The FPA Capital Fund (Trades, Portfolio)'s Arik Ahitov just sent out its fourth-quarter 2017 commentary. It is an extremely interesting piece because of the firm's variant view on energy. Ahitov sees oil going higher and believes energy stocks are lagging fundamental developments in reality because investors are overly bearish, if not apathetic. He is not wrong, oil has quietly doubled up from its lows. However, energy is the cheapest industry within the S&P 500. It is also one of few industries where insiders are buying at a healthy clip. All this data is tracked by GuruFocus. FPA looks at five important bear arguments on oil and discredits them all:
1. Bears argue slower global economic growth
"That’s looking unlikely since the International Monetary Fund is now forecasting that only six of 192 countries will register an economic contraction in 2018, the fewest on record."
Very few people are expecting a pending global showdown. I do not think this is a contrarian argument at all.
2. Bears argue consumption risk in China
"Crude demand in China is up 7% YTD versus the same period last year, more than double the consensus figure at the beginning of the year."
In addition, I would say energy may not be the first thing to go if China curbs spending. I do think there is something to the Chinese credit story.
Source: Federal Reserve Bank of St. Louis
Credit growth only just started slowing down. I am not convinced this is not going to be a factor, but did not realize the extent of Chinese demand recently.
3. Bears argue electric vehicles
"EVs make up just 0.1% of the global installed vehicle base, and that miniscule percentage will not change meaningfully over the next five years."
A Navigant report forecasts a maximum of 4 million electric vehicles sold in 2023. General Motors (GM, Financial) by itself sold about 10 million cars last year, and there were only a few electric vehicles among them. I often sense people are overestimating the number of electric vehicles that are sold and think will be sold.
Source: Navigant Research
4. OPEC will ramp up supply
"For the House of Saud, the most obvious incentive to keep oil supplies tight stems from budgetary constraints. The country needs over $70 oil just to neutralize its fiscal deficit."
"Vladimir Putin had his 2018 re-election campaign in mind when he endorsed the 2018 quota extension. Russia’s economy is substantially dependent on crude oil, with 70% of Russian exports related to the oil and gas sector."
Saudi Arabia and Russia were the number one and number two producers in 2016. Note the U.S. is number three on this list. But these two countries are not just powerhouses in terms of production. Both nations wield a tremendous amount of influence within OPEC and outside of OPEC. Neither is afraid to use that influence to further their goals. It seems likely OPEC and Russia will remain unusually disciplined for a little longer.
Source: Wikipedia
5. U.S. shale producers will flood the market
"Operators focused on their best acreage during the downturn, leaving them with costlier and less productive sites – Researchers at the Massachusetts Institute of Technology found that half of recent well productivity gains in the Bakken came from taking rigs out of fringe acreage and concentrating them in the core."
Remember the U.S.'s position on the production list? Guru David Einhorn (Trades, Portfolio) argued a similar point in his famous presentation on Pioneer National Resources Co. (PXD, Financial).
"Oil and gas companies are starting to embrace more financial discipline. In fact, a number of large E&Ps are now signaling cash-flow-neutral growth (i.e. not overspending), returning cash flow to shareholders, and improving compensation incentives in 2018."
I tend to cheer for financial discipline at companies I own, but this does not merely show increased attention to risk. It may also indicate the opportunities outside of the core areas are just not good enough to get to a justifiable internal rate of return.
FPA elegantly countered the bear case and are putting their money where their mouth is with 60% of the portfolio in cash and energy stocks. The fund's three largest holdings in energy are:
- Simarec Energy Corp. (XEC, Financial)
- Noble Energy In.c (NBL, Financial)
- SM Energy Co. (SM, Financial)
Disclosure: Author has no positions.
