Black Gold (Energy Part I)

My great-grandfather, Ignatius Aloysius (“I.A.”) O’Shaughnessy, was born in 1885, exactly 100 years before I was born. From very humble roots in Stillwater, Minnesota, he built one of the country’s most successful private oil companies: Globe Oil. Once honored as the “king of the wildcats,” I.A. built a huge fortune and then slowly gave it all away (mostly in support of education and ecumenicalism, click below to check out the letter from the pope to I.A.s wife after he died).

It is the ultimate irony, given my profession, that I.A. distrusted stocks. According to his son (my grandfather) “[I.A.] didn’t like those people on Wall Street. He thought that what was going on economically in his companies shouldn’t be determined by Wall Street and its fluctuating stock prices…he tended to invest directly in companies that made money, not in the market. He didn’t play the market…he relied on his own business to create companies that were prosperous in finding oil and refining it.”

For his entrepreneurship and philanthropy, I.A. is one of my idols…but I have to disagree with him on the stock market! Building an oil business requires hard work and lots of luck, but investing in energy stocks is much easier. Given that oil (and gas) are the lifeblood of modern society, it is a fascinating sector to explore. This will be the first of two parts on the energy sector, laid out in a format similar to the two-part series on Consumers staples (Part I here and Part II here).

Sector Overview

Given oil’s ubiquity in our lives, it is amazing that the industry is only about 150 years old. The U.S. oil industry started when “rock oil”—so called to distinguish it from whale and vegetable oils—was first discovered in Pennsylvania and proved to be an excellent “illuminant” for lamps. The oil industry became massive providing only lamp oil, but ballooned once cars and planes started using gasoline as fuel.  By World War II, both Japan’s attack on Pearl Harbor and Hitler’s invasion of the Soviet Union were driven in large part by the desire for oil[ii]. Today, behemoths like Exxon, Royal Dutch Shell, Petro China, and Chevron sit in the top 15 companies in the world by market capitalization.

The energy business has the same objective today as it did in Pennsylvania in the 1850’s: find oil (and gas), get it out of the ground, transport it, and sell it. Most modern energy companies still fall into one or all of these categories. We can group energy stocks into sub-industries using the global industry classification standard (GICS), which breaks out the energy industry as follows:

At the industry level, oil & gas dominate over energy equipment & services, here is the number of stocks in each industry and their total market cap through history.

Within oil & gas, there are three primary lines of business called upstream, midstream, and downstream. Upstream (also called exploration and production, or E&P) involves finding oil and getting it out of the ground. Midstream involves processing and transporting oil. Downstream involves refining oil & gas into consumable fuel for end consumers.  Some companies focus on just one element, but the largest energy companies—like Exxon—are categorized as “integrated” because they participate in all three stages.  

Here is a look at the historical breakout between these three stages of the oil business. You’ll notice interruptions in the “midstream” companies, because at various points they were classified as utilities. This is inconvenient for this analysis, but they represent a fairly small part of the overall energy market.

Integrated oil and gas stocks, along with upstream E&P stocks, dominate the market.

Competition and Concentration

In its early years, the energy industry was dominated by Rockefeller’s Standard Oil, which had up to 90%  market share. Today, the energy industry is much more competitive, despite a few top companies like Exxon and Chevron controlling large chunks. One convenient way to measure concentration is the “four firm concentration ratio,” which simply adds up the market share (% of total sector sales) of the top four firms in the energy industry group. 

Of the 24 industry groups in the entire stock market, energy stocks are the 12th most concentrated industry.

Historical Returns

The returns for energy stocks have been strong relative to the nine other economic sectors, but with an annual standard deviation of 24.1%, they have also been the second most volatile (trailing only technology stocks)[iii].  Note that in this chart, the results are slightly different than in Part I of consumer staples, because here I have included ADRs in the universe to capture the large global energy stocks that are an essential part of the energy market.

The returns for the energy sector as a whole are quite volatile, but this is especially true of companies that focus on upstream, E&P operations. Exploration and Production companies have by far the worst risk-adjusted return (Sharpe ratio) of the major sub-industries within the energy sector.  I don’t have complete data for midstream companies at this point, but relative to E&P stocks, returns are better for refining companies and significantly better for the vertically integrated oil & gas companies. This latter group represents a small sample size (only around 20 integrated companies today), but they have delivered very impressive historical returns.

Oil & Energy Returns

Oil is almost like money

— Robert O. Anderson

The price of oil has an obvious relationship with the success of energy stocks. To price oil, I use two primary benchmarks: Brent Crude, and West Texas Intermediate.  Data for Brent goes back to 1957, and today Brent Crude is used to price two thirds of crude oil globally. Here is the real price of oil (adjusted for inflation, shown in terms of today’s dollars).

When you compare the price of Brent crude to the energy index I’ve created, you see a clear relationship, especially in the 1975-1985 period and in 2008.

A Hyper Cyclical Sector

Some energy stocks have delivered outstanding long term returns, but the sector as a whole is very volatile. The previously explored consumer staples sector has had very stable returns on equity (ROE); but the energy sector is much more cyclical. Below are the historical ROE for the sector at large, and for the key individual industries.

The sector has huge swings relative to the market, but things get very interesting at the sub-industry level. The giant integrated oil & gas stocks drive the sector’s ROE, and are (relatively) more stable. By contrast, refiners and E&P stocks are much more cyclical. Early wildcatters, like my great grandfather, were not faint of heart. Not much has changed. Energy in general, and upstream E&P specifically, remains a tough business for entrepreneurs and investors alike–but those that have succeeded have earned huge returns. 

 

 

Notes: I have only just begun to explore this sector, and am contemplating a much more comprehensive (~50-100 pages) e-book. If you have any interesting resources (books, articles, white papers, anything really) on the sector please send them my way at patrick.w.oshaughnessy@gmail.com

For the custom “indexes” I’ve created in this post, I constitute each index in December and include all stocks with a market cap > $200MM adjusted for inflation and equal weight them (this gives a fair representation of the opportunity set). The indexes are then rebalanced and reconstituted each December. I use GICS codes to determine industries.

 

[ii] The Prize: The Epic Quest for Oil, Money & Power by Daniel Yergin (THIS BOOK IS PHENOMENAL)

[iii] These returns differ somewhat from the first post on consumer staples because I am including ADRs