This is probably just an extension of the recent discussions around building industry/sector specific rankings, I’m just kind of interesting in picking people’s thoughts on this subject. I’m at the point where I’m just thinking about excluding energy from my broader entire ranked universes, like is commonly done for utilities or financials. Part of that is driven by frustration over recent market underperformance of the energy sector, so I want to think this out and make sure I’m not just doing this out of recent frustration/emotion.
This isn’t to say that you can’t make money in the energy sector utilizing P123 fundemantal driven techniques, I know many can and do, it’s just that the industry is so unique and specific that applying it to rankings built with broader multi-sector universes in mind is trying to fit a round peg in a square hole. I think it takes a certain amount of specific experience and insights into the energy sector to be successful, that go beyond just a general knowledge of broad accounting principles that work for other sectors.
Here are my thoughts…
I recently saw some data that showed that energy, by far, requires more fixed capital costs than any other industry. This generally does not seem to fit the theme of my quality based rankings that reward capital efficiency.
I read a book called Saudi America by Bethany McLean (previously famous for writing the Enron book “The Smartest Guys In the Room”) which details the shale/fracking revolution in the US. The story makes quite clear that this phenomenon was only made possible from the cheap/easy debt that was made possible from zero/low interest rate policies. I wonder how sustainable this is going to be in a rising rate environment if/when that takes place going forward.
I generally have a broader problem with building a fundamental model on an industry that is not subjected to the market forces of supply and demand as much as a commodity pegged by a global cartel that is largely influenced by unpredictable (by my untrained eye) geopolitical forces. In otherwords, it doesn’t matter how cheap/high quality your models say Energy Company ABC is, if OPEC decides that oil is going to remain dirt cheap then by-and-large Energy Company ABC’s price aint going anywhere until OPEC decides to change their mind.
Quick take: People are usually excluding the utilities and fiance companies because of differing accounting methods. If you care about the current ratio then you’re not going to glean any information about finance companies. I’ve never really gone in depth into utility statements, but I know that both Reuters and Value Line had separate financial presentations for them, and there was probably a reason.
Eliminating energy stocks simply because they’re underperforming feels kinda cheaty to me. Personal opinion. I agree that I wish that we had some of the more industry-specific data, but I could say that about lots of industries.
The trick of course is to say, “Do I have enough confidence that I can create a model with the historical information that I have and will that model continue to work once the industry conditions exist to make that industry profitable again”?
I think the hydrocarbon centric sector that we have today is going to change a lot over the next 50 years. And those changes will create new investment opportunities. There will be a lot of unknowns and factors like the Government’s mandates (both in the US and internationally) in controlling pollution (esp China and India), relationships with utilities and their grids, distributed production versus centralized generation, nuclear, renewables, electric cars, driverless cars (fewer cars needed), PV panel conversion efficiency improvements for the home and office buildings, and the overall leveling off of energy use.
I think the oil pricing craziness created by OPEC is going to decrease in the next 10 years because of the US’s own oil production from fracking, the rise of the use of natural gas (that comes from a lot of places now and not just the ME) as well as the rise of alternative electrical power generation (natural gas, renewables and hopefully nuclear). Change is coming to the energy sector in a big way, IMHO.
This is true of cyclical industries, and the upcycles and downcycles in energy are so long it’s hard to capture a significant sample in a ~20 year backtest.
I have been excluding the energy industry from my universe for several years. My reasoning is that I don’t want to invest in companies that are dependent on commodity prices for their earnings. I exclude all such industries from my universe.
as an insider in the oil industry it is quite amusing to see the outside views on the sector.
First of all: Imran, you should not exclude the energy sector nor any other sector; there are opportunities out in both oil and renewable energy.
Now let’s zoom in a bit more in detail:
debt: debt is indeed an issue for many companies in the sector these days. These include - as mentioned above - 1) many companies who went into the unconventional oil/gas plays; many of them will hardly be able to pay back their debt, in particular if their acreage and the associated production profile is not in a prolific geological area; 2) oil service companies who get hit hard by still ongoing cost reduction measures of their clients; this category for instance includes Weatherford who declared bankruptcy last week; 3) offshore drilling companies who invested in big drill ships during the boom years and which now are idle because oil majors don’t want to invest big money for drilling expensive offshore wells.
diversification: oil and gas companies range from pure upstream to full value chain upstream & downstream businesses. Purely upstream related companies are more vulnerable to fluctuations in oil & gas prices, whereas those including refining & marketing are better positioned during times of low energy prices. Diversification is also important when it comes to the upstream portfolio: the more countries a company has business with, the lower is the political risk and the more diversified is the nature of the produced hydrocarbons (which allows a better blend in refineries to create superior products).
So if any of you want to invest in the oil/gas energy sector right now, I would recommend to stick to the 6-10 major oil companies which are all well diversified, engage in both upstream and downstream business, have relatively low debt and pay stable dividends.
I agree 100%. Utilities generally have negative free cash flow if you use conventional metrics. Most of their capex spending is not maintenance capex, so what you could do is put a conditional formula in your free cash flow nodes, subtracting only a portion of capex for utilities. For financial companies, enterprise value is meaningless and tangible book value (which won’t mean much in many industries) is meaningful. And free cash flow is, well, iffy. Every industry has its quirks. The trick is to either create a system that has enough factors and flexibility that it’ll encompass all industries, or else to focus on particular industries and use metrics suited to them. Or somehow combine the two. It’s a huge challenge. Personally, I do the former, and want to do the combo down the road. I own three energy stocks right now (TGA, HNRG, and AE), six financials (NGHC, CRD.A, RVSB, EBMT, MFNC, SVBI), and one utility (CWCO). The only things I steer clear of are REITs, MLPs, and BDCs, because not many of the metrics I use can be usefully applied to those companies.
