10th July 2023
Dear Investor,
As we discussed in the June performance review, we added some Natural Gas (NG) equities to the thematic portfolio. From that commentary:
“Natural gas had a big move up from depressed levels and to us the evidence is that it has bottomed for this cycle. We will be adding some NG producers to the thematic portfolio this month” (see Commentary #8 for our original discussion of Natural gas).
The Long term chart of NG, displayed below, shows the tendency for big moves up so we believe the time and state of the world is right for a repeat of this cycle.
Zooming in to a one-year chart, we can see the price has bounced around 10% from its low and so we believe the downside is limited. The move up is hard to see given the extent of the move down over the last year.
Now you can read our more in-depth discussion of NG in Commentary #8, but the short version is that NG is the cleanest fossil fuel and so demand is and will increase going forward. We have discussed a few times the supply side of the equation, with ESG concerns and investors pushing companies not to develop new supply. This, together with the peak in shale oil production (from which NG is a byproduct) and the supply disruptions due to the ongoing conflict in Ukraine and the new world order we see evolving means, to us at least, that NG is going higher.
As we wrote in March about the NG situation
“There was lots of doom and gloom in the press about how Europeans would freeze over winter and really it could have been a lot worse, but a few things happened to save the day.
Firstly, as stated above, demand collapsed from industry. Secondly, as China was still in lockdown, Europe did not have to compete for gas from that large buyer and so were able to fill up their storage facilities. Thirdly, there was an unseasonably warm winter in Europe and fourthly, America rode to the rescue by transporting cheap US Natural gas to Europe.
Looking forward, what do we see?
- China coming out of its Covid slump and, even if there is not a resurgence in growth, you will see an increase in demand for NG from China and its trading partners after 3 years of lockdowns and subdued economic activity.
- European industries starting up again as prices come down (and if they don’t restart and Europe deindustrialises on the margins, that creates another whole problem as the supply of many items contracts, increasing overall inflationary pressures).
- A continued focus on energy security as actually getting energy will be more important than the price of that energy.
- A very low Natural Gas price which has much more upside than downside from here.
- A continuation of constrained supply routes due to the geopolitical situation.
We think we are close to exiting the eye of the storm. Now we already have UNG in the thematic portfolio, which is an ETF holding NG futures but there are associated costs with that and is only suitable for short-term trading, which is why we have added the equities of some NG producers. They hedge some of their production and so we can be certain of cash flows even at these depressed levels and have upside to price increases from their unhedged production.
While we have a basket of stocks, we will just look at one, Southwestern Energy, as they all have a similar profile.
Let’s first look at a shorter term 1 year chart. We can see, similar to the NG price pattern, that the stock price went down from around $8 to a low of $4.50 and has since rebounded to around $6.
Now, we are not looking to buy this for a move from $6 to $8, although a 30% move is nothing to be sniffed at. Instead, we are looking for a continuation of the energy bull market. Let’s zoom out to a longer-term chart.
You can see the recent move is just a blip and in the last 2 oil and gas bull markets, this stock traded over $48.
Since 2014, a large number of US gas companies have gone bankrupt as capital had flooded the sector, resulting in a glut of drilling and an oversupply of gas which led to the aforementioned bankruptcies, including Chesapeake Energy, a pioneer of the shale boom, and, peaking at a market cap of US$36 Billion in 2008, all the while issuing debt and equity, spending on drilling and acquiring land. From 2017 to 2013, it spent an average of over $10B p.a on drilling and racked up debt of $16B.
As the oil and gas boom peaked in 2014/15, cash flows dried up and the company was forced to file for bankruptcy in 2020. This was a story that played out for many companies in the industry with Chesapeake being the poster child for the excesses of that time.
As we have discussed previously, the combination of investor disgust with the loss of their capital and ESG constraints reducing investment in the sector, management of most companies switched focused to exploiting the fields they already have. So, an immediate repeat of that cycle is extremely unlikely. Let prices go high enough and we may see a turnaround in that discipline, but we are a long way from that point.
What about valuations? Looking at the below chart from Eikon, which bases the multiples off average broker estimates. We can see that Southwestern trades on a price to cash flow of 2.06 x December 22 cashflow. Now that included bumper gas prices and this year the multiple increases to 2.9x. But based on the next 2 years, this multiple goes down to 1.9x.
Now the usual argument for these stocks is that they trade at cheap multiples due to the peak in price of the underlying commodities they produce. But with current prices so low and not much increase factored into the futures prices, we believe they are on low multiples on low commodity prices.
These estimates are based on current futures prices for natural gas, (which is currently trading between 3.50 and 4.50 for at least 10 years out in the future) not any increase as we are expecting.
There is of course some debt in the capital structure, but looking at the EV multiples, you can see again very low single digit multiples which shows debt is not high- after all, very few investors want to lend to oil and gas companies. Now given we have discussed the propensity of investors to require returns to shareholders, we are likely to see very high dividends or share buybacks as time goes on.
We believe the risk reward of holding a basket of gas shares is highly skewed to reward. We have added the three companies below as a basket.
Southwestern Energy (SWN), Antero Resources (AR), and Range Resources (RRC).
Turning to Asia, we had US Treasury Secretary Yellen visit China last week after a slew of CEOs traveled there over the last month as well as US Treasury Secretary Anthony Blinken and we can only hope for further rapprochement between the two great powers. It would be very damaging for the world and the economy to have a continued proxy war between the US and China. One proxy war between the US and Russia is already very damaging, not least in lives lost.
So should we hope for better days ahead? Well, it is always good to hope for the best but plan for the worst. One of the only things that both US political parties agree is to be tough on China. After Trump lost the US Presidential election in 2020, there were high hopes that tariffs against Chinese goods would be reduced, if not removed, but Biden and the Democrats have proven to be as tough on China as the Republicans. Partly this is domestic politics as it is a time honoured tradition to distract attention from domestic worries by focusing on a foreign enemy (Russia and China), and partly, as we have discussed, there is a continued move towards a new world order where the dependence on China’s supply chain is reduced with reshoring , friendshoring or whatever buzz word is used for ABC (“Anything But China”)
So we see articles like the below:
Analysis: Yellen raised China’s hopes for tariff cut; U.S. politics will crush them
WASHINGTON, July 12 (Reuters) – U.S. Treasury Secretary Janet Yellen’s trip to China has raised hopes in Beijing that Trump-era tariffs on Chinese imports may be eased as she tries to smooth relations between the two nations, but strong anti-China sentiment in the U.S. may make that impossible.
Trade and political analysts in Washington say that even though cutting some of the “Section 301” tariffs would help U.S. companies and consumers, as well as Chinese exporters, doing so would expose Biden to a buzz-saw of Republican criticism at a dangerous time.
“The political calculus is pretty clear,” said Harry Broadman, a former White House, World Bank and U.S. trade official who is now a managing director with Berkeley Research Group. “That would be red meat for the opposition.”
Looking soft on China could cost Biden the 2024 presidential election, he said, adding that anti-China sentiment in the U.S. in recent years is the highest he’s ever seen, fueled by former President Donald Trump’s China policies.
Now it is not all bad. The fact that there are high level talks going on is encouraging and as we have said, there will be times when tensions flare up and times when things are calmer. We appear to be in the latter zone although with a US Presidential campaign coming up ahead of elections next year, there is no straight path ahead. The continuation of talks will hopefully mean things are not so volatile both geopolitically as well as in the Chinese financial markets. A reduction in volatility will be a precondition for those markets to move up.
Economically speaking, there has been weak data out of a lot of Asia not only China as the manufacturing recession spreads. A selection of headlines below.
Reuters July 11th
Taiwan June exports slump the most in 14 years on weak China, US demand
- June exports -23.4% y/y vs -13.35% forecast in Reuters poll
- Exports to China -22.2% y/y (previous month -19.4% y/y)
- Govt forecasts July exports to decline 16%-19.5% y/y
- Ministry sees “considerable pressure” on exports going forward
Reuters June 30th
South Korea’s June PMI new export orders falls
South Korea’s manufacturing activity shrank in June for a fourth consecutive month and by the fastest pace in nearly three years, a private survey showed on Wednesday, adding urgency to Seoul’s efforts to pump-prime a sputtering economy with fresh stimulus.
Japan Machine Tool Orders Plunge 21.7%
RTT News Jul. 11
Japan’s machine tool orders declined for the sixth straight month in June amid lower demand both domestically and internationally, preliminary data from the Japan Machine Tool Builders Association, or JMTBA, showed Tuesday.
Machine tool orders plummeted 21.7 percent year-on-year in May, slightly slower than the 22.1 percent fall in the previous month.
Domestic demand was 29.9 percent lower in June compared to last year, and foreign orders contracted 16.7 percent.
Now there has been a lot of pressure on the Chinese currency the Yuan (CNY) as the economic data weakens and one of their major competitors Japanese Yen (JPY) remains weak. Part of the reason for the “shock” devaluation of the CNY in 2015 was the weakness of the JPY. There is a risk that history repeats. The chart below shows how the JPY and the CNY have been moving in tandem.
Now, there is currently a huge speculative short position in the Japanese Yen (looking at futures data in US markets) as everyone and their dog is short the yen.
This is a big potential risk to global markets, as the so-called yen carry trade is funding positions elsewhere. The simple way it works is that speculators borrow JPY, convert to another currency, and invest in assets denominated in those other currencies. So, for instance, you can borrow JPY at 0.5% convert to USD and buy US 2 year notes yielding close to 5%. As the yen weakens, you make even more money as you have to repay a lower amount in USD. The consensus view is that Japan is not raising rates anytime soon and so there is little risk here.
But, all it takes is a few % move in the JPY the wrong way to wipe out all that profit especially as the leverage used will be huge. We will add a 10% position in FXY, an ETF holding the Japanese Yen as a hedge against both our Japanese stock positions (which could suffer in price terms from a strong yen) as well as a general move away from risk
The chart above shows the JPYUSD pair has already strengthened from 144 to 140 and the Topix index has come off a bit too, but the SPX which follows a similar pattern has yet to follow suit.
Let’s hope it is a quiet summer!
Until next time,
