FPA Capital 4Q17 Letter – Why We Invest in Energy and Hold Cash

FPA Capital 4Q17 Commentary

• Almost 60% of the portfolio is invested in energy-related companies and cash; this compares to less than 5% in energy and 0% in cash for the Russell 2500

Why do we have such a large exposure to energy?

• Believe we are in the early stages of another historic multi-year oil bull market
• Our energy investment is not just tied to our belief that oil prices will go higher. We see that extreme investor bearishness, and perhaps apathy, have caused oil-related equity performance to disconnect from crude oil commodity performance
• Bear argument #1: global demand growth will fizzle out (bears will often cite the following)
  • Slower global economic growth: that’s looking unlikely since the IMF is now forecasting that only six of 192 countries will register an economic contraction in 2018, the fewest on record
  • Existential consumption risk in China: crude demand in China is up 7% YTD versus the same period last year, more than double the consensus figure at the beginning of the year
  • The rise of electric vehicles: EVs make up just 0.1% of the global installed vehicle base, and that miniscule percentage will not change meaningfully over the next 5 years
• Bear argument #2: OPEC and its partners, including Russia, will ramp up supply growth
  • Actions taken since November 2016 and quota compliance data don’t back up this argument
  • For the House of Saud, the most obvious incentive to keep oil supplies tight stems from budgetary constraints; the country needs over $70 oil just to neutralize its fiscal deficit and stop the ongoing bleed of foreign currency reserves
  • In the Kremlin, we must assume that Putin had its 2018 re-election campaign in mind when he endorsed the 2018 quota extension; Russia’s economy is dependent on crude oil, with 70% of Russian exports related to the oil and gas sector
• Bear argument #3: US shale producers will flood the market
  • There are a few interrelated reasons why US shale will surprises to the downside
  • Operators focused on their best acreage during the downturn, leaving them with costlier and less productive sites
  • Weak financial results at top producers despite higher oil prices and focus on best acreage
  • Investors are pushing E&Ps to better prioritize returns over production growth
• With average global demand growth expected to be at least 1.3 million bbl/d in 2018, we estimate the global inventory overhang would clear before the end of next June, or roughly six months prior to the end of OPEC’s current quota agreement
  • Last time this level of inventory was reached, oil prices were hovering about $100/bbl, while global demand was about 5 million bbl/d lower than it is today
• To conclude, we think it’s important to point out how similar this set up looks relative to major oil bull markets of the 1970s and after the dot com bubble
  • These time periods were preceded by accommodative monetary policy, sky-high equity valuations, robust crude demand, and extremely bearish sentiment
  • 1960-1970: S&P 59% vs WTI 16%; 1970-1980: S&P 47% vs WTI 1004%; 1980-1990: S&P 143% vs WTI -34%; 1990-2000: S&P 300% vs WTI 24%; 2000-2010: S&P -5% vs WTI 162%; 2010-2017: S&P 111% vs WTI -28%; 2018+: ?
  • Selling our energy stocks today would be akin to selling the farm before a historic harvest

Why is our cash level so high today?

• We have simultaneous bubbles across virtually all traditional asset classes
• Mechanics are relatively simple to understand: in a low-interest-rate world, investors must buy riskier assets to generate adequate returns, and this in turn drives up the price of those assets
• But what will happen now that central banks have begun to unwind the purchases and raise rates?
  • We expect these market distortions to eventually collapse under their own weight, providing patient, cash-rich investors with substantial opportunities
• What have returns looked like from this valuation level for the S&P? Terrible. Over the last 100 years, returns have averaged negative 7% over a 3-year period at similar valuation levels
  • When S&P 500 CAPE was below 10x, 3-yr returns of 39%; between 10x and 14x, returns of 34%; between 14x and 18x, returns of 13%; between 18x and 22x, returns of 20%; between 22x and 26x, returns of 22%; between 26-30x, returns of negative 1%; greater than 30x, returns of negative 7% (31x today)
• Bubbles appear to be cropping up everywhere
  • European junk bond yields fall to 2.6%
  • $450 million da Vinci painting sale shatters previous record
  • Even depreciating assets are appreciating (composite index of Porsche 911s has increased in value by more than 30% over the last four years)
  • Bitcoin appreciates over 1,300% in one year
  • Over $3 trillion invested in ETFs
• Don’t try to time an avalanche, just get out of the way
• Cash may now be one of the only undervalued asset class left
  • Cash’s value comes from two sources: 1) yield and 2) optionality
  • When just about every asset class is expensive, cash may be one of the only undervalued asset classes left

Image Source: EIA, Capital IQ