Musings: Energy Stocks Have Mostly Trailed the Market This Year
The results of the November 2nd election and the recent Federal Reserve Bank’s announcement that it was embarking on another attempt to stimulate the economy by encouraging bank lending through a program to provide more liquidity to the banking system, known as the second quantitative easing, or QE2, have driven the stock market to levels that existed immediately before the collapse of Lehman Brothers. Accompanying the QE2 announcement, the worth of the United States dollar among world currencies fell in value helping to boost the price of commodities including crude oil. Natural gas prices in the U.S. have not benefited from the weakening dollar as the product is truly a local one.
When we look at the performance so far in 2010 for the overall stock market, as measured by the Standard & Poor’s 500 Stock Price Index, it has been solid. The S&P 500 index is up nearly 10% through the end of last week, and is at a level exceeding that achieved in late spring this year. But when we look at the performance of energy stocks, they have tended to lag the performance of the overall stock market despite the strong impetuous from commodity prices.
If we look at what has happened this year in energy markets, there have been two primary events that have shaped the business – the Gulf of Mexico oil spill disaster and the recovery in economy activity following the 2008-2009 recession. While energy demand has recovered from the drastic drop experienced last year due to the recession, the combination of rising supply and continued subpar economic growth and energy demand in the industrialized economies of the world has muted the magnitude of the oil price rise. Crude oil is denominated in U.S. dollars globally, and its price is impacted by the fluctuating value of the U.S. dollar. At various points in time during the year oil prices rose or fell sharply in response to movements in the value of the dollar, however, there was no sustained move in any direction either up or down. As a result, the price of oil on the futures market has remained within a trading range of $68 to $86 per barrel as shown by the straight lines bracketing the oil price line in the exhibit below.
Exhibit 1. Energy Stocks Mirror Commodity Moves; Lag Market
Source: Yahoo Finance, EIA, PPHB
When we look at crude oil prices during this year so far, it becomes clear there were periods when the price movements up and down were quite sharp. These moves mostly coincided with economic data and political events that either helped boost or weakened the value of the U.S. dollar. What also becomes evident when looking at the stock market performance of the various energy segments and the overall stock market index was just how correlated they have been with the price movements of crude oil, even though the stocks are indexed in value to the start of 2010 and crude oil prices are stated in absolute dollar terms.
When we turn to the relative performance of the energy sector versus the overall stock market, we see that for most of this year energy has lagged. The one sector that has outperformed all the other energy sectors along with the overall market was the OSX, or the Philadelphia Oil Service Sector. This industry sector did well in the first third of the year until the Deepwater Horizon disaster in late April and the resulting BP oil spill. From outperforming the overall stock market by nearly 10 percentage points in April, the OSX, at its low in the summer, underperformed the market by nearly 15 percentage points. Today, the OSX is ahead of the overall stock market performance for the year, and is leading all other energy sectors. Why is it the case?
We suspect that the over-performance is a combination of factors including: better earnings prospects through more global business exposure; small cap stocks that can outperform large cap stocks during periods of market volatility; merger and acquisition events; and strong balance sheets that can fund increased capital investments, higher dividends and more stock buybacks. The importance of these characteristics cannot be underestimated as they have helped to overcome the weakness oil and gas companies have experienced in natural gas prices and energy demand that has impacted crude oil operations.
As a result of the Deepwater Horizon disaster in late spring, those offshore contract drilling and supply vessel companies tied to the Gulf of Mexico by either their equipment capabilities or organizational structure suffered greater stock market price declines than their competitors with more global operating footprints. Additionally, the offshore contract drilling and supply vessel companies suffered greater stock price declines than the broad-based oilfield service companies with large international operations. Wall Street perceived that international oilfield activity would continue to grow even while the offshore industry was suffering and that Gulf of Mexico-centric companies would be hurt the most.
The relative performance of small cap versus large cap stocks seems to be shifting in favor of the oilfield service stocks, although this trend is somewhat a function of the risk trade investors are willing to assume. The stock market oscillates between periods when small caps are in investor favor and they outperform their large cap peers, and vice versa. The types of stocks that do well at any particular point in time are largely a function of their earnings prospects and their financial strength. In times when business is deteriorating, investors favor companies with large and strong balance sheets in order to offset the economic and financial risks from a weak economy. On the other hand, when investors focus solely on how fast companies can grow their earnings, then small caps become the preferred investment vehicle.
The oilfield service industry appears to be in the midst of a restructuring of its business. So far this year we have seen two major service companies disappear – BJ Services and Smith International – as they were gobbled up by larger competitors. In the past week we had two offshore drilling companies signal the possibility that they might be sold – either to another contract drilling company or possibly to private investors. We have also seen a number of smaller companies acquired by larger strategic industry buyers, which has reduced the number of companies available for money managers seeking a presence in this investment space. Companies such as Dresser-Rand (DRC-NYSE), Allis-Chalmers Energy (ALY-NYSE) and Superior Well Services have all been the subject of acquisition transactions either closed or underway. All of these transactions mask significant acquisition activity among small companies and demonstrate that the oilfield service industry is in a rapid restructuring phase.
Balance sheets of oilfield service companies are quite strong, a reflection of management lessons learned during past industry downturns. Managers learned that financial leverage is an accelerant for growth in up-cycles, but can destroy businesses in down-cycles. Low debt levels and meaningful cash balances have become the preferred operating philosophy for oilfield service companies. As a result, managements are constantly weighing how much money to allocate for new capital investments to fuel future growth versus rewarding shareholders through increased cash dividends and stock repurchases.
When it comes to dividends and share repurchases, understanding the role each plays in rewarding shareholders is important for managers. Buying back shares is a way to shrink the denominator in the earnings per share calculation. The theory is that when cash is used to repurchase shares, the lost interest earnings will be more than made up for by the boost in earnings per share from fewer shares and the resulting company valuation will increase. In theory this exercise should lead to a higher stock price, but in practice share prices often do not benefit from the shrinking capitalization. What happens is that shareholders seeking to exit from their holdings are rewarded as the stock price paid often does not appreciate sufficiently to offset the lost income from the cash used to effect the transaction.
Another negative about stock buybacks is that managers elect to do them when they have excess cash. That often occurs at or near the top of business cycles when share prices tend to be highly valued. As we have seen in the past, share repurchases in this cycle peaked in 2007 as the stock market was advancing steadily only to crash in 2008 with the financial crisis. The net result was that the returns earned from the cash utilized to repurchase shares were negative. The fall in the stock market was one reason stock buyback returns were negative, but this approach for returning cash to shareholders ignores the fact that the share repurchases were one-time events and there was little reason to remain loyal to the company.
Exhibit 2. Stock Buybacks Often Come At Market Tops
Source: GMO White Paper
Historically, income from dividends and growing dividends have accounted for a meaningful share of the total returns earned by shareholders as shown for the period 1871-2009 in Exhibit 3. Over this very long historical period, dividends accounted for nearly 90% of the return to investors. On the other hand, in periods when stock prices are falling, dividends provide a positive offset to the negative returns from continuing to hold on to shares as was the case in 2000-2009. Importantly, dividends, and especially dividend increases, represent positive statements by managers about the health and outlook for their companies. Dividends tend to rise slowly as companies grow stronger and more profitable.
Exhibit 3. Dividends Are Important In Total Return
Source: GMO White Paper
Dividends are not just a U.S. phenomenon. Since 1970, dividends have played a large role in returns earned by investors around the world as demonstrated by the chart in Exhibit 4. In Europe, anywhere from 80% to 100% of the total returns earned by investors since 1970 has come from dividends when both the current yield and dividend growth components are considered. The importance of dividends for investors was driven home this summer when BP (BP-NYSE) elected to stop paying its dividend while it was engaged in cleaning up the oil spilling from its Macondo well in the Gulf of Mexico. Prior to the dividend elimination, BP’s payment accounted for £1 ($1.62) of every £6 ($9.72) paid out in dividends to British pension holders, or nearly 17% of their dividend income.
Exhibit 4. Dividends Worldwide Are Important
Source: GMO White Paper
As we start the 11th month of the first year of the new decade, energy stocks in general have lagged the performance of the overall stock market. The energy business has entered a new phase following the strong growth period that marked the decade of the Aughts. We continue to believe this decade may prove as challenging for energy companies relative to the Aughts as the 1980s were for those companies riding the rocket powered by high energy prices in the 1970s. While it was impossible at the start of the 1980s to envision the total collapse in global oil prices that occurred merely a few years hence, it is equally as impossible to envision the scenario that would mirror the collapse in the coming decade. For those of us who have lived through these great industry cycles, we try not to look too far ahead when walking to avoid stepping into a pothole. Our hope is that any pothole we do step into doesn’t turn out to be a chasm.