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Kevin, last week the equity research shop, Redburn, published a
report to clients where it downgraded all the energy majors citing
valuation concerns on the idea that oil demand was not going to be
as high as once expected.
We've seen a lot of other media reports and investor concerns
and bankruptcies. More specific to North America operators' ability
to generate financial returns and cash from unconventional oil and
gas development. Are you noticing this news play out in actual
investor commitments to these companies shares?
Kevin Roy:
Yeah. Absolutely. What I would say is not only are we witnessing
that, but it's really accelerated over the last 18 months or so
what had already been probably a 10-year trend of institutional
investors—investors that represent the largest ownership of
publicly-traded energy companies, who are reducing what we call
exposure to the energy sector. So, whether that's upstream,
midstream, or downstream, and specifically North American E&P
companies. For that group, the exit or the reduction of exposure
has really accelerated over the last couple of quarters.
Hill Vaden:
So, the trend your saying is about 10 years old? But the
acceleration is more recent and isn't necessarily tied directly to
that 2015 price collapse?
Kevin Roy:
Yeah. That's the way we think about it when we talk to our
clients. Ten years ago, the energy sector represented 10%, a little
over 10%, of the S&P 500 Index. Fast forward to today, and the
sector represents less than 5% of the S&P 500 Index. So that's
a pretty dramatic reduction of the energy sector's presence.
Certainly, a catalyst would have been the 2015 collapse, but it's
more about investor decisions to allocate capital to a sector that
has not done a very good job of returning capital to shareholders
or just really demonstrating a return on their invested capital.
Meaning, the dollars that they invest in drilling for a well and
earning a return on that capital that they deployed for that
well.
Hill Vaden:
Well, you mentioned the index. I think last month was the first
time in almost 100 years that Exxon fell out of the top 10 of the
S&P 500 Index. So, this is hitting all the small North American
E&P's, but it's moving all the way up to the large integrateds
too.
Kevin Roy:
Yeah. That is shocking. Particularly for a company the size of
Exxon. I would add that there's another dynamic at play here in the
broader equity markets for those of us who invest in 401k's. We
give our money to -- we'll call it a Fidelity or Vanguard. Fidelity
is what we call an active investor. So, when I was talking earlier
about investors really exiting the space, what I was talking about
were these active institutional investors who have portfolio
managers and analysts who make decisions on what company shares
they bought. That group of investors in the market are really the
ones who are reducing exposure to energy companies and E&P
companies.
Kevin Roy:
What has also been happening in the broader markets is, those
active investors are losing their own investors or clients, you
know me and everyone else, because we're rotating our money to the
Vanguards of the world. Vanguard is what we call a passive
investor. Meaning, they look at an index like the S&P 500, and
they allocate the money that they have to invest based on the
weighting that we're talking about. So, while that's happening, the
passive owners of energy companies is actually increasing.
Hill Vaden:
So if the passive is 5% to match the index, then the active is
1-4%.
Kevin Roy:
Correct.
Hill Vaden:
Huh. So, Dan, from where you sitting and analyzing…your team has
been analyzing these companies for some 20 plus years. Obviously,
Exxon falling out of the top 10 S&P 500 is new. How has this
resembled or how does this feel different than the priors? This is
a cyclical industry, so energy falls out of favor almost
predictably every several years or decades.
Dan Pratt:
Yeah. Just to go back to Kevin's point. The trend, the sector
rotation out of energy is an even longer term than that. Go back to
the 90's, energy was about 15% of the S&P, and a decade before
that it was 20-25%. So, this has been a long-term trend and
increased tremendous pressure in terms of competition for capital.
Not only is it, how do companies compete for capital with these
other sectors? But if their pie or their share of that capital is
shrinking, how do they compete with their peers for that capital?
And how do they differentiate themselves? How do they get their
story out to investors?
Dan Pratt:
So it's certainly been trickling down and put a lot of pressure
in terms of their business models going forward. If you bring in
more of what we've seen here recently…if you look at the share
performance, you know the integrateds have actually done a little
bit better. They're down about 10% over the last 12 months, but the
E&Ps are down 40-60%.
Hill Vaden:
Sorry. Is the integrateds up performance would you say that's
more tied to yields? Some of these companies are generating 4 or 5%
dividend yield. Or, is it just the value of refining and marketing
within their integrated operations? Or, a combination of both?
Dan Pratt:
I think it's a combination of both. The integrateds business
model allows you to sustain your profitability a little bit better
through the peaks and valleys. But, I do think these guys have a
business model set up for what investors are looking for today in
terms of return of capital, higher dividends, etc. So the business
model in the downturn supports them.
But in terms of why it feels little bit different this time,
Hill, I think in the past boom and bust cycles, it's been more
about, "Are we going to have enough oil? Or, is there too much oil
compared to the future demand for fossil fuels?" This time it's
very much a question of, "Is that demand going to be there?" So
short-term, we have these supply concerns, but longer term if you
look at what's happening in terms of fears around peak oil demand,
de-carbonization and the whole energy transition. There feels to be
some real concern about what level of demand we're going to see in
the future for fossil fuels. So, that's what to me feels a little
bit different this time.
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