Investing in Oil Stocks

Hey guys, amidst recent sell-off in commodities thought I'd share some key points from an Oil investing piece I wrote a few weeks back (see generalistspace.com for full article and charts)

Investing in Oil Stocks:

1. The MACRO picture, and the view on a higher oil price environment is the most important driver for Oil stocks. Generally, a “rising tide lifts all boats”.

2. Within MACRO focus on supply side dynamics. Across the demand side knowing the general direction can suffice. Directionally, demand for Oil is expected to be in growth mode for the foreseeable future unless there is tail risk event (something like GFC, or COVID 2020).

3. Across the supply-side, history has indicated uptrends in oil prices have correlated with geopolitical events affecting supply. Recent sanctions on Russian Oil (major supplier), are therefore supportive of higher oil prices.

4. Adding to the geopolitical noise, there is structural underinvestment in the sector (net-zero goals, ESG etc). European Oil Majors are building renewables projects over incremental Oil supply.

5. Shareholders have US Oil E&P's on a “leash”; executives are focused on paying down debt, boosting shareholder returns (buybacks, higher dividends special dividends) over drilling for new reserves.

6. To summarise; the current MACRO picture is painted by supply side challenges from Geopolitical issues and structural underinvestment. These are supportive of a higher oil price (>$60/Bbl.) environment, and in turn Oil Equities.

7. After concluding that MACRO is favorable, focus shifts to individual stock fundamentals. As a generalist I prefer to invest in the highest quality names which I asses by the factors below; high asset quality, low break-even prices, strong B/S's and good S/H return policies.

8. High asset quality, are those that have long asset lives and can sustain production without incremental exploration and drilling. Typically at maturity, Canadian Oil sands assets (20+ years of life) will last longer than US Permian assets (~5-10 years).

9. Break-even prices refer to price of Oil below which co.'s start to become negative FCF, after deducting maintenance CAPEX and DPS. The lower the break-even for an oil stock the more “margin of safety” it can afford when oil prices are declining.

10. Strong B/S-> in the current E&P space this is defined as net cash B/S or a future path to net cash.

11. The market is rewarding Oil companies that are focused on returning cash, therefore stick with those that are buying back stock, initiating dividends etc.

12. One such company that fits all of above is Canadian Natural ($CNQ).

13. The last check I like to do is valuation. On a EV/EBITDA basis, oil companies are still cheap if we assume they return to historical median valuation spread levels to the S&P 500 (See Figure 12, on generalistspace.com).

tldr: History shows oil goes up when there's supply shocks, which are usually driven by geopolitics. Now you have this, but also underinvestment which means opaque line of sight for supply recovery, which could mean prices will remain high unless you get a recessionary shock event similar to COVID, GFC etc. Safest way to play in my opinion is to buy oil equities that have strong shareholder returns (prioritising returning capital over drilling), low decline rates and low breakeven prices. Valuation for sector is still attractive as trading below the average historical EV/EBITDA spread to SPY.