Why you should monitor energy trends

When analyzing global energy stocks, you should do more than compare securities based on current valuations and market volatility.

You must also consider how past trends have shaped the sector, and how current developments will drive future energy projects and oil prices, says Michael Peterson, managing principal and portfolio manager for International, European and Global Value Strategies at Pzena Investment Management in New York. He manages the Renaissance Global Value Fund.

For context, he adds, think back to when oil prices were expected to peak in the mid-2000s. At that time, “there was a widespread belief that oil was headed for $200 per barrel. Prices were very high, led by a demand spike out of China, and a slow response to find oil.”

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As a result, prices surged and “there was a strong impulse among energy and oil producers to invest.” Afterward, there was massive supply to meet investors’ needs.

But, unlike in prior decades, those producers did more than support the development of basic onshore wells. They were able to invest in projects or companies tied to “horizontal and deep water drilling, shale extraction, and Canadian tar sands.” Relative to projects from 20 years ago, “all of the projects to find oil are massive, expensive [undertakings] that require multiple years of investment” from market participants.

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As a result, many major oil companies agreed to take on “multi-year expenditures, which was good for the energy service sector [since] they saw a huge rise in volumes and business [activities].”

At the same time, however, “it was bad for the free cash flows of the major intergradients. As this went on and as you got well into the investment phase (2010 and 2011), you can look at the relative valuations of the large, intergradient oil companies, and it looked like the market was giving up on them.”

In fact, major companies like Shell had “record-low valuations, relative to the market. The reason for these low valuations was the markets frustration with the lack of free cash flow [at major companies],” which investors weren’t used to seeing when analyzing balance sheets over the four or five decades prior to the mid-2000s.

Read: Exercise caution as energy stocks test highs

Today, the tide is turning for energy companies. Valuations of some intergradients are still low, says Peterson, but “finally, there’s evidence that the highest point of [these companies’] spending is behind us and you’re starting to see an improvement in the free cash flow profiles of the major intergradient[s].”

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Despite lingering skepticism about the low value of some oil stocks, he regards these companies—which make up a low beta and low volatility part of the energy market—as “the most interesting place to be invested today and where most of [his team’s] portfolio is weighted.”

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