TALO - SA Interview: Investing In Energy With The Energy Realist

2023-04-15 07:30:00 ET

Summary

• The Energy Realist has 20 years of finance and accounting experience in the energy industry. The Energy Realist is also a CFA charterholder and has been actively managing their personal portfolio for 10 years.
• The bull thesis for oilfield services providers, why small cap energy stocks may outperform large caps over the next few years and key takeaways from the boom-bust nature of the energy sector are topics discussed.
• The Energy Realist shares a long thesis on Talos Energy and Oil States International.

Feature interview

The Energy Realist has 20 years of finance and accounting experience in the energy industry. The Energy Realist is also a CFA charterholder and has been actively managing their personal portfolio for 10 years. We discussed the importance of looking at the prevalent macro themes before identifying companies that can best capitalize on them, how investors should approach the ESG trend and an “out of consensus” call on the challenges for US shale ahead.

Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?

The Energy Realist: As a value-oriented investor, I look for sectors and companies that are out of favor and can be bought at attractive multiples. In the last few years, most opportunities have been in the energy sector due to a unique set of factors that has been in the making since 2014, the year which marked the prior peak in oil prices. That said, I periodically run broader screens, but right now very few prospects outside of energy meet my investment criteria. Second, like everyone else, I also prefer to invest in companies that I understand well. As most of my professional experience has been tied to the energy sector, it is easier for me to understand companies' business models or read their financials. In industries where I am less knowledgeable, I am more likely to go for an ETF.

SA: To follow up, what does your idea gen process look like? Where/how have you typically found your best ideas? How (if at all) do you use stock screeners?

The Energy Realist: I like to identify the prevalent macro theme and then look for the companies that can best capitalize on it. For example, in 2021-2022 most energy stocks went up. Over the next few years, I expect that differences in relative performance will be more meaningful and that oilfield services will outperform E&P. I also think that smaller caps, especially those that aren't exposed to U.S. shale, have more room ahead. I outlined my macro view for the energy space in a recent article . As for stock screens, I do find them very useful although in the energy space one has to go beyond the standard financial ratios and also look at production costs, reserves and others. Lastly, Seeking Alpha can also be a great source for ideas. I view it as a two-way street; as a contributor I share my current ideas, but I also benefit from the insights of other contributors or readers who often post great comments.

SA: Almost everyone reading this can probably name several popular ways to play the green energy or ESG trend– are there any under the radar or unconventional ones?

The Energy Realist: I am probably more in the camp that sees green energy as having failed to deliver on many of its promises. I think this view has gained more ground since the Russia-Ukraine war began and put energy security issues back on the table. The reality is that wind and solar power intermittency is a big problem that no one has been able to solve so far and most likely fossil fuels will be with us for a while. Nuclear energy could be a viable alternative that ensures reliable supply while contributing to carbon goals, but there are a lot of political roadblocks. At the same time, I do recognize that the ESG trend has gathered a lot of momentum and won't just reverse overnight. In my view, the best way to capitalize on these competing imperatives may be through traditional energy companies that incorporate a green aspect in their portfolio. One example is Talos Energy (TALO), a conventional oil and gas producer that also develops a carbon capture and sequestration business. Companies like this will probably be rewarded with easier access to capital and higher multiples over time.

SA: Is the market being realistic or too pessimistic assigning low valuation multiples to energy names? How should these stocks be valued? What are best practices for valuation analysis of energy stocks?

The Energy Realist: That is a great question and the current turmoil in the banking sector suggests that the market indeed may have had a point. Generally, I see three reasons for the low multiples. First, ESG investing limits the flow of capital to the sector; unfortunately, this isn't in our control, but I see some encouraging signs from policy makers in both the US and Europe that the blanket opposition to fossil fuels may be revisited. Second, the Fed tightening cycle is making a recession likely and the market thinks that oil prices will crash again. It is a valid concern, but I think structural supply issues will limit the magnitude and duration of such a crash this time around. Lastly, US shale is past its best years, and some shale players are running out of inventory. In my view, this third concern is often overlooked, but will become quite important in the next few years and will drive relative performance differences between companies that have ample reserves and those that are tapped out. Ultimately, when multiples are distorted across the whole sector, a net asset value model is needed, but this is often hard to run using public data. In practice, comparisons to historical multiples are often used, but, if the investment constraints on the sector remain in place, there is no guarantee we will ever revert back to them.

SA: Which industries in the energy sector have the best or worst outlook and why?

The Energy Realist: Energy investors need to consider three main facts. First, US shale was the dominant force during 2010-2020, but those days are gone. Shale is running out of Tier 1 opportunities and it is getting costly just to maintain production flat. The reduced competition from shale has opened up longer cycle projects, which require several years to pay back, in the offshore sector. Hence, companies with conventional, longer-lived assets such as offshore should do better. Second, the lean years 2014-2020 took out a lot of oilfield services capacity. Now that investment is ramping up, companies are finding out there aren't enough rigs, pipe or even frac sand. The supply constraints are allowing services providers to improve their pricing at the expense of upstream operators. That is why I am very bullish on oilfield services, and specifically companies that provide offshore services or equipment such as Transocean (RIG), Borr Drilling (BORR), Tidewater (TDW) or Oil States (OIS). Lastly, smaller caps currently have much lower multiples than larger caps. I understand the upstream/downstream diversification argument and why people would be willing to pay more for an Exxon (XOM), but some of these small companies have virtually zero debt so they aren't really endangered by a recession. I don't fully understand the reasons for the small caps mispricing, but my bet is smaller caps will appreciate more over the next few years.

SA: Are there any “consensus” opinions about the energy markets that you disagree with? If so, which ones and why? Does this create any opportunities?

The Energy Realist: I think many investors have not yet fully awakened to the challenges for US shale ahead. Everyone has their list of favorite companies and point to the amazing cash flow yield, but fewer people ask if the company's reserves and acreage will allow it to maintain these production levels for the next 5-6 years. In terms of opportunities, I focus more on offshore and also on services providers whose help will be more needed as the shale cost curve climbs up. Generally, I am a long-only investor, but I could also see merit in some long-short trades that pair producers with longer-lived / conventional assets against some of the shale players that are most at risk of depleting their inventory.

SA: You published a bullish thesis on Ecopetrol as part of the Top 2023 Stock Pick Competition (which was selected as the winner and a Top Idea) - can you discuss how politics can create contrarian opportunities in this sector?

The Energy Realist: Ecopetrol (EC) remains a paradox to me. The conventional wisdom is that the election of a leftist president in Colombia puts at significant risk the interests of Ecopetrol's minority investors. It is probably also an instance of home bias because at the same time politicians in the so-called "West" (US, Canada and Europe) are openly touting market interventionism such as the windfall taxes that were adopted in several countries. Colombia, however, has fairly strong institutions or legislative "gridlock" and in that sense is not unlike US politics where changing the status quo is something quite difficult. So in typical news headline fashion, the reporting has focused on the agenda of the new president and what he wants to do, but little was said about what he can realistically do given the legislative rules and his lack of majority in the country's congress. So in that sense it is not really the politics, but rather the misperception among Western observers that is opening up the investment opportunity. So far, it seems Ecopetrol is rolling on as usual and the company recently proposed a dividend that is more than 20% of the market cap - a mind-boggling number; if the dividend is formally approved at the end of March, I am not really sure where the political risk is.

SA: There have been a lot of high profile fortunes made (and lost) over the past few decades in the energy markets – what are the key takeaways from these events that can be applied going forward?

The Energy Realist: Energy has always been a boom-bust industry. There are many reasons for it, but one aspect is the long lead times between capacity investment decisions and when production actually comes online. This means that many industry participants are often in the dark about what the future will look like, and the industry shifts from oversupply to undersupply and back again. I think the most important takeaway is to be cognizant where in the cycle we stand and act accordingly. Second, energy demand will keep growing, so buying when short-term disruptions occur will remain a profitable strategy. In my view, the lows in 2020 driven by the COVID lockdowns won't be repeated anytime soon, but if the current banking crisis finally tips the economy into recession, there will be lots of decent buying opportunities around.

SA: What’s one of your highest conviction ideas right now?

The Energy Realist: I would like to single out two of my recent ideas. One is Talos Energy (TALO), a small offshore producer in the Gulf of Mexico. The company has low production costs, long-lived conventional inventory and trades at a 50% discount to its proved reserves value; debt is manageable and the company has been earning credit rating upgrades. TALO also has a start-up carbon capture business that could be a differentiator and catalyst in the medium term. The stock fell quite a bit in the last couple weeks as the banking crisis impacted oil futures prices and trades now at around $11 with the Wall St. consensus target at $28. Second, I am also very bullish on Oil States International (OIS), a small oilfield services and equipment company, that among others provides equipment for floating production storage and offloading (FPSO) units. A big catalyst could be Petrobras' (PBR) ambitious growth plans that necessitate more FPSOs. Moreover, as OIS supplies secondary equipment, its costs are a small fraction of the overall project costs so pricing increases will be more tolerable. My medium-term target for OIS is $14-$15; after this week of failed banks and turmoil in the oil futures markets, OIS now trades at about $7.50. For more context, I would refer readers to my recent articles on these two ideas.

Thanks to The Energy Realist for the interview.

The Energy Realist is long TALO, OIS, EC, RIG, BORR, TDW, XOM

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