Lindy’s Law (also known as The Lindy effect) refers to the observation that for certain things, their future life expectancy is proportional to their current age. In other words, for such things, the longer that they have been going on, the more likely – not less likely – that they will go on longer. And sadly, war is one such example. A war that has been going on for 1 month has a good chance to end in a month. But if it has already dragged on for 5 years, its chance of ending soon actually diminishes. It now has a good chance to go on for another 5 years – exactly the opposite of what common sense would expect (which goes more or less like this: since it has been going for 5 years already, it must end soon).
Now, back to Suncor Energy Inc. (NYSE:SU) and Exxon Mobil Corporation (NYSE:XOM). I have been publishing my bull thesis on energy stocks since October 2021, long before the Russia-Ukraine war broke out, because the bull thesis did not (and still does not) need the war. Furthermore, I won’t pretend that I was able to see the war coming back in Oct 2021.
In my view, the bull thesis was fundamentally supported by two factors independent of the war. First is the structural underinvestment in our energy infrastructure over the past YEARS. And second, the unreasonably depressed oil price at that time (below $80 per barrel), which does not even keep up with inflation in the past decade. And, as you can see from the following chart, their stock prices have been indeed climbing up before the war broke out.
Nonetheless, the Russia-Ukraine war did break out on February 24, 2022. As you can also see from the following chart, the war has accelerated the bull thesis. Crude oil prices went up from around the $95 level before the war broke out and peaked above $120 after the war broke out. Retail gasoline prices started at about $3.4 per gallon at the beginning of the year before the war and now hover around $5 per gallon.
Now the war has been ongoing for 126 days. And sadly, according to Lindy’s Law, it now has a good chance to go on for another 126 days. So, the war has now become a part of the energy thesis given Russia’s role in the global energy market (as to be elaborated on next).
And you will see why integrated players, especially those in North America, such as SU and XOM, are our best ideas to navigate the ongoing turmoil. There are both first-order effects that are easy to see, such as the rising oil and natural gas prices caused by the war. But there are also higher-order effects and risks to be considered, such as their hedging role against geopolitical risks.
Russia’s role in the global energy market
Russia is the 2nd most important energy exporter in the global market. As you can see from the following chart, before the war broke out, Russia has been exporting more than $400 billion worth of energy per year in 2018 and 2919. And the majority of the export came from oil (more than 200 billion U.S. dollars per year), followed by natural gas (about $50 billion per year). As the Russian/Ukraine situation deteriorates, the global supply chain of energy has been severely disrupted. The European countries that used to rely on Russian export now are forced to seek alternative solutions. And integrated players, especially those located in North America such as SU and XOM, will be their top candidates to fill up the holes (pretty large holes on the order of hundreds of $B). They will not only need natural gas and oil but also other downstream products such as diesel fuels and refinery capabilities as analyzed by the following Energy Policy report (abridged and emphases added by me):
Russia is the second most important exporter in world energy markets and Europe is especially dependent upon energy exports from Russia. Russia is responsible for about one eighth of the world’s oil exports. Europe, the largest importer of oil from Russia, is particularly vulnerable. While they import some of that oil by tanker – and thus can replace Russian sources with others, in principle – an important share comes in by pipeline in various forms. For example, refineries, landlocked in Central Europe located along a pipeline specifically designed for Russian oil, do not have very many other sources of oil and are likely to face distress as they try to find alternatives. Europe also depends heavily on Russian exports of diesel fuel. In gas European dependence is even more acute. Russia is second to the United States in natural gas production and is the world’s largest gas exporter. Russian natural gas accounts for about 40 percent of the supply in Europe and is used for home heating, power generation, and industry.
SU and XOM’s sensitivity to upstream and downstream prices
Under the above background, both SU and XOM are our top ideas to navigate the ongoing turbulent energy market, for several key reasons.
Firstly, SU is one of Canada’s largest integrated energy producers while XOM is America’s largest integrated energy company. Their geographical location helps to minimize the geographical risks. Furthermore, their ideology and political proximity to European countries make them the top choices to replace the Russian supply.
Secondly, both of them are integrated players. And therefore, both are well-positioned to weather the price volatilities (either upward or downward) of both upstream products and also downstream products. SU explores and produces crude oil and natural gas. It also transports and refines crude oil to petroleum and petrochemicals. XOM has a very similar integrated operation (at a larger scale than SU though). It also explores and produces oil (about 2.3 million barrels in 2020) and natural gas (about 8.5 billion cubic feet per day in 2020). In terms of downstream products, its 2020 daily refinery ran at about 3.8 million barrels and produces about 25.4 million tonnes of chemicals.
The advantages of being a leading integrated player are multifaceted. The diversification of revenue streams makes them more resilient to price fluctuations in both raw materials and end products and provides a better hedge for their profits (more on this in the risk section). As an example, the first chart below shows, without any surprise, that both SU and XOM’s income has been positively, and strongly positively, correlated with natural gas prices. For SU, the correlation coefficient has been above 0.5 about half of the time, with a long-term average of positive 0.37. Currently, the correlation is at a very strong 0.81. The picture for XOM is very similar as seen in the bottom panel of the chart. And also, their operating income also positively correlates with oil price (to an even stronger degree). The pictures are very similar and won’t be shown here.
In terms of downstream products, their profitability also correlates strongly with retail fuel prices as you can see from the next chart. The top panel shows the correlation of SU’s diluted EPS with respect to retail diesel prices. You can see a pretty strong correlation here. The correlation coefficient has been above 0.5 most of the time with an average of 0.61 in the long term. And currently, the correlation is at 0.94, an almost perfect correlation. And the picture for XOM is very similar, as shown in the bottom panel of this chart.
Such a strong correlation with both upstream and downstream product prices is a major advantage for investing in integrated companies like SU and XOM. For players who focus either upstream or downstream, they will be more exposed to the commodity price volatilities one way or the other. For example, refineries such as Phillips 66 (PSX) consume oil as feedstock to produce refined products (such as gasoline, diesel, lubricants, et al). So, they suffer higher costs when oil prices rise. Integrated players like SU and XOM supply their own feedstock to a large extent and are shielded from such risks.
The following comments from XOM CEO Darren Woods best illustrate the dynamics here (and also the role of the Russian/Ukraine situation). The comments were abridged with emphases added by me. And these comments apply to SU equally well:
Before I cover our financial results, I want to provide a perspective on the market environment. In the first quarter, a tight supply/demand environment, primarily due to low investment levels during the pandemic contributed to rapid increases in prices for crude, natural gas and refined products. Clearly, the events in Ukraine have added uncertainty to what was already a tight supply outlook. Brent rose by about $22 per barrel or 27% versus the fourth quarter…. Today, natural gas prices remain well above the 10-year historical ranges, driven by tight global market conditions and ongoing European supply concerns. The same tight supply to manufacturers have also pushed refining margins near the top of the range.
Valuation and project return
Despite the robust demand ahead and high margins, both stocks are undervalued both in absolute and relative terms. As seen below, SU is for sale at 5.13x of its operating cash flow (“CFO”) and XOM at about 6.77x. Such valuations are substantially lower than the overall market and also many other market subsectors (as detailed in my earlier article here).
In relative terms, the valuation for SU has fluctuated in the past decade between 2.1x CFO and 18x CFO with a long-term average of 7.15x. Therefore, its current valuation of 5.13x CFO is below its historical average by almost 30%. XOM is valued with a similar discount as you can see from the bottom panel of the chart. The valuation for XOM has fluctuated in the past decade between 4.5x CFO and 20x CFO with a long-term average of 10.2x. And its current valuation of 6.77x CFO is below its historical average by more than 30%.
Assuming a valuation reversion to the mean in the next three to five years, both stocks can easily deliver double-digit annual total returns considering their growth potential. And their return potential is further catalyzed by the large-scale share buybacks plan as detailed next.
Roles of large share repurchases
Thanks to the robust cash flow, both companies enjoy capital allocation flexibility. Shareholders can expect handsome rewards ahead in the form of both dividends and share repurchases.
SU just announced a 100% dividend raise recently. And XOM return a total of $5.8B to shareholders in 2022 Q1, including $3.8B in dividends and $2.1B in share repurchases. Looking forward, both companies have announced an expansion of their share repurchase plans. And given the cheap valuations mentioned above, such large-scale share repurchases will be very potent to boost shareholder returns.
SU has just announced to repurchase up to 7% of its outstanding shares, the largest share repurchase program in its history. As for XOM, it has also just tripled its original plan to repurchase $10B of its shares. It now plans to repurchase up to $30B of its shares through 2023 as its CEO Darren Woods commented below (the emphases were added by me). Based on the parameters as of this writing, a $30 billion repurchase would reduce its outstanding share counts by 8.2%:
We returned $5.8 billion to shareholders, of which about 2/3 was in the form of dividends and the remainder, share repurchases, consistent with our previous program. We said during our Corporate Plan Update in December that we expect to repurchase $10 billion of our shares. This morning, we announced an increase to the program, up to $30 billion in total through 2023. This move reflects the confidence we have in our strategy, performance we are seeing across our businesses and the strength of our balance sheet.
Final thoughts and risks
SU and XOM are our best ideas to navigate the ongoing turmoil in the energy sector. Their geographical location helps to minimize the geographical risks. Ideology and political proximity to European countries make them the top choices to replace the Russian supply. As leading integrated players, their diversified revenue streams provide a better hedge for their profits. Finally, despite their leading position and profit prospects, they are undervalued by about 30%. Assuming a valuation reversion in the next 3 to 5 years, both offer favorable odds for double-digit annual total returns. The return potentials are further catalyzed by their large-scale share buybacks under such accreditive valuations.
Finally, there are some risks to be considered too. In the long term, environmental and sustainability concerns are a fundamental risk for energy stocks in general. SU and XOM are no exception. Commodity stocks are notorious for their extreme price volatilities and conservative investors need to assess their risk tolerance level. If you recall from an earlier chart, SU’s valuation fluctuated by more than 9x in the past decade, from as low as 2x CFO to a peak of almost 18x. And XOM’s fluctuations were almost 5x, from a low of 4.5x CFO to a peak of nearly 20x. Lastly, XOM’s chemical business is facing some headwinds, as its CEO Darren Woods commented,
Chemical margins in Asia have fallen sharply, with product prices lagging the steep increases in fees and energy cost. In our case, the U.S. ethane feed advantage provided a significant positive offset versus this global view.