Tuesday, 22 November 2016

The very long term for oil

With al the noise about the era of oil and gas coming to an end soon let's take a look at the prospects for the industry in the future.

It is hard not to sit up and take notice when you see that Royal Dutch Shell has delivered compounded returns for the buy-and-hold investor of 14% annually between 1911 and 2003. It’s been one of the best living, breathing examples of the notion that you only have to get one decision right in life to radically change your financial circumstances, and the particular case of Royal Dutch Shell comes with the important side benefit that much of the total return comes from the dividend income.
There are 50+ companies out there with similar 50+ year track records, but what distinguishes Royal Dutch Shell is that the total returns significantly exceed earnings growth. It applies The Philip Morris principle explained in Dr. Jeremy Siegel’s book research “Stocks for the Long Run” in which perpetual undervaluation enables reinvested dividends to give you a long-term result that is much better than you would otherwise have a right to receive if you assumed that earnings per share growth would simulate the returns you’d get over the long term by owning a particular business.
This is old hat to those of you that have been reading here for awhile, but it’s a principle that many in the investment community seem to have forgotten. People are upset that Chevron hasn’t raised its dividend, seemingly unaware of the fact that the $95 price of the stock probably helps you out more than a dividend raise while the stock was in the $130s last summer.

Over the next three years, Chevron will pay out $12.84 in dividends if it maintains the current rate. At a price of $95 per share, you will be collecting 13.5% of your initial investment from dividends alone. That alone is enough to turn 100 shares of Chevron in 2015 into 113.5 shares of Chevron during this time in 2018. My estimate may understate the case because: (1) Chevron is likely to be paying out higher dividends in 2018 than 2015, and (2) my estimate analyzes cumulative dividend payouts but does not take into consideration the iterative effect of receiving new shares every 90 days that advances this process a bit.

The current price of Chevron and the other oil giants may not be once-in-a-generation pricing( earlier this year is was a pretty good moment), but it’s in that zone where you can improve your long-term investment performance by purchasing high-grade assets selling at 15% to 30% discounts.

What strikes me about the world of financial commentary is that very few analysts seem to be making decisions with certain first principles in mind. I don’t want to be one of those people who rush towards oil stocks in 2007 and 2008 saying “Hey, it’s a nonrenewable resource, and the world’s energy demand is growing” while recoiling from the sector in 2009 because the price of the stocks is falling and the narrative switches to “Hey, we won’t be using this stuff in 2080.”

Some of my first principles that apply to the oil sector specifically are this:
One, I will not abandon companies that are still immensely profitable during adverse conditions in the business cycle. Chevron and BP are going to make $9 billion and $7 billion in net profits this year, respectively, assuming oil remains in the low $50s. That is where my sense of courage with these companies originates–the business model for oil isn’t “broken” unless you believe that oil will 
sell for $20 per barrel for 10+ years. That’s what it would take for the giants to generate losses.

Two, I recognize that true value investing often involves some unpleasant metrics. Companies don’t go on sale when they are paying down debt, delivering double-digit revenue growth, buying back stock, and gaining market share. Companies like Visa have no debt and grow at 13-15% every year, but the catch is that the valuation is 30x earnings. That removes some clarity from the wisdom of buying shares right now.
With Chevron, you see that the company has been burning through its reserves at twice the rate it has been replacing them over the past years, as most of the profits have gone towards maintaining the dividend. The appeal of Chevron is largely the expectation that, at some point, profits will return to $15-$20 billion, and large capital gains and dividend increases will accompany that return. The cause for hesitation is that people people make forecasts based on recent trends and decline to recognize a reversion to the mean.

However, if you can think pragmatically on this issue and recognize the inherent fluctuations in commodities, you can avoid this recency bias and avoid becoming one of those DALBAR Study people who only generate 3% annually while the general market delivers 9-10% returns. There’s a lot of smart investors that advocate buying wonderful companies at fair prices, and there are others advocating buying companies selling at a price less than they are worth. A good blend of these principles involves giving hard looks to Exxon, Chevron, and Royal Dutch Shell as they trade at moderate discounts.

Three, it would be impossible to advocate buying oil stocks for the long term without making some kind of prediction about energy sources over the long haul. My prediction for oil is two-fold: First, to borrow a phrase from Hannibal’s finest, “the rumors of oil’s death are greatly exagerrated.” It’s not just the difficulty of replacing it at the gas station (which accounts for 46% of petroleum’s usage in America). It’s also used in heating oil (20%), jet fuel (8%), propane (7%), liquefied natural gas (6%), still gas (4%), feedstocks (2%), asphalt (2%), lubricants (1%), and waxes (less than 1%).
And secondly, I have the expectation that the large oil companies of today will have a seat at the table and participate in the energy innovations of the future. If sun and wind power the future, which kinds of firms do you think are going to be purchasing the equipment from General Electric to provide that energy? Just as Rockefeller moved past whale oil to crude oil, and just as modern companies have incorporated natural gas and hydrocarbon gas liquids (which is a lucrative source of profits involved in plastic manufacturing), I expect the energy companies of today to transition to the energy outlets of the future.

This isn’t some crazy departure from precedent–every company that you see today evolves as it invests retained earnings and sometimes takes on debt to prepare for the growth of tomorrow. Owned Coca-Cola for the past 50 years? Great, but those dividends that were primarily funded through soda sales now come from soda, water, energy, juice, and tea sales. Been twenty-year holder of Procter & Gamble? Great, Tide has always been supporting your growth, but eventually the sale of Gillette razors came to support your underlying profits.

I see no reason why Exxon, Chevron, BP, Total SA, and Royal Dutch Shell won’t be the owners of the energy sources that propel the world’s future, and with a growing world population of 7 billion people that is still rapidly industrializing, the energy demands in the future decades will be enormous. If you can shrug off volatility because you can appreciate the current underlying profits and recognize that the industry will eventually morph to reflect technological advances in the energy space, owning these large oil stocks can be one of the best dividend investments you can make for the super long haul.

This same scene repeats itself over and over. Energy companies work through the business cycle, and wild pessimism takes over. But Chevron is stronger than it has ever been, producing over a million barrels of oil equivalents per today, and currently offers a 4.5% dividend yield. Worrying about the dividend freeze misses the forest for the trees. The important principle is that these companies generate enormous amounts of cash even at the current point in the business cycle, and worrying about near-term dividend turbulence ignores the high amounts of dividend income and capital gains that will arrive in the future. Actually holding and reinvesting Chevron dividends for ten years would give most people a better feel for how downturns increase the velocity of wealth creation provided the dividend-paying company remains in sound health, and the constant acquisition of free shares through dividend reinvestment softens the blows of volatility. The current reality, and the future for oil companies, is much brighter than the current conventional wisdom on the sector would have you believe.

Full disclosure: Long RDSB, XOM, KO, Total ( trough GBL).

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