taking a backseat to the COVID-19 pandemic, oil markets have garnered their share of attention of late. Excess supply and lack of demand have driven prices down more than 60% year-to-date, at one point even turning negative. Recent volatility has caused many to ask about the level of energy exposure in their investment portfolios and whether oil price declines create a compelling buying opportunity. In this article, I offer my perspective on the oil market and how we think about oil in client portfolios. In addition, three of my colleagues (Ali Fahs, Lucas Mansberger and Chris Burns) offer perspective on their specific areas of focus in their own words. The consistent message is that oil specifically, and energy companies generally, are intentionally underrepresented in our clients’ portfolios and while there may be short-term opportunities in the energy sector, we remain underwhelmed by longer-term prospects.

The volume of questions we receive on commodities like gold or oil seems to spike when they have done really well (should I jump on this bandwagon?) or really poorly (great time to buy?). Commodity prices can, and do, rise and fall, but it is important to remember that at the end of the day a barrel of oil or an ounce of gold is just a thing. These “things” have value, but they don’t produce value, which means their long-term expected return is roughly commensurate with inflation. In the short-term, significant price movements (volatility) spark interest. The table below highlights why we have not held an explicit allocation to commodities generally, or oil specifically, in client portfolios in my time as director of research.

Over the last 25 years, commodities have slightly trailed inflation on an annualized basis while displaying equity-like levels of volatility. As such, we struggle to see the long-term benefits of a strategic allocation to the asset class.

In the short-term, oil prices have suffered from both high supply and low demand. Regarding supply, in early March disintegration of the OPEC+ alliance triggered a full-blown price war among the world’s biggest oil producers. OPEC had convened in Vienna, Austria to discuss oil production cuts that would steady the market against softening demand from early coronavirus travel restrictions. Talks, and an important alliance between Saudi Arabia and Russia, broke down after Russia balked at the proposed scale of cuts. Saudi Arabia responded aggressively by discounting prices and committing to boost production in April. As production ramped, demand continued to slide as large portions of the global economy shut down in response to COVID-19. Lots of oil was being produced, nobody needed it, and storage capacity eventually ran out causing benchmark prices for WTI crude oil to bottom at -$37.63 on April 20. Prices have since recovered somewhat to +$33.52 as of this writing. Production cuts went into effect starting in May, and demand is slowly increasing as portions of the global economy re-open.

Valuation of oil companies depends heavily on oil prices. Therefore, the energy sector has fared worse than others year-to-date. On a near-term basis, it is possible that the energy sector rebounds. The adage “the cure for low oil prices is low oil prices” will eventually lead to a realignment of supply and demand. Longer term, we believe the oil market will continue to be well supplied. Advancements in extraction technologies (i.e. hydraulic fracking) have unlocked abundant incremental supplies of oil, while the electrification of vehicles will likely result in lower demand. While a short-term trade into the energy sector may temporarily benefit from rising oil prices, we note that even $50 oil (150% of today’s price) is not profitable for many industry participants long term.

Below, my colleagues offer additional insight on the energy sector in the context of our internally managed domestic equity strategy (Intrinsic Value Strategy), third-party managers and fixed income strategies.

Intrinsic Value Strategy
Greenleaf Trust’s Intrinsic Value Strategy is an internally-managed US equity strategy. The strategy focuses on companies with durable competitive advantages trading below their intrinsic value. Ali Fahs, Vice President and Senior Equity Portfolio Manager, shares his perspective on the energy sector in the context of the Intrinsic Value Strategy:

The Intrinsic Value Strategy has not been invested in the energy sector since 2018. The decision to exit our energy position was not predicated on a macro call or a view on the future direction of oil prices. Instead, our decision reflected the reality that most companies in the energy sector are incompatible with the investment framework we established in 2017. Our investment philosophy and process revolve around the long-term ownership of high-quality companies that trade at attractive valuations. For us, a company’s quality emanates from its industry structure, business model, financial statements, and management. We seek to maximize our exposure to high-quality companies that are capable of generating predictable and durable free cash flow per share. Conversely, we will likely avoid highly competitive industries that earn insufficient returns on invested capital through an economic cycle.

In many ways, energy-related companies are the antithesis of what we define as high-quality companies. These companies tend to be highly-cyclical, capital intensive, and commoditized. Not only does the sector lack capital discipline, but also capital spending is often financed with leverage. What’s more, these businesses have historically generated inadequate returns on invested capital, leading to shareholder value destruction over long periods of time. Valuing these assets is equally challenging. Oil prices are inherently volatile, and yet oil price forecasts are the key inputs in equity valuation models.

Traditional value investors might be tempted to view energy companies as cyclically depressed and an opportunity to earn excess returns. A “valuation call” could be predicated on the mean reversion of oil prices that ultimately translate into substantially higher normalized earning power. Clearly, we do not subscribe to this brand of value investing. Mean reversion is far from a guaranteed outcome. Also, if the price of oil remains low for an extended period of time, then energy companies’ earning power will also remain depressed. Under this scenario, indebted energy companies face the dual threat of operating leverage and financial leverage, which in combination increase the likelihood of permanent capital impairments.

In our view, capital appreciation and capital preservation are of equal importance. Competitive advantages, profitable growth potential, balance sheet strength, corporate management, and valuation are important attributes we focus on in periods of economic expansion and contraction. By concentrating on companies that possess these attributes, we believe the Intrinsic Value Strategy is well positioned to earn adequate returns over time. Correspondingly, the ownership of high-quality companies coupled with thoughtful portfolio construction also enables us to minimize the risk of permanently impairing our clients’ capital.

Third Party Managers
Greenleaf Trust allocates to third-party investment managers in some segments of client portfolios. Lucas Mansberger, Investment Strategist and Senior Manager Selection Analyst offers his insights into how some of our managers approach the energy sector.

Our manager selection efforts are focused on differentiated, actively-managed strategies that can enrich client portfolios with a broader diversity of investment style and exposures. Our equity managers share an emphasis on fundamental, bottom-up stock selection and we generally classify them as “growth” or “value” depending on their relative emphasis on faster-growing or less expensive companies. That difference in focus is particularly relevant for investing in the energy sector.

Our growth managers tend to focus on companies with favorable long-term growth prospects while deemphasizing cyclical sectors and companies. As a result, with the exception of the Fidelity New Insights fund (which only averaged a 3% position in energy stocks), our growth-oriented managers have very little exposure to energy.

In contrast, our value managers view the energy sector differently. Starting the year, our managers held energy sector weightings that aligned with the benchmark weight of approximately 7%. The managers cited constructive industry fundamentals at the beginning of the year, including a strong economic backdrop for cyclical companies, improving oil supply/demand dynamics, and better balance sheet management amongst oil companies, as reasons to be favorable on the sector. Our value managers’ views have changed somewhat due to the oil price war and the COVID-19 pandemic, and several have reduced their allocations year-to-date. Importantly, while their energy allocations may have had a negative impact in absolute terms, their specific energy positions have collectively added value.

Fixed Income Strategies
Greenleaf Trust offers internally-managed individual bond portfolios for clients where appropriate. Chris Burns, Investment Strategist and Senior Fixed Income Analyst, describes our general philosophy for investing in energy sector bonds and offers his perspective on the current market environment.

Low oil prices are stressing the creditworthiness of many companies in the energy industry. The oil and gas industry is composed of upstream, midstream, and downstream companies. The table below summarizes their operations. Every segment of the industry is pressured by low oil prices, but each is facing unique dynamics specific to their own operations.

We view many aspects of owning energy-related credits as unappealing. Some of the drawbacks of lending to the industry include:

• Companies compete to produce commodity products (i.e. companies are price-takers and cannot differentiate)
• Highly competitive industry with many government-affiliated producers globally
• Highly cyclical revenue and cash flows
• Capital intensive industry with high proportions of fixed costs
• Revenue sources are subject to depletion
• Highly regulated industry

So, where we incorporate energy bonds into portfolios we are seeking a combination of (1) a compelling yield advantage for the additional risks, and/or (2) a sufficiently creditworthy issuer. That typically leads us to invest in higher quality credits and to avoid riskier, but higher-yielding issuers. As a result of this conservative orientation, most client portfolios have experienced minimal impact from this period of volatility in energy credits.

Energy companies are responding to low energy prices by reducing operating & capital expenditures and reducing payments to shareholders (dividends and buybacks). Some high yield issuers are negotiating with lenders to reorganize debt profiles to avoid default. This is all being done to preserve liquidity. Ratings agencies have been downgrading companies, particularly in the high yield independent exploration and production segment. Without a meaningful increase in the price of oil, we expect additional downgrades and defaults in the coming 12-18 months.

As we look forward, we will continue our conservative approach to investing in energy credits. We will be paying close attention to the ratings environment, particularly watching the stock of “Fallen Angels”, companies downgraded from investment grade to high yield. We believe there are several candidates for downgrade to junk in the Independent E&P segment as well as the midstream segment.

Conclusion
In closing, reduced output and gradual demand increases could cause oil prices to rise from current levels, which would likely coincide with short-term appreciation of energy company stocks and marginally improved credit-worthiness. That said, our investment philosophy assumes a long-term orientation at the portfolio level and within underlying strategies. This approach to commodities, oil, and the energy sector has served our clients well and we will remain disciplined in our evaluation of investment opportunities. Please contact any member of our team if you have questions.