Energy Investors are Jaded

by Cole Smead, Smead Capital Management

Dear fellow investors,

My colleague Albert Starshak and I headed to one of the meccas of energy investors last week: the Calgary Stampede. The Stampede is the largest community festival in Calgary. It provides Canadian banks and brokers a big draw to host prospective and current customers to talk with analysts and executives in the space. One overwhelming takeaway we had from the week is that investors in the space are frustrated that oil and gas companies are not already garnering higher valuations. The primary reason why is that there are no prospective investors coming to the space. Ultimately, the potential buyers are jaded like a former lover would be. Miley Cyrus sings this tune better and more beautifully. Her poetic truth tells the story the best.

I don’t wanna call and talk too long. I know it was wrong, but never said I was sorry. Now I’ve had time to think it over. We’re much older and the bone’s too big to bury.

Oh, isn’t it a shame that it ended like that? Said goodbye forever, but you never unpacked We went to Hell, but we never came back

Oil and gas companies are voraciously seeking to appease potential investors. These investors “don’t want to call and talk too long.” What these companies believe investors want is low levels of debt, large capital returns to shareholders (sometimes in dividends and other sin buybacks), good ESG scores and long-life assets. Most prospects in the space don’t care because they used to invest in energy from 2005 to 2020, but now they “know it was wrong.” They “had time to think it over.” They are not interested now that their “much older.” They “went to hell, but we never came back.”

I’m sorry that you’re jaded. I could’ve taken you places. You’re lonely now and I hate it. I’m sorry that you’re jaded

Most investors in 2023 are jaded toward energy investments. We and our investors believe that these could take “you places.” The oil and gas companies know that they’re “lonely now and” they “hate it.” There is a danger of the issuers being too investor-focused. The danger in this strategy is that these are the same investors that wanted them to drill, drill, drill in the 2010s unsuccessfully. Now they are praying that debt goes to zero and return of capital is the only thing done. Both of these strategies have one long-term goal: low returns. Wasting cash flow on capex was a nightmare for much of the last 30 years until recently, as you can see from the chart below. There was no return left after drilling wells or finding oil.

On the flip side, being too conservative can produce bad returns as well. When you pay off debt you lower your ROE (return on equity). There are times right now when companies pay off debt that banks will not lend to them. Why pay-off capital you may not be able to get back and at interest rates you can no longer get from a lender? Trying to get these low-return investors excited is a foolish strategy. We at Smead Capital Management would say to these investors that we’re “sorry that you’re jaded.” We believe companies should do something different than what investors seem to want.

You’re not even willing to look at your part. You just jump in your car and head down to the bar ’til you’re blurry. Don’t know when to stop, so you take it too far. I don’t know where you are and I’m left in the dark ’til I’m worried. Oh, and it hurts me.

Source: Bloomberg.

These jaded investors are “not even willing to look at your part.” At the dead flat top of oil in 2008, they were willing to pay the highest book multiple. Today, energy stocks are producing higher ROE than in 2008, but they aren’t paying the same book multiples. It looks like they “don’t know when to stop, so you take it too far.” We believe this leaves a huge opportunity for oil and gas executives that don’t act like these foolish investors and for the investors of Smead Capital Management that don’t want to emulate foolishness either. We would advocate that companies optimize their capital structure to produce the highest ROE possible. After all, high ROE always produces high book multiples.

And it’s a…shame that it ended like that. You broke your own heart, but you’d never say that. We went to Hell, but we never came back

Below is the energy holding weight in the S&P 500 Index, since 2005.

Source: Bloomberg.

We would prescribe the goal of producing the highest ROE possible, including keeping leverage that is not due. Forget what the investors say because they are a bad guide! Lastly, we believe you should make every capital allocation decision based on what gives you the higher ROE at the cheapest price. This may be acquiring other companies for stock or cash, buying back stock or investing in projects that you have in your company that have high returns. Dividends don’t fit into that framework. Why pay down debt to then commit to regular dividends which are a liability? Taking down liabilities to add them back makes no logical sense. Even Miley would scratch her head.

Mr. Market knows that low ROE produces low multiples and high ROE produces high multiples. He’s just very manic when he is jaded. We are seeking high-return businesses that are mispriced. By God’s grace, there are a lot of jaded investors and a lot of mispricing in this space. We’re sorry that Mr. Market is jaded. The right business managers can take us places. These companies are lonely now and (in comparison) we love it. We are sorry that investors are jaded.

Fear stock market failure,

Cole Smead, CFA

The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Cole Smead, CFA, CEO and Portfolio Manager, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

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