My last article had me questioning my sanity for investing in energy companies. The last decade has been brutal, and the political environment is brutal.
Before delving into the questions, I would like to comment on a common narrative — that the invasion of Ukraine caused a European energy crisis. The narrative is highlighted by the following quote from a recent article in my local Calgary paper. “Consumers are seeking alternatives to (natural) gas after prices rallied to unprecedented levels as Russia’s invasion of Ukraine sparked an energy crisis in Europe.”
Farmers will easily recall the spike in urea pricing last fall, partly caused by the closure of European plants due to their inability to source natural gas. European wholesale natural gas prices, which ranged from about 10 to 25 euros per megawatt hour over the past decade, began spiking in the summer of 2021, reaching a record of 136 euros in December of 2021, well before the invasion.
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Coal ranged from about US$50-120 per tonne over the past decade and spiked to more than $250 in the fall of 2021, while European electricity prices quadrupled between the summer of 2021 and December of 2021. The invasion did not cause a European energy crisis. While we will never know Putin’s thought process, I would submit that he chose the timing of the invasion because of the energy crisis with full intent of using energy as a weapon. The invasion exacerbated a crisis that already existed.
Commodities are notoriously volatile, which makes them tricky investments. My history with such investments is checkered. I have had some wonderful successes like Imperial Oil, which returned about tenfold between 1995 and 2008. And I did well with energy trusts when they existed, but I have also experienced some of my worst failures, namely the bankruptcy of two ocean drillers. I am still underwater on a couple of the E&P companies mentioned in the previous article.
The reason Imperial did well from 1995 to 2008 is it averaged 27.1 per cent return on equity (ROE), 12.1 per cent return on assets (ROA) and 17.9 per cent cash flow to assets (CF/A) during that 14-year period. Those are very good return rates — double the 9.6 per cent ROE, 5.2 per cent ROA and 9.3 per cent CF/A of the past decade.
Reversion to the mean
A powerful concept called reversion to the mean is applicable to many aspects of life, including investing. With canola yields as an example, plotting your last 25 years on a graph will likely show that while erratic from year to year, yields have followed a trend line, probably up by about two per cent per year. If you drew a straight line through that series of points and projected out several years, you can visualize future expected yields. If your yield falls below the line, it doesn’t mean you became a terrible farmer. Likewise, if it comes in way above the trend line, it doesn’t mean you figured out a silver bullet that will forever increase yields. The next few years will likely mean-revert to the trend line.
Similarly, if a stock sector has performed poorly, there is a strong probability it will mean-revert to its trend line while other sectors that have done well may also mean-revert downwards to their trend line. Energy companies traditionally trade at about five to seven times cash flow and are now three to four times cash flow. Reverting to traditional valuations would represent a nice gain, even if oil prices stabilize. Additionally, momentum often overshoots trend line before mean-reverting back down, in a never ending see-saw manner.
The world was running out of oil in the 1970s, then again in the 2000s. Each time new discoveries brought production back to meet demand. While the most dangerous three-word phrase in the markets is “this time is different,” in the oil business it might be different. There has been a dearth of exploration over the past decade because of poor pricing and the political environment. There are only 47 years’ worth of known reserves at today’s usage rate, with eight years in Venezuela. Without a regime change that oil is inaccessible, leaving only about 39 years’ worth.
Saudi Arabia also has about eight years’ worth, with Canada in third place at about five years. In other words, Canada could, if allowed, supply the entire world needs for just five years. Nuclear remains the only known technology that can replace any amount of fossil fuels.
While my past energy investment record has been checkered, my recent past has been quite successful. Just one example is the purchase of Cardinal Energy for $1.32 in February of 2021, selling part for $7.99 and still holding the majority currently valued at $8.25. That’s six times the purchase price in just over a year. If, as I expect, oil company profitability reverts to the levels of 1995-2008 and company valuations mean-revert to five to seven times cash flow, there is lots of upside. Political risk and a severe recession represent downside risks.
