Join Guillaume Roux-Chabert, from IBKR Singapore and Stefano Grasso, Portfolio Manager for the Enhanced Value Fund in Singapore on a deep dive for value in the energy markets.
Summary – IBKR Podcasts Ep. 135
The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.
Welcome everybody to this week’s podcast. My name is Guillaume Roux-Chabert from Interactive Brokers Singapore. I think it would be a very good way to start the year, I have 2024 with my client and friend Stefano Grasso by reviewing everything in energy.
Welcome back Stefano.
Hi, Guillaume. Thanks for having me again.
You’re welcome. All right, so let’s have a crack at it together. Everything in energy. Let me start with this question, given your background within the energy practice with McKinsey and at Columbia University and you know, trading with Eni, I understand you also have quite a lot of energy exposure with enhanced value fund, your fund that you manage here in Singapore. Can you maybe help give a bit of an overview of how you think about energy from an investment perspective?
Sure. I think the starting point is the importance of energy for the war. And you know, it’s not something that is nice to have. It’s something that is needed and sought after really across the globe. You know, maybe some primary energy numbers to start with are important because typically especially these days we talk about a lot about renewable energy, which is only electricity.
There is a lot of debate of fossil versus non-fossil fuel. But the reality is that about 80% of the primary energy usage is still fossil between oil, coal unfortunately and gas there is a lot of energy that is needed and consumed via fossil energy. The energy density that is in fossil fuel is just different, difficult to replicate with batteries and other technologies. We’ve seen the kind of decline of nuclear and hopefully now the resurgence of nuclear that is going to help make the zero-emission transition. And of course, together with energy, you have also to talk about carbon emission. There is actually a proper market about carbon emission and that’s increasing effectively the cost of producing and consuming the most polluting form of energy. And to just conclude this very brief introduction, I think energy is probably one of the most heated and politicized sectors I can think of. And for us at Enhanced Value Fund, that provides, typically, when there is this situation, a good opportunity to approach it from a very rational and data-driven approach where we try to deviate from the narratives, but just stick with the numbers, and so what I hope to discuss with you today.
Shall we dig in a bit more into the subcategory of the sector of energy, you mentioned about nuclear, you mentioned about charcoal or coal, which is like around 40% of the of the energy mix if I’m not wrong. So how do you value those different like segment of the energy sector and which sector do you prefer or, you like in particular?
So, let me give you a brief overview. Of course, the sectors that we like the most are the sectors that have attractive valuation. So, that’s mainly what’s driven our interest from one and another.
Let me start by saying that biofuel, hydrogen, and other kind of innovative energy plays are a bit too risky for us. And when I say too risky, I mean, there is a lot of uncertainty around technologies that are not proven and the cost of the whole value chain. One theme that’s also recurrent is to large extent their success and their economics are linked to incentives, and this is very dangerous from our perspective.
We want to invest in sectors and businesses that can make money and stand alone on their own legs without having incentives and now this is not the case for these innovative energy plays. More traditional sector is utilities. We’re talking about electricity here and you know, there are the kind of gas CGT or even coal-fired traditional plans and the green ones that produce electricity. From basically the utility install, in case of, you know, the renewable energy, the green installation, they install wind and solar panels and they’re supposed to have a sort of bond-like return because they sell electricity typically at a fixed regulated price. And they bear the risk, like project development, project execution, of course, they need to be careful with the leverage, not to exceed it, but in essence they are going to get a return on the investment that should be predictable.
What we didn’t like a year ago was the valuation, especially given the increasing interest rates. But nowadays the after the recent correction, you saw some big players like NextEra in the US and or Orsted in Europe coming off quite dramatically on the backlash, you know, of some offshore cancelled project in the US, especially for Orsted. And now we see valuation that are more bond-like with the premium for the execution of the project which we like. Before was like bond-like minus which we didn’t like that situation. So, the utilities are the least exciting sector – if you want. But the good thing is that the kind of prices came off a bit, so we see value there. We also, related to this new energy production, we like to go a bit upstream in the new energy sector, so to speak.
So, there are commodities like uranium, which you know we mentioned nuclear before, copper, lithium, polysilicon, which is the base material for solar panel since they are energy related resources, we look at them under the energy hut, and they are quite volatile in terms of price movement. But nonetheless, they are in dire need, and we like the supply demand balance across these different commodities.
Truth being so told is different time horizon. So, for example it looks like copper is probably tighter than the lithium in 2024 and also polysilicon is going to tighten probably in 2025. But there is a clear demand and we kind of feel it’s reasonable to understand the supply and demand dynamics, so companies that produce this kind of commodity either mining or you know through them, technical process, we keep a close eye. Then if we move on to the more traditional oil and gas sectors, oil and gas companies are typically much more volatile because they are exposed to the underlying price of the commodity being these oil or gas. And you know, we can divide them in four categories. One is downstream, which is the business of converting fuel into oil products. And these economics, the economics of this business is a function of the demand for end products. We’re not excited about this sector in today’s valuation, but we can go back there and talk in more details, some sector in the oil gas is the midstream which is a business of moving oil around, oil and gas around.
So, our pipeline, you know ships, terminals, and these kinds of assets. These guys, these companies make money with volume and there is a very strong certainty about the growing demand for oil and gas, also for oil going out to 2030. Then it is debatable when it’s going to peak, demand. But the need for this infrastructure is kind of rock solid in the mind of everyone and we like the risk adjusted return currently of these assets. And again, we can discuss in some details if you want, but the concept here is very predictable, the demand side and the economics are quite clear, and easy to understand.
Finally, the third sub-sector is the upstream side of business and here the business is about extracting the commodity out of the ground and of course is a pattern, the commodity price, so might be oil or gas. The interest that we have is less in the bigger cap names but more in the smaller cap names, because we see some multiples that are very interesting, consider the fact that our understanding of the oil supply demand is that.
There is a lot of Capex that needs to go in the industry just to maintain supply, let alone to increase. So, you really need companies putting CapEx to maintain oil production and we see companies trading below 5x EBITDA which for sure are in a much more volatile sector than you know, the midstream sub-sector, but the upside is really there and the need fundamentally of these companies still there.
So, this is again a sector that we like as well. And finally, there are all the ecosystem of companies that work around the oil and gas sector, which are the oil services companies. Some are also owning rigs and you know heavy machinery and these companies have been gaining quite some attention lately. The valuation has increased a bit. We were less bullish than we were a year ago on these names, but definitely also in this case you get a bit less volatility and somewhat certainty of the utilization rate of their equipment and there, you know, manpower for the foreseeable future given this increased demand for oil.
At Enhanced Value Fund, we like to travel between the sub-sectors depending on where we see value. So, you know, this very conversation we’re having, we’re having today, might be quite different in three, six months’ time if evaluation readjustment for some reason change. Uh, you know, between big cap and small cap, sometimes things change quite quickly. Usually small cap, you know, lag, but sometimes you know, in when the market is super-hot, they go ahead of themselves and we sometimes also kind of took position in the commodity itself as a hedge against our equity exposure. Or as a diversification out of the equity that we have in the portfolio, ah, bit of trying to run through many things at in one go…but hope this makes sense.
It does, and if the landscape changes, we can always have another podcast. maybe. So, you touched a bit on that in your in your development here, but can we please focus on oil and gas for a second? And could we have like another look at the oil prices, I mean you were trader at Eni before and what are the drivers you see in the market especially?
So, I think the job that they’re trying to forecast the oil price is a bit of a fool’s game. And you know, I used to be asked by, you know, Reuters and Bloomberg, they were like Monday competition about who was getting closer to the Friday settlement price for Brent and so forth.
It’s really impossible, even more so than in the stock market. The short-term movement is very difficult to predict. So, I am surprised, what I can say is I’m surprised how low the oil price has been, given the amount of uncertainty that we have, and the fundamentally supply demand scenario.
If you are today an oil and gas company, you’re struggling to find, to finance projects. I mean, banks don’t want have loans on their balance sheets, loans given to a company. If you try to price a bond, if it is not an ESG bond, you pay a premium, you don’t have a lot of interest for those bonds. I mean there’s still liquidity, but definitely is a hated kind of sector of the market.
So, this lack of funding, inevitably push the IRR of the projects higher because you don’t fund projects that don’t have very rich IRR and return on capital because you don’t have a lot of capital you need to compete for these kind of things.
So, I don’t have a forecast, let’s say for 2024, for oil. But what I can tell is, I think that below, let’s say $50-60 per barrel, a lot of marginal production is not profitable and for that I think of that as a floor. Then upside that is for oil all the way to $100 -150, whatever, is going to average in the next you know, 3-4-5 years, is going to depend on how much CapEx, the industry is going to put it. How much, you know, productivity the current equipment is going to be able to achieve, and how much resources, terms of very difficult also.
There is the human resources crisis in the oil and gas industry and young kids out of university don’t really want to join you know an oil and gas company, for good reason. So it’s very difficult for us to see 3-5 years’ time with the oil demand forecast to increase to 105 to 110 million barrels per day, whichever, you know, forecaster you pick in terms of volume. So, like let’s say you know 3 to 8 million barrels per day more oil is going to be needed compared to what we today are producing.
It’s very difficult in this scenario to foresee an abundance of oil. And I think that’s also why, in part, savvy investors like Warren Buffett are investing in Occidental in his case. But in general, in oil and gas, because there is a lot of risk of having scarcity and you want, we all want to transition to renewable energy, but we need to have an alternative and that 80% that is fossil cannot switch overnight. So unfortunately, we can accelerate the transition, but we cannot just switch the oil and gas sector, so it kind of shapes as a kind of predictable supply demand scenario that we are keen to be invested in, in some shape or form.
I see. Well, at least I you’re able to kind of like emphasize on some level of pricing like around $60 per barrel. That has an Impact. Can you … on more of the impacts exactly on the corporate fundamentals such as the EBITA and also according to you, where should the multiples be for oil companies?
So, I mean, this is of course this is not investment advice, but I can tell you like what that Enhanced Value Fund, what is our kind of thought process. So first off in oil and gas producing there are certain countries that in the UK for example, the taxes and royalties on oil producing companies are very high, I think 88 to 90%. So, your leverage to oil price is, you know linear with that drag. For other situations, other jurisdictions and specifically in in the US example, in case of the US shale, you pay once you develop the land to a certain extent. The proceeds that you get from that land are your own proceeds.
So, if your cost of producing oil is like $50, $60, say it’s $60, if the price of oil is $70, you know you make $10. If the price of oil is $80, you make double that, right? So, you have an exponential exposure. I’m simplifying a bit, but I just want to give the idea that not all the barrels around the world have the same economics, even though the carbon chain within the liquid is the same.
So economically, you know, you want to be… if you think that the floor for oil prices is not far from where it’s trading now, then you know you want to be exposed to the upside. And currently you have at $70 $80, you have many companies trading at 5x single digit EBITDA.
And in a scenario when oil goes to $9 per barrel, you know $100 per barrel, then you have inflection and then you talk about tripling the EBITDA and then most likely when the EBITDA is going to triple, the multiple and evaluation are going to expand as well. So, you’re going to get the, you know 5X – 7X, you know your kind of money. And that can happen, you know, organically or can happen because you have a US, a Middle East crisis. You know, we all read about the shipping disruption. And you can have, you know, war in the Middle East that escalate, the good thing about, you know, North American Canadian production is that you produce oil in jurisdiction that are much safer than other jurisdictions. So, you get this double plus, and unless there are some crazy ruling WTI and brands should trade more or less, you know, in close proximity. And so, we think that’s a good exposure to have. It’s also an insurance against some of the geopolitical crisis that might happen.
Certainly, makes sense. A final question. Could you let us know more on the dividend yield and how to classify the landscape of oil and gas companies. I mean there must be like so many different profiles to understand for savvy investors?
One thing about dividend that you know, we don’t particularly like is the taxation. So we are incorporated in in Singapore and you know U.S. companies are eligible for withholding tax. So, any dividend that we get from U.S. companies, are subject to 30% withholding tax.
So, if a company paid 10% dividend, we get, all international investors get 7% net dividend. So, we look at how companies return capital, and we look at the free cash flow yields, which is basically operating cash flow after CapEx that the company has a disposal and can decide what to do. Then they can do reinvest partially in the business, do buybacks, or do dividend. So, the dividend … it’s inefficient, specifically for non-us investors. There are companies outside the US, they don’t have this problem, even if they’re listed in the US because their incorporation is outside the US.
But what we really focus more than on dividend yield is free cash flow yield. And we like under different price scenario to have companies that are protected in case of low prices, they don’t go bankrupt. They don’t have a lot of debt. Or when they have leverage exposure to oil price and when the oil price goes up or gas price goes up, they have a lot of cash to distribute and then hopefully they’re going to distribute wisely.
Even the current situation prefers share buybacks, because is an enhancement of the return over time and doesn’t have the kind of tax drag that we mentioned. In the midstream sub-sector, which is the one that historically typically paid the highest dividends, it’s even more true. We consider shipping as midstream and in the shipping industry there are some Norwegian company that are there are quite a few Norwegian companies because it’s a big market for shipping. And the taxation on their dividends is 0, so you get these 10% 15%, 20% depending on the current field that they pay, tax free, which is great, you know return compared to a US listed withholding 30% penalization, so that’s a bit how we think about the dividend deal.
Understood. And we are reaching out to the end of this podcast. So, Stephanie Grasso, Portfolio Manager at Enhanced Value Fund in Singapore. Thank you very much for joining us today. So, thanks again and thanks all for listening.
Absolutely. Thank you, Guillaume.
Thank you. Happy trading ahead. Cheers. Bye.
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