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Are Energy Stocks A Good Bet?

Energy Stocks

Is the battered energy sector about to stage a major turnaround, or are contrarian investors trying to catch a falling knife?

That’s the million-dollar question at the forefront of every energy investor's mind as reports emerge about “smart money” quietly piling into the industry, hoping it has bottomed out.

Legendary investors Warren Buffett, Carl Icahn, Sam Zell and Jerry Jones have strategically upped their ante on the sector even as portfolio managers and the rest of the investing universe continues to give it a wide berth.

So, what do these heavyweight investors see that others don’t and, more importantly, should you follow their lead?

Ultra-Low Valuations

The current year caps a truly miserable half-decade for the energy sector, and investor sentiment has rarely been this cold. 

After peaking around mid-2014, the sector’s valuation has plummeted 40% resulting in the sector’s weighting in the S&P 500 tumbling to an all-time low of just 4%, a far cry from the 13% slice it owned back in 2008. Investor sentiment on the industry has taken a real hammering, with the sector’s 1.5x multiple to book value way below the S&P 500’s 3.5x average.

With valuations this dire, Buffett and co. are betting that the sector is oversold and the sky is not about to fall like everybody else seems to think.  Related: The Infinite Possibilities Of Cosmic Energy

For Buffett, he is simply following his well-worn mantra to ‘‘Be fearful when others are greedy and greedy when others are fearful.’’ 

Buffett’s Berkshire Hathaway has already committed to invest $10bn to back Occidental Petroleum’s bid for Anadarko Petroleum. OXY completed the takeover in August for a reported sum of $58 billion, and Berkshire will have to keep its word and purchase $10 billion worth of preferred stock in Occidental.

Occidental Petroleum got a bad rap earlier this year when activist investor Carl Icahn dumped $400 million of the company’s shares--good for a third of his then 4.4% stake--in protest of the Anadarko purchase. Icahn has been very critical of the highly leveraged deal, saying it’s “extremely dangerous” to own OXY shares and has not ruled out selling even more due to concerns about the company’s balance sheet.  

Nevertheless, the veteran activist clearly has not lost his faith in the sector as evidenced by the $5.6 billion in his portfolio dedicated to energy stocks including Occidental, Cheniere Energy and CVR Energy despite OXY stock dropping nearly 40% since the deal was first announced in April.

Sam Zell, founder and chairman of private equity firm Equity Group Investments, has been purchasing distressed energy assets in Texas, California and Colorado at fire-sale prices, noting that some have run out of money to drill.

Dallas Cowboys owner Jerry Jones, has made a huge $1.5 billion bet on natural gas because he believes the future is bright for the industry despite low gas prices. Mr. Jones is a contrarian investor par excellence, having made a similar [winning] bet on the Dallas Cowboys when the team was losing tons of money.

Thomas Hayes, chairman of hedge fund Great Hill Capital, says he has been investing in E&P (exploration and production) companies because they have the most leverage to oil prices. Hayes has built positions in out-of-favor E&P names including EOG Resources, Concho Resources, Occidental Petroleum, Pioneer Natural Resources and ConocoPhillips believing they are set to benefit thanks to Saudi Arabia and its OPEC allies committing to a fresh round of crude production cuts.

Higher Earnings

But perhaps the most bullish argument to be made for the energy sector is that earnings growth in 2020 is expected to clock in at 23%, the highest by any sector and well ahead of industrials at 17% and materials at 15%.  Related: Trump Prepares For Another Key Tariff Decision

Obviously, much of that growth will come on the back of favorable comps courtesy of an epic decline this year. The energy sector is expected to post earnings decline of 32% for the fourth quarter, far worse than the market average of -1.5%.

There are other reasons why the outlook for the sector could be more favorable than what a casual glance might suggest, including the fact that energy companies sector have been increasing dividends at a fast clip--something that rarely goes down badly with investors. 

Nevertheless, don’t just jump into the bandwagon blindly with these billionaire investors.

Warren Buffett has an interesting take on why he’s investing in oil--the Permian Basin

“I mean the Permian Basin is four million barrels a day. It’s incredible. Remember it was the last great find in the United States 40 years ago or more...The United States is producing 12 million barrels and four million are from the Permian,’’ he gushed to CNBC

In the same breath, he admitted to not knowing much about the oil industry:

Charlie [Munger] is quite impressed with the Permian Basin. He knows more about oil than I do, which isn’t really much praise, but we both follow that.’’

Carl Icahn does not exactly have a sterling record betting on energy companies. 

Three years ago, his investment vehicle, Icahn Enterprises, sunk to multi-year lows thanks to a string of losses from his energy bets. His returns this year are a mixed bag: Occidental stock is down 38.8% in the year-to-date, Cheniere Energy shares are up 0.64% while CVR Energy has gained 20.7%. 

Even after this year’s gains, Icahn is yet to recover his losses in Cheniere Energy after a disastrous fall in 2015. His investment in oil refiner CVR Energy has done much better having more than doubled since he took over majority stake in 2012.

The contra trade crowd has been on the losing end countless times in the past, but as Hayes has aptly noted, another repeat of the early 2000s crazy oil boom could be knocking on the door ‘‘with a very happy ending.’’ With so much uncertainty on when oil prices might rebound definitively, investors who build long-term positions now are the most likely to eventually come out on top.

By Anes Alic for Oilprice.com

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