A Fresh Perspective on Energy

A. In general, we prefer high-quality, high-margin, stable businesses that produce significant free cash flow. Meanwhile, energy companies sell a commodity product and traditionally employ lots of financial leverage while generating cyclical earnings and poor returns on capital. So, for the first 25-plus years of our firm’s history, we largely avoided the energy sector.

A. From a supply perspective, oil and gas producers have sharply curtailed investment for the past eight years. Looking back, a steep drop in oil prices in 2014 led to a wave of bankruptcies over the next several years. 2017-2018 ushered in a bit of a recovery, followed by an even more abrupt halt with the pandemic. The sudden drop in demand as the world shut down led to negative oil prices and a complete washout in the industry.

A. We made our first investment in a Canadian oil sands producer, Canadian Natural Resources (CNQ). Historically, companies in the oil sands look more like manufacturers than traditional exploration companies trying to find new resources. The oil is there. And the oil sands industry spent tens of billions in capex building out the facilities, which can run for decades in the future. That meant we could come in as outside investors in early 2021 and reap the potential rewards. We think that CNQ has a very differentiated business model and an excellent management team.

A. With oil prices touching $120 a barrel in 2022, the natural expectation (and historical precedent) would be a wave of supply in response. Yet we just haven’t seen that. We think that is partly due to the way the world now views energy. We have seen pressure from governments, regulatory agencies, and ESG influences damping enthusiasm for oil and gas in favor of renewables. These pressures have suppressed the usual supply response to higher prices.

In certain cases, the compensation systems for management teams have shifted to include ESG metrics or environmental goals. During previous energy upcycles, energy companies were reinvesting more than 100% of their cash flow into new investments. Now they are reinvesting less than half. Instead, companies have shifted to returning capital to shareholders via share repurchases and dividends. The market has rewarded such capital discipline. Even if a company had a profitable billion-dollar project today, the market would likely react negatively to such an announcement—and a falling share price would only reinforce for other management teams that “I’m not going to do that.”

A. With our broader energy investments, we do not try to predict the short-term price of oil. It is an extremely volatile commodity with prices often heavily influenced by investors and speculators trading around the paper price of oil as opposed to physical barrels. We have also seen material disruptions from government intervention, such as the U.S. releasing significant barrels from the Strategic Petroleum Reserve, which has impacted prices over the last year or so. 

Ultimately, there are too many variabilities influencing the price of oil on any given day. Our thesis rests much more on the supply/demand imbalance over the medium term.

A. We think the risks have been mitigated somewhat by companies using this period of high prices and underinvestment to significantly deleverage balance sheets. Most of our energy investments have very little debt and are repurchasing shares and paying attractive dividends. The dividend yield for U.S. E&Ps is now significantly higher than the broad market. 

Select producers have also done a tremendous job lowering their cost structure, with many now breaking even below $40 per barrel. That lower cost structure provides a meaningful cushion from a pullback in energy prices. The combination of low-cost producers with strong balance sheets and shareholder-friendly capital return policies is a marked departure from prior cycles in energy. While this mitigates the downside, exposure to the sector does partially hedge the portfolio from the threat of spiking energy prices (with the recent situation in Europe serving as a stark reminder of what can happen when people are worried about keeping the lights on).