"Value Still Lies Within Energy" Market WrapUp by Chris Puplava

Value Still Lies Within Energy
Disbelief Leaves Room for Modest Multiple Expansion
BY CHRIS PUPLAVA

Every decade has its investment theme where one asset class or sector outperforms its counterparts. There are different reasons for this, such as the economic environment at the time, whether the period was characterized by inflation or deflation, monetary tightening or easing, or liquidity contraction or expansion, as well as technological advancement.

What characterized the investment background of the 1970s was inflation as seen by the chart below, which shows rising bond yields and a corresponding rise in commodities as reflected by the CRB Spot Index.

In this type of environment the best performing sector was oil as shown by the chart below. Oil was the best performing sector going into the mid-cycle slowdown in 1974-1975 and was off to the races as the decade ended, finishing up with a 250% return for the decade.

In the 1990s technological advancement was the predominant theme, with the chart below showing technology shares surging and outperforming all other sectors by a large margin, with a return of more than 1000% (chips) by the end of the decade. Note that like the 1970s, the period was characterized by a mid-cycle slowdown with the bulk of performance coming in the later half of the decade.

The second half of the 1990s saw a significant expansion in price-to-earnings (P/E) in all sectors, with the greatest expansion seen in technology shares with the average forward P/E rising to a peak near 50 in 2000. The P/E expansion reflected the pouring in of funds that drove up the price of technology shares faster than earnings were rising and thus expanded the P/E ratio.

In contrast to technology shares, oil & gas stock prices did not keep pace with earnings growth and their P/E ratios actually contracted to single digits instead of expanded during this decade.

In the latter half of the 1990s, computer and electronic inventories built up as shipments could not keep pace with manufacturing. Technology shares closely followed the shipments/inventory ratio, as seen in the chart below.

As the economy cooled and shipments slowed, technology shares corrected in 2000 and the inventory glut in computer and electronic products began to work off.

Looking into oil & gas inventories sheds some light on whether energy stocks have indeed peaked. Though energy inventories have risen, they are still below levels seen in 1998 and 2002 and are not excessive. This is especially true as global spare capacity is thin; at the same, time global oil production has been on the decline.

Global economic growth remains strong with China and India representing the bulk of increasing demand for energy, commodities, and machinery as their economies continue to develop. Despite media opinion to the contrary, there is no sign of slowing of China and India’s economies as seen by the machinery inventory to shipments (I/S) ratio. The surge in China and India’s economic growth can be seen in the chart below, with the machinery I/S ratio falling to record lows.

Due to the strong demand for machinery in developing nations, the I/S ratio continues to fall while the backlog for machinery makers like Caterpillar (CAT) continues to climb, not to mention CAT’s stock price.

Returning back to investment themes, as in the 1970s, the oil & gas sector has been the star performer this decade. As oil & gas prices have surged, so too have oil & gas company sales with the energy sector posting sales growth of more than 250% by 1^st Q 2005, with consumer staples coming in second, with less than 150% growth in sales since 2000.

Figure 9

Source: Aggregate sales of top ten market cap stocks in each sector normalized to 2000 sales,
as cited in annual reports.

Like the 1970s mid-cycle correction in oil stocks, the current correction likely presents an attractive entry point for the next run out to the late decade which may dwarf the returns seen in the first part of the decade if energy shares experience an expansion in their P/E ratio. The latter part of the 1990s showed not only a P/E expansion in technology shares, but also other valuation multiples like the price-to-cash flow (P/CF) and price-to-sales (P/S) ratio.

Figure 10. S&P 500 Information Technology Index P/S and Standard Deviation Bands

Data Source: Bloomberg

Figure 11. S&P 500 Information Technology Index P/CF and Standard Deviation Bands

Data Source: Bloomberg

As seen in Figures 10 and 11, with the final run in technology stocks in the latter part of the 1990s the S&P 500 IT index’s P/S and P/CF moved in lockstep fashion with the index’s price. By the end of the decade the valuation multiples exceeded more than one standard deviation above the mean and sharply corrected back toward the mean with share prices following suit.

Like technology shares, energy stocks' valuation multiples reached overvalued territory by the end of the 1990s, exceeding more than one standard deviation above the mean and corrected sharply. What is different with the energy shares valuation contraction relative that of technology shares after 2000, was that technology share prices fell much faster than earnings did, driving down valuation multiples while energy share prices did not correct as much as earnings rose to compress valuations. This can be seen when looking at Figures 10 and 11 that show technology shares (black line) falling sharply along with their valuations, while Figures 12-14 show the S&P 500 Energy index (black line) correctly modestly at the same time valuations dropped sharply due to a rise in earnings.

Figure 12. S&P 500 Energy Index P/BV and Standard Deviation Bands

Data Source: Bloomberg

Figure 13. S&P 500 Energy Index P/CF and Standard Deviation Bands

Data Source: Bloomberg

Figure 14. S&P 500 Energy Index P/S and Standard Deviation Bands

Data Source: Bloomberg

As seen in Figures 12-14, whenever the S&P 500 Energy index’s valuation multiples neared or exceeded one standard deviation above the mean, a correction occurred. Likewise, valuation multiples near or exceeding the lower standard deviation from the mean were attractive entry points as shares soon advanced. Looking at Figures 12-14 show that all three current valuation multiples are near the lower standard deviation bands, at levels not seen since the beginning of the bull run in energy stocks in 2003.

Some of the structural and fundamental underpinnings of the oil industry may sustain the bull market in energy for years to come. Unlike the past where shortages were created by manmade actions like war, and oil embargoes, the current situation is due to demand outstripping supply.

Charley Maxwell, senior oil analyst from Weeden & Co, who has been in the oil business for almost 50 years provides the following commentary from a Barron’s interview conducted by Sandra Ward entitled, “Oil Prices: A Pause, Then Up”:

We often say there are not a lot of advantages to getting old except that we have seen it all before. After a big move upward, there is always some counterreaction. We saw it during the 1973-74 crisis, in the '79 to '86 crisis and then in the two wars with Iraq. These crises were manipulations of the oil market by human beings. War, economic problems, but particularly military considerations, were creating, as they say, facts on the ground that worked into shortages that were real, but they were shortages created by the actions of man not nature. It is terribly important to differentiate between past periods and now.

[…] What came out of the 1986-1987 collapse in prices was a huge overcapacity of about 20% in the world's oil production system. The international oil companies began to adjust their capital spending quickly to adapt to that and they more or less serviced a 1% increase in demand each year. The capacity surplus began to come down naturally. We have now had 20 years and taken that surplus down to about 2% to 3%. For efficiency in the energy industry, given the weather factors and political factors and so on, we need something in the 7% to 8% range of excess capacity in order to cover the mountains and the plains of demand and weather and political events. But when the surplus got down to those levels between 1997 and 2000, the companies didn't add to capacity at a fast enough rate.

[…] We are now getting a reaction to the higher oil prices. It is translating into slower economic growth and, of course, it is allied with a rise in interest rates. Don't think that it is just that rising oil prices equal lower economic growth. It is a question of rising oil prices and less liquidity and higher rates that's a triple threat. The bottom could be in the high 40s, though that wouldn't be sustainable. On a yearly average, we will stay in the 60s, but we'll spend a lot of time in the 50s. Then they'll start up again in 2008-2009 and go up for some time. When we get to 130 or 150 there will be another pullback.

[…] In 1930 we found 10 billion new barrels of oil in the world and we used 1.5 billion. We reached a peak in 1964 when we found 48 billion barrels and used approximately 12 billion. In 1988, we found 23 billion barrels and used 23 billion barrels. That was the crossover when we started finding less than we were using. In 2005, we found about 5 billion to 6 billion and we used 30 billion. These numbers are just overwhelming.

With China and India still growing at an astonishing pace, global oil production in decline (Figure 6), global oil spare production capacity thin, OPEC cutting production, oil inventories not excessive, and energy valuation multiples at bargain-basement levels, investors may well be rewarded by purchasing energy shares under these conditions.

The Mortgage Bankers Association of America (MBA) released their weekly mortgage applications survey which showed mortgage demand decreased 2.2% last week, purchase applications rose moderately (0.4%), and refinance applications fell 5.3%.

The Consumer Price Index (CPI) for September came out today, with the headline CPI falling 0.5%, greater than the 0.3% expected decline, while the core CPI fell 0.2%, in line with expectations. The greatest contributing factor to the decline in the headline CPI was a 4.1% drop in transportation prices relative to August and a 7.2% drop in energy prices. With the sharp decline in energy prices, the headline CPI’s year-over-year (YOY) rate of change is now below that of the core CPI for the first time since late 2002.

In other economic news, housing starts rebounded in September with a 5.9% jump over August with September housing starts coming in at 1.772 million units, above the consensus of 1.64 million units, though down 17.9% from last year's levels.

Crude oil inventories rose a sharp 5.0 million barrels last week while gasoline inventories fell 5.2 million barrels and distillates fell 4.5 million barrels. The increase in crude inventories and the decline in refined products was the result of a decrease in refinery capacity, which fell sharply to 86.3%.

The big news on the day was the Dow Jones Industrial Average breaking 12,000 for the first time in early morning trading, rising as high as 12,049.51 before falling back below 12,000 to finish the day at 11,992.68 on the release of the CPI numbers from the Labor Department.

The action of the S&P 500 mirrored that of the Dow, rising in early morning trading before finishing up slightly on the day, rising 1.91 points to close at 1365.96. The NASDAQ on the other hand finished down on the day, falling 7.80 points to close at 2337.15. The 10-year Treasury note yield fell to 4.764%, and the dollar index posted a small gain on the day, rising 0.02 points to close at 86.89.

Overseas markets were up except for Brazil’s Bovespa, which was down 0.54%. France's CAC-40 and Germany’s DAX Index were the big movers posting gains of 1.10% and 1.11% respectively. Mexico’s Bolsa, London’s FTSE 100, and Japan’s Nikkei 225 Index posted advances of 0.94%, 0.68%, and 0.25% respectively.

The performance of the ten S&P 500 sectors were mixed on the day with the health care and utility sectors posting the strongest gains, up 1.18% and 1.01% respectively, and the energy and technology sectors putting in the weakest performances, down 0.67% and 0.39% respectively.

CONTACT INFORMATION
Christopher M. Puplava
PFS Group
PO Box 503147
San Diego, CA 92150-3147
(888) 486-3939 Toll Free
(858) 487-3939 Tel
(858) 487-3969 Fax
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