March 2022 – Energy Independence

Russia using energy as a weapon has changed the paradigm.

War in Ukraine and subsequent sanctions have jarred the world into the realization that energy independence is necessary. In early March, the United States announced a ban on all Russian oil imports. Should the rest of the world follow, or Russia ban exports themselves, this would take about 10% of global oil production offline. Ban or no ban, Russia using energy as a weapon has changed the paradigm. Developed nations are now shifting toward energy independence, after years of hostile stances against traditional energy supplies.

Wait! We need this stuff?

While global supplies are flowing, it is easy to take energy access for granted. Yet, even before the war in Ukraine, it was clear this carefree attitude towards oil dependence was adding risk. In fact, we wrote about it extensively in summer of 2021. Predicting a war is impossible, but when you have a supply chain that is barely able to keep up with demand, the system has a complete inability to absorb any shock. War is shocking, but should peace agreements be reached tomorrow, energy-dependent developed nations would be foolish to remain at the mercy of antagonistic producers like Russia, Iran, and Venezuela. Investors are waking up to this paradigm shift, and we believe there is a lot of room to go in energy stocks despite their superior returns YTD in 2022.

Crowded Entrance

As we also previously mentioned, the Energy Sector is currently less than 4% of the S&P 500. Investors looking to increase exposure to energy will probably do so with ETFs or directly in the stocks themselves. However, after ESG-focused investors neglected these issues for years, their collective market capitalizations are far too small to absorb new capital. We believe flows could be a major source of upside in energy stocks going forward.

How Much is Enough?

The Baker-Hughes count has been increasing steadily from its trough of 200 US rigs in 2020. Today the number of US rigs stands at 650. However, in 2015, the rig count peaked at 1600!

source: tradingeconomics.com

If the US is serious about energy independence, leaders need to shun rogue sources like Venezuela and Iran, and instead focus on secure homeland supplies. Drilling, supporting, and distributing these rigs will require access to capital, fixing supply chains, and finding qualified workers. None of these are quick-fixes, which could cause energy prices to remain elevated for an uncomfortable amount of time. In fact, US production peaked at 12.3 million barrels per day in 2019, while sinking 10%, or to 11.1 million in 2021. With Russia producing around 10 million barrels per day, it is clear countries like Canada and the UK will also need to significantly increase production.

Stock-pickers Paradise

As mentioned above, with the S&P 500 less than 4% energy stocks, indexers cannot access the potential upside in these companies. Even advisors running benchmarked portfolios will have great difficulty out-sizing energy relative to the indices they hug. Thankfully, our approach at Frank Capital has always been to go where the value is, and our pure-equity portfolio remains over 15% energy stocks, or roughly 4x the average passive investor’s exposure. We are benchmark agnostic, meaning our process permits large allocations to sectors like energy when valuation, quality, and opportunity align like they are today.