I’m around 30% cash. I can’t find many screaming buy ideas right now. I’ll dig deep into a company and walk away thinking things will get much worse. The economic world is a crazy place right now. It appears as if we are going to go into a deep recession with high levels of inflation. The first major currency could blow up. Then the rest will go along with it.
The only place I am finding real value is in the energy industry. Outside of my large cash pile the vast majority of my wealth is tied up into energy securities. Energy is really the only industry that looks cheap on a trailing basis. And if you can underwrite securities using current strip pricing for the next twelve months, everyone will walk away with a lot of money.
Almost any energy company I underwrite using current strip gets me forward earning valuation in the 2-3x range. Cheap by any value standards. The problem with energy and commodities for that matter is pricing is volatile and almost impossible to predict. If prices drop by half those 2-3x earning valuations double and I’m stuck holding and energy stock I bought at peak pricing. I’m pissed and my investors are pissed.
I wouldn’t be underwriting and investing in these energy companies if I thought pricing was going to come down from here. Let’s get this straight. I don’t like making big macro predictions. But when you are investing in anything commodity related you need to make those high level predictions. Because at the end of the day the only thing that matters is the price of the commodity. The price of the commodity will determine how how much free cash flow will be coming back to investors. Nothing else really matters.
So here is my prediction. Energy prices will continue to stay at high levels as there’s been a severe underinvestment in the space since 2014. Capital expenditures have been slashed to bare bone levels and investors are calling for a return of capital rather than the investment in growth. And the kicker? Russia’s involvement in Ukraine will likely last more than a couple years.
I don’t think my prediction that energy prices will be elevated for years to come is even that bold. In fact, I think it is grounded by logical fact. There has been a vast underinvestment in the space and the war in Ukraine will keep prices elevated for years to come.
Here’s the thing, European natural gas prices are already up 400% this year and on Monday prices were up another 30% after Russian said it halted the gas flows from the Nord Stream indefinitely. The Nord Stream has historically supplied one third of Europe’s gas needs. This is huge. European’s are looking at a very challenging winter should prices remain elevated.
"Supply is hard to come by, and it becomes harder and harder to replace every bit of gas that doesn't come from Russia," said Jacob Mandel, senior associate for commodities at Aurora Energy Research.
I am willing to bet that the Russian invasion of Ukraine will be a multi-year affair. This will not end overnight. Think of how long the Iraq and Afghanistan war lasted. Wars are not quick. They are long and drawn out. Putin will not backdown and Ukraine will continue to fight. Economic sanctions against Russia will remain and Russia will fight the West back by halting the supply of commodities like natural gas.
In addition, OPEC wants to keep prices of oil high as seen by the recent price cut they initiated over the weekend.
What we have is an industry that has experienced massive underinvestment for almost a decade, a war that will likely continue for the next few years and major oil producing countries that want to keep pricing elevated. In addition, hyperinflation is beginning to occur in major countries given the massive amount of fake fiat dollars flooding the world, which should be a net positive to commodity prices.
So what to do about all of this should my thesis play out? Buy energy companies. Get exposure to natural gas prices. Own the companies that have massive operating leverage to higher prices. Should my thesis play out, energy companies will generate a significant amount of free cash flow.
Here are a couple of names that I am looking at closely that should do well in a high priced energy environment. One of the names makes up over 20% of my net worth and has been a long-term Alpha Letter Pro pick.
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