The energy sector still requires caution and patience

As an international equity portfolio manager and a former geophysical engineer in the petroleum industry, I've long been cautious about opportunities within the energy sector. My skepticism is rooted in an awareness that it can often take a long time for crude oil prices to recover from a sudden drop.

While oil may have already reached a bottom, the extent of any sustained price rally is likely to be too small to significantly relieve the cost pressures that oil exploration and production (E&P) companies will continue to face for years, in my view. The industry is still in the early stages of adapting its capital intensive business models to the realities of low cost oil. Even those E&P companies that eventually succeed in adapting may continue to struggle in aligning costs with revenues to the degree needed to restore healthy cash flows, generate attractive profit margins, and maintain sustainable dividends. The absence of any one of these elements can undercut what might otherwise appear to be an attractive investment opportunity. As a result, I've continued to focus on opportunities outside energy, even amid the recent price recovery that has lifted oil from the nearly 13-year low of around $27 a barrel reached in February 2016.

Difficult math

Caution about energy is warranted in part because of the constrained outlook for global economic growth. I monitor a number of global indicators that help me recognize potential turning points in macroeconomic cycles, and, throughout 2015 and early 2016, data has consistently pointed to a slowing global economy. Soft demand for commodities such as oil, coupled with oversupply, has weighed heavily on prices.

While E&P companies faced little pressure to rein in capital costs when the economic outlook was brighter and oil traded above $100 a barrel, everything changed as the price subsequently plunged. The energy sector is capital intensive by nature, as a result of the constant need to maintain production from current oil or natural gas projects while pursuing new reserves to replace those that are depleted or become less economically viable.

These costs are so high that, globally, most E&P companies today generate virtually zero free cash flow margins—the amount of revenue available to either distribute to shareholders or reinvest after current capital expenditures and tax obligations have been met. As a portfolio manager, I seek to invest in companies that generate free cash flow margins that are superior to those of their peers. A company that generates high cash flow margins has the ability to return cash to shareholders in the form of dividend payouts or share repurchases, or to invest resources back into the company in a way that will hopefully increase shareholder value in the long term. In today's slow growth environment, companies that can generate free cash flow margins in excess of their peers rank attractively in my investment process.

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Long-term trends

Energy firms continue to look unattractive in my investment process because their inability to generate free cash flows leaves little or no room to return cash to shareholders over the long term. While they may resort to borrowing funds in order to pay dividends or buy back shares, this is not a sustainable approach given today's low oil prices. The shale revolution—the widespread adoption of extraction techniques such as hydraulic fracturing and horizontal drilling to unlock large deposits of shale oil and gas—has lowered the cost curve for all energy companies around the world. While this revolution has so far played out primarily in the United States, the extraction techniques pioneered here will become more widespread abroad, weighing on oil and gas prices globally.

Adding to the pressures on E&P companies is the growth of solar energy. The cost of providing solar energy to consumers has been declining sharply, and it may not be long before we see parity in the incremental costs of electricity generated from solar power relative to electricity generated from natural gas or crude oil. If that happens, solar could take a significant market share of global energy production.

Selected opportunities in energy services

While caution is still merited in the energy sector, select opportunities may emerge if we see a shift to a stronger global growth environment. If that happens, I would seek undervalued energy companies that can grow fast. My primary focus within the sector would likely be energy services companies—those firms that help E&P companies extract oil and gas from the ground or help process this energy and transport or distribute it to marketers. Broadly speaking, energy services companies are not burdened by the capital intensive business models that have made many E&P companies vulnerable in today's era of low cost oil. While I do believe opportunities will crop up in the energy sector over time, I must always view these potential investments in relative context to the broader opportunity set.