The Federal Open Market Committee (FOMC) met this week, deciding to leave the reserve rate unchanged as expected (a unanimous decision amongst voters). The Fed’s so-called “dot plot,” which projects participants’ expectations for future rate moves, continued to indicate two additional cuts (50bps total) for 2025, which is generally consistent with the market’s betting odds (calling for 2-3 cuts). The market expects the Fed to remain on hold through its next meeting (May 7th), with an expectation for a June 18th rate cut.

While two cuts with an additional two next year seem benign, many expect a more volatile outcome (indeed, the dots themselves suggest that possibility with many well removed from the average). Economist Steven Blitz at TS Lombard noted the following:

“With the current outcome highly uncertain and recession now a marginally higher possibility, policy dosage needs to be subtly hawkish without damaging current growth. That is what the FOMC delivered. The economy determines what comes next, meaning the Fed will be late if unemployment jumps. In other words, funds rate forwards are wrong. It is a binary game – 200BP of cuts if unemployment hits 5%, or no cuts this year and hikes in 2026.”

While this was a relatively quiet Fed day, the announcement was made of an adjustment to the path of Quantitative Tightening. The statement noted, “Beginning in April, the Committee will slow the pace of decline of its securities holdings, by reducing the monthly redemption cap on Treasury securities from $25 billion to $5 billion.” Moreover, participants noted uncertainty around the economic outlook (not the least of which would be fiscal policy, namely tariffs).

As is typical, Chair Powell noted that “The Committee is attentive to the risks to both sides of its dual mandate,” referring, of course, to employment and inflation. Of late, sentiment indicators, consumer spending, and fiscal policy have created concerns regarding economic growth, which could weigh on the employment side of the mandate. However, this meeting saw a continued (and accelerated) worry logged amongst participants in regard to the future path of inflation. This two-sided attack hints at stagflation, a rare phenomenon feared by investors and policy makers alike, though likely much too early to consider as a major alarm.

Strategas as of 03.19.2025

One final point of note would be the Fed’s projection for long-term rates. Of course, one could consider this no better than a shot in the dark, but it provides insight into what policy makers are thinking in terms of perceived structural shifts. From the following chart, what we see is through the inflationary years of 2021-2023, Fed officials still believed that rates would eventually settle back at 2.5% (remember when inflation was “transitory”?). Over the last several meetings, that rate has ticked up to 3.0%, even as inflation has largely subsided on a year-over-year basis. This tells us that those making policy have changed their views on the neutral rate, a slight nod to the “higher for longer” camp.

Since our update two weeks ago, the 10yr treasury note has chopped around, declining by a few bps. Frothy sentiment among investors in view of the new administration initially drove rates higher, peaking at 4.8% on January 14th. We then witnessed a complete reverse of course, with rates dropping on the growth scare narrative and the realization that Trump 47 is seemingly more concerned with rightsizing policy (including explicitly driving long-term interest rates down) than with the equity market scoreboard.

Now that rates have come off the boil, investors are weighing multiple inputs including fiscal policy (tariffs), economic growth, inflation, and liquidity, the last of which is driven in part by the absence of new debt issuance due to the debt ceiling being reached. To that end, the government is financing continued deficit spending via a drawdown of the Treasury General Account, a piggy bank with an absolute $0 bound that will eventually need to be replenished. In the meantime, this should serve as a headwind to higher rates and allow the debt ceiling debate to be kicked into the back half of the year.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2503-22.

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Let’s first take a step back. A company in need of debt financing — whether for ongoing operations, business expansion or corporate acquisitions — can turn to various sources of financing. One common source is a loan from a bank, which would then either hold the loan on its balance sheet or syndicate it to a group of similar investors. A large company can also issue bonds that subsequently trade in the public markets. Or the company can turn to private credit, working with a single lender to craft a tailored capital solution.

Source: International Monetary Fund, Global Financial Stability Report, April 2024

As noted, public markets have typically been reserved for the largest, most credit-worthy lenders. To warrant open trading, investors must have confidence in the viability of the underlying borrower and the liquidity of the issue. While such companies issue large nominal amounts of debt, the vast majority of issuers are much smaller in size, and unable to meet the requirements (either expressed or implied) of a public exchange. This cohort has traditionally been serviced by the banking sector, as banks carrying low-cost deposits use that capital to make riskier (though calculated) loans, realizing the net interest margin as profit.

However, in the aftermath of the Great Financial Crisis, central banks focused rules and regulations on systemic banks, pushing lending into other areas of the financial system. This was further exacerbated by the Federal Reserve’s rate hike campaign in 2022, with higher rates drawing cash out of 0% checking/savings accounts into higher-yielding money market funds.

Source: Bianco, as of 03.15.2024

These trade winds have caused many to wonder whether banks are well suited to make such risky loans at all. Quoting Matt Levine’s May 1 “Money Stuff” Bloomberg Opinion column:

“’A banking system is a superposition of fraud and genius that interposes itself between investors and entrepreneurs,’ wrote Steve Randy Waldman in 2011; it allows society to use the money of risk-averse depositors to fund risky investments in growth. But it is possible that this magic no longer works: In a world of financial transparency and fast communications technology and flighty deposits, you can’t really expect to hide the risks of the banking system; you have to fund the loans with people who know they’re funding the loans.”

Therein lies the opportunity of private credit, which has emerged as a solution and grown in earnest. Between willing capital ready to calculate and absorb risk and the ability to structure loans tailored to correctly price that risk and accommodate borrowers, private credit is seemingly the more appropriate outcome to corporate America’s need for cash.

Source: International Monetary Fund, Global Financial Stability Report, April 2024

More recently, as bank lending standards tightened throughout 2022 and into 2023, private credit was there to fill the liquidity void. In that sense, one has to wonder whether it was part of the reason (though certainly not the primary driver) why we didn’t see the recession of 2023 which everyone forecasted. So private credit has replaced a portion of traditional banking, and helped keep Corporate America afloat, all while producing attractive returns for pension funds, insurance companies, wealth funds, and mom & pops alike – seems like a win/win?

Time will tell if its burgeoning growth produces any unintended side effects, but two areas to watch are leverage and opacity. Leverage is the borrowing of cheaper funding to enhance higher-returning opportunities. Let’s say you have a prospective project that will cost $100 and yield 10% annual returns, and you can borrow 50% of that cost at 5% annually. Instead of making a 10% return on invested capital (ROIC), using leverage amplifies your return to 15% ($10 return, less $2.50 interest, divided by $50 cash outlay). Free money!

The problem is that this dynamic can also work in reverse. Using the same example, the $50 borrowed has a senior claim on cash generated from the prospective project. If the project only ends up returning $2.50, the interest paid on $50 gobbles up all of your return. Things look worse when considering the prospect of actually losing money.

Source: International Monetary Fund, Global Financial Stability Report, April 2024

Now consider this, the typical borrower here is a small to mid-size company that already has a leveraged capital structure. This credit may be coming in at any level of that structure, sometimes subordinate to existing borrowings. Furthermore, and here’s the kicker, sponsors often utilize leverage at the fund level to amplify returns. This drastically increases the probability that loan-level losses result in fund-level losses.

Moving on, the function of a public market is to provide real-time price discovery on that which is being traded. While one may argue the market isn’t perfectly efficient (thus the rationale for value investing), the current price is the collective best effort to value a security at any given time. As such, the known risks of owning a security are typically reflected in its price.

This isn’t the case with private credit. Loans aren’t traded, and sponsors aren’t required to mark assets to market (and if they are doing so, they are the ones setting their own marks). If you were running a fund, would you price all known risks into the carrying value of your loan? Or would you give yourself the benefit of the doubt?

I’ll include one final bonus risk – the private credit system is intertwined with a mix of self-dealing. According to a recent IMF (International Monetary Fund) study¹, 81% of private credit assets are managed by firms that also manage private equity funds. As shown below, 72% of US deals are to borrowers with private equity sponsors. While not to suggest any nefarious activity, it isn’t farfetched to think that credit deals are being used to prop up invested capital within private equity.

Source: International Monetary Fund, Global Financial Stability Report, April 2024
¹ International Monetary Fund, Global Financial Stability Report, April 2024

In closing, we believe there are opportunities within private credit, but recommend investors maintain a discerning eye. Not all funds are created equal – look for sponsors that:

1. 1. 1. Are smaller in size (though large enough to employ proper fund resources)
      2. Have a niche/specialty (some technical, legal, or sector-specific expertise)
      3. Possess unique deal origination opportunities
      4. Prioritize downside protection over maximizing returns
      5. You personally like and trust!

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward-looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2405-10.

The post The Risks and Opportunities in Private Credit appeared first on Aptus Capital Advisors.

Source: Bloomberg, LP; SPX Index = S&P 500 (market-cap weighted), SPXEWTR Index = S&P 500 (even-weighted), BM7T Index (market-cap weighted index of AAPL, MSFT, GOOGL/GOOG, AMZN, NVDA, TSLA, META)

Presented differently:

Source: Raymond James Institutional Equity Strategy 2024 Outlook, as of 11.30.2023

Valuation

One complaint many market participants have regarding equities is their high valuation. However, like this year’s performance, it seems that the largest names are inflating the index valuation – strip out those holdings and it becomes a more palatable price-to-earnings ratio.

Earnings

So, index returns have been strong, driven in part by soaring valuation multiples in the largest names… but is it justified? That is a matter of opinion, but the earnings story seems to say “yes.” As seen below, negative 2023 year-over-year earnings for all stocks outside of the Magnificent 7 reflect the dour economic picture that so many predicted this time last year. It was those seven names, aided by strong demand, cost-cutting measures, and no small part from the renaissance in artificial intelligence (“AI”), that carried the brunt of the earnings load. To a lesser extent, this is projected to happen in 2024 as well.

Source: Raymond James Institutional Equity Strategy 2024 Outlook, as of 11.30.2023

Conclusion

2023 has been about seven stocks: Apple, Microsoft, Google, Amazon, Nvidia, Tesla and Meta. To what extent you owned those names determined the fate of your investment returns. Their success has vaulted them to eye-watering valuations, but these appear to be supported by continued favorable earnings outlooks. The law of large numbers says this can’t happen infinitely, but for the time being, it is the way of the market.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2312-5.

The post Magnificent Seven appeared first on Aptus Capital Advisors.

As expected, crude oil markets applauded the move, with the front month WTI contract +6% as of the time of the writing, which is roughly where it has been all day at a price/barrel of just over $80. What made OPEC act now (there was no scheduled meeting), and what impact will this have on energy markets longer-term?

Saudi Arabia is the primary producer and de facto leader of OPEC, responsible for 36% of the 13-member group’s February 2023 output of 28.9 MMbls/d. They have expressed recent frustration at the price of oil, namely, the seeming disconnect between the physical market (where traders buy/sell oil for immediate use/delivery) and the paper market (futures contracts, which include speculators and hedge positions). Though certainly weaker than last summer, the physical market has held up much better than the paper market, suggesting market participants are trying to get in front of an expected economic slowdown that could curtail oil demand. 

Separately, the Saudi’s have not appreciated the moves made by the Biden administration to use its excess supply to ease oil prices over the last couple years. The SPR (Strategic Petroleum Reserve), created in the wake of the 1970’s Arab oil embargo as a measure of national defense, was turned into a political lightning rod with the government releasing 221 MMbls over the course of 2022, drawing the inventory down to levels not seen since 1983.

To be fair, ingenuity and resilience shown by the domestic oil industry has positioned the US as an energy powerhouse, far less dependent on foreign imports when compared to the 1970/1980’s. A case could certainly be made that we don’t need 713.5 MMbls of oil (SPR capacity) sitting in salt caverns scattered along the gulf coast (for reference, the current inventory is 371.6 MMbls). Even so, in late 2022, the administration had hinted at partially refilling the SPR once prices reached the ~$70/bbl level. In the minds of many, including perhaps the Saudi’s, this would serve as a pseudo floor wherein the US could be counted on as a price supporter as opposed to the pressure they had applied over the preceding months.

Surely the Saudi’s might not have been thrilled when US Energy Secretary, Jennifer Granholm, came out two weeks ago saying plans to refill the SPR will take years, and likely won’t begin in 2023. Planned maintenance at two of the four storage sites and the fact that another 26 MMbls draw is scheduled between April-June (a Congressionally-mandated, federal budget-aiding measure passed years ago) makes a refill in the near-term simply impractical.   

So perhaps the Saudi’s (and OPEC) had the motivation to make a move, but will it make more than a short-term difference? Let’s first take a look at what is being done. Not all OPEC members are participating in this cut:

Source: OPEC, *non-OPEC countries participating in the cut

The voluntary nature of this move is somewhat unique. It is worth noting that of the participating members, many are cutting from a position of strength, meaning they have spare capacity. In comparison, take the October announced OPEC+ cut; it included several members (namely Nigeria and Angola) that were producing so far below their quota, they could continue to grow production without hitting the newly announced cut threshold (meaning the nameplate 2 MMbls/d cut would never reach that volume in practice). This time around, only Russia is producing materially below their quota (which is voluntary anyway, given Russia isn’t an OPEC member). Russia had previously announced its own 500,000 bls/d cut to begin last month, and coincident with this OPEC announcement, they extended that cut through 2023. It is yet to be seen whether or not they will comply with their self-imposed sanctions, but they appear resolved as they seek to hit back over western-imposed export price caps affecting their own energy sector. 

Source: BloombergNEF, as of 04.03.23

Ultimately, we believe this move will be more impactful in the short-term than the long-term. By cutting supply, OPEC is merely counteracting the negative demand sentiment surrounding crude. According to the US EIA (Energy Information Agency), implied domestic oil demand is still 8.7% below the high reached in July 2019. With many market commentators forecasting recession in the next 12 months, that deficit would only be expected to widen. This line of thinking is reflected in the paper markets referenced earlier; according to the CFTC’S (Commodity Futures Trading Commission) Commitment of Traders report as of March 28, large speculators were the least long crude going back to 2011 (which is another reason for the big price response in oil today – traders weren’t positioned for it). OPEC’s action sends a strong signal to the market that they intend to backstop the weakness typically witnessed in past economic contractions. 

Longer-term, we believe structural undersupply borne by chronic underinvestment will support oil prices. After all, as quickly as OPEC can support markets by cutting supply, they can also bring it back into strong demand. What can’t be so easily manipulated is the type of long-cycle investment that has eluded global commodity markets over the last several years. This is seen perhaps most clearly here in the US, where investment has taken a backseat to shareholder-friendly cash return policies. Even with rampant oil service cost inflation, nominal capital expenditures still haven’t retaken 2018/2019 levels, much less the early part of the decade. This has global implications, as the US is now the largest producer of crude oil and liquids products.

Source: Strategas, as of 03.16.23

Our view for crude oil and energy more broadly supports near-term frustration (recession narratives and risk-off fears overtaking even this impactful move from OPEC) eventually giving way to sustainable upside for the industry. With material energy transition likely to take years longer than originally believed, this should provide a nice runway for energy companies to produce resilient cash flows which they are now generally dividending out to shareholders. Having coordinated support from OPEC should help smooth what could be a bumpy forward 6-12 months.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

When a page is marked “Advisor Use Only” or “For Institutional Use”, the content is only intended for financial advisors, consultants, or existing and prospective institutional investors of Aptus. These materials have not been written or approved for a retail audience or use in mind and should not be distributed to retail investors.  Any distribution to retail investors by a registered investment adviser may violate the new Marketing Rule under the Investment Advisers Act.  If you choose to utilize or cite material we recommend the citation, be presented in context, with similar footnotes in the material and appropriate sourcing to Aptus and/or any other author or source references. This is notwithstanding any considerations or customizations with regards to your operations, based on your own compliance process, and compliance review with the marketing rule effective November 4, 2022.

Advisory services offered are through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-ACA-2304-5.

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The Fed Funds rate provides a reference for institutions to guide such lending. It is chiefly through this mechanism that the Federal Reserve, commonly referred to as “the Fed,” seeks to control its dual mandate designated by Congress – achieving price stability and maximum employment. By changing this overnight lending rate, the price of money becomes more restrictive or more relaxed, which has a direct impact on monetary supply. The flow-through dictates what banks charge on loans they give and deposits they pay to customers, influencing behaviors in the greater economy.

Data as of  11.21.22

The US Treasury issues debt in many different increments and maturities to fund its activities. Perhaps the most widely followed issue is the 10-year Treasury Note, in part because it is the leading proxy for mortgage debt. Unlike the Fed Funds rate, this rate is dictated by the market. With that said, it would be incorrect to say that the Fed has no influence on this rate. In one sense, the 10-year rate equals the average expected Fed Funds rate over the next ten years, plus a term premium (additional yield to compensate investors for locking funds for ten years vs overnight). But more important for this daily moving rate are future economic expectations – how will the US economy act over the next ten years as reflected by GDP output? As a corollary, when risk sentiment diminishes, investors often flock to the safety of government notes, driving prices higher and yields lower.

What Effect Has The Behavior of These Rates Had on the Equity Markets?

At the beginning of the year, the Fed Funds rate was targeted at 0-0.25% and the 10-year note was at 1.51%. At that time, the Fed was still vocalizing the narrative that rapidly increasing inflation was transitory – in other words, that supply-side disruptions caused by the COVID lockdowns would eventually fix themselves, naturally alleviating elevated pricing levels. By March, they had more or less abandoned that line of thinking, acknowledging that historic increases in the money supply (driven by their own actions in conjunction with massive stimulus payments from the federal government during COVID) were fueling consumer demand in conjunction with said supply-side disruptions. That led to a 25-basis point increase in the Fed Funds rate, the first of seventeen (17!) such increases absorbed by the market through the most recent Fed meeting on December 14, where it currently sits at 4.25-4.5%.

Every rate increase came with further guidance from the Fed that additional increases were likely warranted, leading the markets to continually reprice expectations for where interest rates would eventually settle. As we said earlier, the 10-year Note doesn’t act in a vacuum – it has some correlation to the Fed Funds rate and can’t stay still in an environment such as that where the overnight rate is rising at such an aggressive clip. It peaked in October at 4.24% and currently resides at 3.59%. The high-velocity spike in interest rates this year has been the reason for both equity and bond performance. Higher rates have hurt longer duration fixed income investments, as reinvestment risk is introduced. For equities, higher rates mean a higher discount rate, compressing valuations. In our opinion, rates have been driving the market’s performance all year, and may not likely change in the interim.

Why Would the 10-Year Rate Go Down While the Fed Funds Rate Continues to Go Up?

The answer ties in to the economic output driver of the 10-year rate; simply put, the market believes that the actions taken by the Fed in raising overnight interest rates to quell inflation will have an adverse impact on economic growth over the long-term. This shows itself in what is known as a yield curve inversion. The yield curve is simply a graphical depiction of each interest rate by maturity. Typically, shorter maturities pay lower interest rates than longer maturities, for the simple reason of term premium discussed earlier.

But in a yield curve inversion, near-term maturities (taking the 3-month treasury bill, as an example) yield a higher rate than long-term maturities. In the present case, the 3-month / 10-year inversion is at -67 basis points. This is statistically significant, as yield curve inversions, especially at the 3-month / 10-year comparison, have historically been leading indicators of economic recessions.

What Does This Mean for 2023?

With an inversion of this extremity, the market is telling the Fed that they cannot go on maintaining short-term interest rates at these levels, much less continuing to hike further. By the market’s projection, the pain in doing so will be great to the domestic economy, eventually ending in recession. The Fed, however, has been vocal that they are willing to risk a recession in order to get inflation down to target. We could then see an ensuing rise in unemployment and continued headwinds in the markets.

Source: Strategas as of 12/16/2022

Ultimately, there are only two ways to lower inflation – increase supply or decrease demand. Since the supply side is out of their hands, decreasing demand through increasing the cost of money is all they can do, and it is what they are determined to do. While many market prognosticators are hoping for a “soft landing,” (a coincident softening of inflation without the commiserate deterioration of economic conditions), it is more likely that history will ring true and this inversion will signal yet another recession, however mild. In such a case concerning dual decreases in inflation and economic activity, company earnings would almost certainly have to follow suit, bringing the equity market lower in turn.

In Summary

The Federal Reserve is in the driver’s seat, and this year has been a great illustration of the importance of their job and how interest rates can impact both stocks and bonds. While we remain cautious on the markets, there is a silver lining for long-term investors. Throughout the year, the market has had a reset not just on valuations, which entered the year at 21.5x forward earnings and now at 16.4x (as of 12.19.22), but also on interest rates not seen since 2007.

Fixed income broadly offers more attractive risk/reward as rates have increased. Historically, yield has contributed 36% of total return. Yet, in the 2010s, it only contributed 14%. We see this changing going forward and believe that embracing this new yield environment within both your equity and bond allocations will support any muted growth in 2023.

We understand this is a lot to consume, so please leverage our team as a resource to think through managing risk and positioning as we navigate your plan.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

The 10-year Treasury Note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.

The 10-2 Treasury Yield Spread is the difference between the 10-year treasury rate and the 2 year treasury rate. A 10-2 treasury spread that approaches 0 signifies a “flattening” yield curve. A negative 10-2 yield spread has historically been viewed as a precursor to a recessionary period. 

The 10 Year-3 Month Treasury Yield Spread is the difference between the 10 year treasury rate and the 3 month treasury rate. This spread is widely used as a gauge to study the yield curve. A 10 year-3 month treasury spread that approaches 0 signifies a “flattening” yield curve. 

The content and/or when a page is marked “Advisor Use Only” or “For Institutional Use”, the content is only intended for financial advisors, consultants, or existing and prospective institutional investors of Aptus. These materials have not been written or approved for a retail audience or use in mind and should not be distributed to retail investors.  Any distribution to retail investors by a registered investment adviser may violate the new Marketing Rule under the Investment Advisers Act.  If you choose to utilize or cite material, we recommend the citation be presented in context, with similar footnotes in the material and appropriate sourcing to Aptus and/or any other author or source references. This is notwithstanding any considerations or customizations with regards to your operations, based on your own compliance process, and compliance review with the marketing rule effective November 4, 2022. 

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2212-24.

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Source: Strategas, 11/29/22

For a commodity-driven sector, the dispersion since July 1 has been significant, to say the least. 

Source: Bloomberg, LP, 11/29/22; XLE – Energy Select Sector SPDR ETF, CL1 – generic front month crude oil contract
(note: difference in price and total return represents roll yield from the downward-sloping crude oil futures curve)

We believe there are multiple forces at work driving this short-term phenomenon. First, energy equities are … equities. True, their input is a commodity, but their earnings are valued by the equity market. After years of equity multiple compression (driven in part of ESG concerns, governmental policy, and poor corporate management), energy equities have finally gained some traction as an investable sector. This has led to a long-awaited (though still relatively anemic) uptick in valuation.

Looking at Bloomberg consensus numbers, XOM went from 4.8x EV/EBITDA on 6/30 to 5.3x as of 11/29. PXD expanded from 4.4x to 5.3x over the same period. One could argue that valuation had simply gotten too cheap, in conjunction with broader market flows out of underperforming sectors like tech needing to find a home elsewhere. 

Secondly, since COVID, energy equities have lost some correlation to oil. 

Source: Strategas, 11/22/22

We would attribute this in part to the way management teams are using the cash flow they are generating. During the last period of sustained, elevated oil prices (2010-2014), companies were rewarded by increasing production, which required them to not only reinvest all cash flows, but to borrow more from ready-to-lend debt markets to do so. This ultimately led to poor returns, overburdened balance sheets and disappointed investors who essentially fled the sector. This time, domestic producers are substantially taking a more shareholder-friendly cash flow return approach, foregoing big production increases to reduce debt, pay dividends and buyback stock.

Finally, while the front month crude oil price (the one you see flashing on TV) has been plummeting, longer-dated contracts have stayed remarkably resilient. In other words, the crude futures curve has flattened out quite a bit. This is a near-term bearish signal, but when pricing a company’s future of cash flows over multiple years, investors are more concerned about the average price than the spot price. 

Notice in the following graph, the current curve (orange) 1-24 month spread is <$8/barrel, while that spread on July 1 (green) was >$29/barrel! Concerns over global economic growth and COVID lockdowns in China have dented current demand, but a myriad of factors including tight global inventories, OPEC+ price support and a US government potentially switching from draining the Strategic Petroleum Reserve to refilling it, have proven to be a longer-term floor for crude. 

Source: Bloomberg, LP 11/30/22

Regardless of the reason, the move in energy equities relative to oil begs the question, “Are energy equities now overpriced?” While they aren’t as attractive as they were 6 months ago (or especially 12 months ago), we believe they are still enticing for the long-term investor. 

Looking at XOM again as an example of valuation, at 5.3x EV/EBITDA, it is nowhere close to its five-year average of 7.1x (same for PXD – 5.3x vs 6.6x). Moreover, while the sector has gained some traction this year in the eyes of certain investors who had put it in the penalty box, it can hardly be described as over-owned. Excluding the drop since the COVID downturn, at 5.2%, energy carries the lowest weight in the S&P 500 looking back 25 years (and compares to a historical average of 11% going back to the 1970’s). For further context, at 6.4%, AAPL has more influence on the index than the entire energy sector!

Source: Strategas, 11.30.22

Of course, energy equities can’t stay disconnected from oil forever. Were the price of oil to find footing from its notable price slide, a return to positive correlation could also prove a tailwind for energy equities. Near-term demand concerns will undoubtedly fill the headlines, but we believe the longer-term, more structural forces of global undersupply and lack of adequate investment will provide support for oil prices for some time to come. 

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

The content and/or when a page is marked “Advisor Use Only” or “For Institutional Use”, the content is only intended for financial advisors, consultants, or existing and prospective institutional investors of Aptus. These materials have not been written or approved for a retail audience or use in mind and should not be distributed to retail investors.  Any distribution to retail investors by a registered investment adviser may violate the new Marketing Rule under the Investment Advisers Act.  If you choose to utilize or cite material we recommend the citation, be presented in context, with similar footnotes in the material and appropriate sourcing to Aptus and/or any other author or source references. This is notwithstanding any considerations or customizations with regards to your operations, based on your own compliance process, and compliance review with the marketing rule effective November 4, 2022.

Advisory services offered are through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2211-23.

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First, we’ll walk through the above sample of negative themes plaguing equity market commentary at present. Then, we’ll discuss how the market prices a stock and in what ways these themes affect that pricing. Finally, we’ll think about what translating these narratives could mean for price levels on the S&P 500.

Fed Funds on the Rise

The Federal Reserve met on Sept 21 and voted to increase the Federal Funds rate by 0.75% to a range of 3.00%-3.25%. Notes from the release implicated an additional raise of 1.25% through the end of 2022, with the potential to go flat / higher in 2023. For context, the Fed kept the funds rate at 0.00%-0.25% for over a decade through earlier this year, besides a brief upward and quickly reversed stint from 2016-2019.

We think what’s troubling is how wrong the Fed has been in seeing this coming. First, they labeled inflation as “transitory,” opting to hold rates flat at 0% for what, in hindsight, was entirely too long. Even since that point, they have continually been behind the curve, as demonstrated by their own projections:

Source: Piper Sandler, 9.19.22; highlights Fed rate forecast at each meeting (date listed right); excludes 9.21.22 meeting, which witnessed another shift higher

Why does the Fed continue to increase interest rates? Because they are trying to quell inflation, the likes of which we haven’t seen in forty years. The means by which they hope to accomplish that is by stifling economy growth via tighter financial conditions.

The stickier inflation proves to be, the more they are demonstrating their will to end it via rate hikes. As we will see later, rising interest rates have a mostly negative impact on equity prices, serving as a headwind in this current environment. 

Housing Market Under Significant Pressure

The Sept 21 reading on single-family existing home sales sank to just 4.28 million, the weakest since Nov 2015 – they are now down 28% from the pandemic peak. The primary culprit is affordability fueled by rising mortgage rates, which recently touched levels not seen since 2008.

Source: Piper Sandler, 9.21.22

Source: Bloomberg, LP; highlighting Bankrate.com US home mortgage 30 year fixed national average at 6.43%, highest since 2008; data as of 9.22.22

Resiliently Low Unemployment Rates, But…

The current employment picture can be described as none other than robust. Not only is unemployment low, but job openings remain high. According to Strategas, there remain roughly 11 million job openings against 6 million unemployed. Part of that mismatch is due to a decades-low labor participation rate, fueled by an aging demographic and lifestyle trends which were altered during the COVID lockdowns. 

Source: Strategas, 9.2.22

With that said, there have been signs of change, especially in those areas which witnessed outsized growth during the pandemic. Here is just a sample of those making cuts:

• Snap: 20% of employees

• Robinhood: >1,000 employees

• Coinbase: ~18% of employees

• Peloton: >4,150 employees

• Shopify: ~1,000 employees

• Rivian: ~6% of employees

• Re/Max: 17% of employees

The Fed released its latest unemployment forecast on Sept 21, calling for 4.4% by 2024, 0.7% higher than current levels. Piper Sandler notes, “There has never been a situation where the unemployment rate rose more than about 0.5% without the economy entering recession.

So the FOMC (Federal Open Market Committee) forecast is an implicit admission that a recession is likely, unless something extraordinary happens.” Their goal is to squash job openings before jobs, and in so doing, take slack out of the labor market. But in their own estimation, they predict casualties to actual jobs as they tighten financial conditions. 

The State of the Consumer

Coming into 2022, there were multiple reasons to be positive on the state of the consumer: healthy household balance sheets, robust savings accounts buoyed by pandemic stimulus, all-time highs in equity and housing markets, and low unemployment. Most of those positives have slowly (or in some cases, quickly) waned. After a violent jump in real (inflation-adjusted) consumer spending, we’re witnessing a move back toward trend.

Source: Piper Sandler, 9.13.22

Inflation has clearly taken its toll, as an increasing number of consumers cite rising prices as their greatest concern, leading to austerity in their purchases. Naturally, the next step is all-out inability to pay, which is on the rise. 

Source: Boston Consulting Group, 9.14.22

Turning now to equity pricing, markets ultimately rely on the price-to-earnings ratio, otherwise known as the equity multiple. Simply put, the equity multiple equals the price of the stock (or index) divided by the next-twelve-months (NTM) estimate of that stock’s earnings per share (EPS). Basic algebraic manipulation then reveals that the price of a stock (or index) is equal its NTM EPS x the equity multiple.

EPS is an easy concept to understand, it represents the total net accrual earnings of a company divided by the number of outstanding shares. The equity multiple is a bit more complicated, and indeed, not a fixture. It is a measure of value expressed by market participants; it reflects the future prospects for the company, the relative current risk environment, and the overall cost of capital (i.e., interest rates).

A company with bright future prospects for growth, such as Apple or Google, typically earns a higher equity multiple than a cyclical commodity producer like Exxon or Alcoa. That aspect concerns individual companies; factors such as risk premium and interest rates affect the equity multiple more holistically. If the perceived level of risk is high, investors will demand a lower multiple in an effort to protect against that risk.

Likewise, as interest rates rise (in particular, real interest rates, which take inflation into consideration), equity multiples tend to contract, as the discounting of future earnings becomes more expensive. Changes in expected EPS and changes in the equity multiple are the quantitative expressions of the economic themes expounded upon earlier. 

There are many ways by which we can assess the risk environment. One is consumer sentiment, as measured by the University of Michigan – a multi-part survey taking consumer temperature on personal finances to economic conditions. As extreme as it may seem, that measure is currently in the territory tested during the Great Financial Crisis. 

Source: Bloomberg, LP; highlighting University of Michigan Consumer Sentiment Index reading in range of 2008 (Great Financial Crisis) and 2011 (S&P downgrade of US debt); data as of 9.16.22

Moving to interest rates, we’ll provide a simple illustration. Ultimately, a company is worth its estimated future cash flows, discounted to the present day. When interest rates are low, future cash flows are worth more, as the opportunity cost of waiting is less severe.

When interest rates rise, investors have the choice between waiting or receiving a higher return on investment today. As a result, the discount rate used to value future cash flows increases, lowering their value today. Therefore, it stands to reason that rising interest rates – in particular, rising real (inflation-adjusted) interest rates – have a negative correlation to the equity multiple. 

Source: Goldman Sachs, 9.23.22

Current analyst estimates for 2023 S&P 500 EPS are $244. This is down roughly 3.5% from the peak estimate earlier this summer, but a sizable jump from the $193 earned in 2021. We’re beginning to see some capitulation in that number, with some macro research shops calling for $190-$200. Based on S&P 500 9/23 closing price, P/E on 2023 earnings of $244 is 15.2x. That is quite a re-rate from the beginning of the year, when the NTM P/E was 21.0x.

One could infer from the chart above that the equity multiple has further to fall, but let’s assume real interest rates eventually reverse course and drop from here…a likely scenario, says Jefferies Trading Desk, if 2023 EPS were to be revised to the $190-$230 level. In that case, 15x equity multiple x $200 2023 EPS = S&P 500 3,000, 19% lower than 9/23 levels. Stated in terms of the 10yr real rate, this is what a pricing matrix could look like (note: with the current 10yr real rate at 1.3%, we would equate the 1.25% scenario below as roughly equivalent to a 15x equity multiple):

Source: Jefferies Trading Desk, 9/23/22; x-axis: 10yr real rate; y-axis: 2023 S&P 500 EPS

To be sure, we aren’t calling 3,000 for the S&P 500, or any level at all. But one can now see how it could get there by quantifying the narratives.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

The S&P 500® Index is the Standard & Poor’s Composite Index and is widely regarded as a single gauge of large cap U.S. equities. It is market cap weighted and includes 500 leading companies, capturing approximately 80% coverage of available market capitalization.

Projections or other forward-looking statements regarding future financial performance of markets are only predictions and actual events or results may differ materially. 

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2209-24.

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What Goes Into the Retail Price of Gasoline/Diesel?

Let’s start by looking at the components of gasoline/diesel pricing. It is not entirely uncommon for folks to refer to oil/gasoline interchangeably. But as this graphic shows, there are more forces at work than just the price of oil.

Data as of April 30, 2022

Perhaps the most important (and most complicated) component of that breakout is refining. As a brief primer, refineries break crude oil down into its various components, which are then selectively reconfigured into new products. Refineries have three basic steps, 1) separation – piping crude oil into a hot furnaces where resulting liquids/vapors separate into petroleum components called fractions, 2) conversion – additional processing of heavier fractions into lighter, more valuable molecules, typically though a process known as cracking, and 3) treatment – required blending in order to obtain the proper octane level, vapor pressure rating and other special considerations¹. The result is a number of various products for end-market uses, the majority being gasoline and distillates.

Data as of March 31, 2022

Refining and Product Inventories – The Supply Side

Now that we are all refining experts (minus the PhD in chemistry), it becomes clear that this process is vital in getting product (gasoline/diesel) to retail (gas stations everywhere). With product demand rebounding from the COVID lull (more on that later), the global refining system has to be ready to meet that demand. The problem is capacity is currently constrained. Raymond James estimates that three million barrels per day (MMbls/d) of global refining capacity is shut-in today compared to 2019². Furthermore, the IEA (International Energy Agency) estimates that refinery processing rates this year will be down about 1.3 MMBls/d below 2019³. Why the discrepancy in those two numbers? The answer is that refineries are running at near peak utilization, this according to the EIA:

¹ US Energy Information Administration https://www.eia.gov/energyexplained/oil-and-petroleum-products/refining-crude-oil.php

² May 27, 2022, Industry Comment

³ May 30, 2022, BloombergNEF

“Total refining capacity has decreased since 2020 because of several refinery closures and conversions. Gross inputs into refineries are only slightly above the five-year average even though refinery utilization is at the top of the five-year range, which indicates that refineries may be running closer to maximum capacity utilization than gross inputs alone would indicate. The faster increase in gasoline demand compared with production has led to inventory draws, and U.S. gasoline inventories are currently 8% below the five-year (2017–21) average for this time of year⁴.” The picture in distillate markets is even more extreme.

⁴ May 23, 2022, EIA Gasoline and Diesel Fuel Update

Data as of May 30, 2022

Data as of May 31, 2022

Furthermore, the same thing is happening internationally across all major product lines.

Data as of May 29, 2022

Speaking May 10th at a conference in Abu Dhabi, Saudi Energy Minister Prince Abdulaziz bin Salman said, “I am a dinosaur, but I have never seen these things,” referring to the surge in refined products prices. “The world needs to wake up to an existing reality. The world is running out of energy capacity at all levels.”

Refining and Product Inventories – The Demand Side

Here is where the real tug-of-war lies. We have seen that supply is constrained, with refineries running near peak capacity and product inventories well below average. The makings of this shortfall came out of the 2020 COVID lockdowns, where expectations did not foresee the vaccine-induced reopening effect of 2021. Demand came roaring back, leaving the aforementioned supply issues fully exposed. Now gasoline demand, while still firmly above 2020 levels, is back in question, as fears of an inflation-fueled slowdown riddle global economies.

Data as of May 27, 2022

The supply side is proving to be the bigger issue, as even muted demand is gobbling up what product is available. The result has been soaring refiner margins, known as crack spreads.

Data as of May 30, 2022

Conclusion

Soaring prices at the pump show little signs of abating any time soon. Not only are crude oil prices high (even in the face of indefinite Chinese COVID lockdowns), but the global refining system is running near full capacity in an attempt to compensate for lingering inventory shortages. The result is tightness in inputs and outputs that could only be partially solved in the near-term by material demand destruction. Longer-term, change in investor sentiment and public policy will likely be required to necessitate a sustained investment cycle leading to secured and predictable supply.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2205-25.

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Russian/Ukrainian Conflict

 It is difficult to understate the importance of Russian oil, not only to western Europe, but to the world. According to the February 2022 OPEC Monthly Oil Market Report, Russia is the second largest global producer of oil at 9.95 million  barrels per day (MBls/d), behind the US at 11.75 Mbls/d with Saudi Arabia a near tie at 9.87 Mbls/d (Nov. 2021 production numbers). To further put this in context, Russia’s share represents right at 10% of global supply. However, unlike the US, which consumes far more oil that it produces, Russia is a large net exporter, meaning that the majority of that nearly ten million barrels of oil each day is being consumed by other parts of the world. The primary beneficiary is Europe, although some of that oil makes it over to the US as well (7% of total November 2021 crude imports to be exact, per the US Energy Information Administration). 

Source: Strategas Securities, LLC, as of 02.28.2022

Disruption of these flows would wreak havoc on global supply, which is why foreign countries who have sanctioned everything from Russian banks to private citizens’ assets abroad have fallen short of denying Russia a market for their most valuable natural resource. Amos Hochstein, the State Department’s senior energy security adviser, said in an interview last Friday that, “sanctions will not target the oil flows as we go forward,” simply because this would be deemed more of a punishment for US and European consumers than it would Russia. Hochstein elaborated, “If we target the oil and gas sector for Putin, and in this case the Russian energy establishment, then prices would spike. Perhaps he would sell only half of his product, but for double the price. That means he would not suffer the consequences while the United States and our allies would suffer the consequences.” 

Given Russia’s place in the global energy scene, it isn’t at all surprising that oil markets would wake up at the sight of heightened geopolitical tensions. Indeed, allowing some sort of premium to account for the thought that the commodity could be used as a weapon in this war makes rational sense. However, while this will certainly drive near-term movements in oil, we don’t believe this is the primary reason to be bullish over the long-term.

Global Supply/Demand Fundamentals

Coming in to 2022, the three major energy forecasting agencies (US Energy Information Agency – EIA, International Energy Agency – IEA, Organization of the Petroleum Exporting Countries – OPEC) all expected that 2022 would be the year when increasing oil supply would outstrip demand and inventories would reverse their decline, leading to more normalized prices. At the end of third quarter 2021, this is where they all stood:

Source: Bloomberg, as of 02.28.2022

Since that time, the outlook has tightened considerably. The IEA has increased its 2022 demand forecast by 900,000 bls/d, citing a milder-then-expected negative impact from the Omicron variant and a weather-driven switch to oil from gas for residential heating and industrial needs. Moreover, while OPEC+ has continued its pledge of adding 400,000 bls/d per month through September 2022 (the gradual rolling-off of COVID-era cuts), they have repeatedly fallen short of that mark due to several member nation’s inability to ramp production from existing capacity. Regarding that point, the IEA noted that unless OPEC+ member nations with spare capacity (namely Saudi, Iraq and UAE) make up for the production deficits of the broader group (namely Angola and Nigeria), the total amount of oil lost in 2022 could approach one billion barrels! The COVID pandemic not only drove oil prices lower than we’ve seen in years, it disincentivized investment in new production, which has now become apparent even in those countries that were believed to have ample ready inventory.

Source: Raymond James, as of 02.28.2022

All of this wouldn’t be overly concerning in a normal environment, but global inventories are currently lower than normal. Even if markets return to a surplus in 2022 (which is looking less certain than it did a few months ago), the added supply will only serve to put a small dent in depleted inventory levels. This is being seen globally, as well as here at home:

Source: Raymond James, as of 02.28.2022

Source: US Energy Information Agency, as of 02.28.2022

Speaking of here at home, how are US producers responding to the jump in commodity prices? As the largest producer of oil and liquids (includes condensate, natural gas liquids) in the world, certainly the US has the ability to influence global supply. The answer is two-fold: yes, activity has increased, leading to greater production domestically; but no, companies are not responding with the frantic growth-at-all-costs proposal of past cycles. This point was driven home in an interview post 4Q’21 earnings announcement with Scott Sheffield, CEO of Pioneer Natural Resources – one of the largest independent E&P companies in the country and largest acreage owner in the prolific Midland Basin. When asked about increasing output in response to elevated oil prices, he responded, “Whether it’s $150 oil, $200 oil, or $100 oil, we’re not going to change our growth plans.” This is coming from a guy who expects oil prices to climb higher, as demonstrated by the fact that Pioneer bought out their entire 2022 oil hedge book in 4Q’21 in order to have unfettered upside exposure to the commodity going forward.  

To be fair, not everyone is following suit. Financial discipline has been witnessed primarily at the public company level, where shareholders are demanding the return of capital over reckless growth (still marred by the capital destruction days of the 2010’s). But after years of industry consolidation, private companies only represent ~30% of US oil production, down from over 60% several years ago¹. That means that lower reinvestment rates, even if just at the public level, should keep spiraling production increases in check.

Source: Strategas Securities, LLC, as of 02.28.2022

This has resulted in free cash flow generation not seen from the energy sector since 2008. Not only are oil prices high, but companies have become much more efficient operators than they were ten or even five years ago. With that said, this level of underinvestment can’t continue. The primary means by which domestic producers have been able to maintain this level of hydrocarbon output while keeping expenditures in check is that they’ve been drawing on an inventory of discounted flows known as the DUC (drilled-uncompleted) well count. This represents those wells that have been drilled to total depth but not yet fracked and put on production. At any given time, there must be some level of DUC inventory due to the fact that operators often complete several wells in a row to utilize frac fleet efficiency. And during times of lower oil prices (like much of 2015 – 2020), operators are incentivized to drill wells (to utilize long-term drill rig contracts) but hold-off completion until prices improve. Right now, we’re seeing the opposite – DUC’s are being drawn down at a record rate in order to increase production without spending as much money. 

Source: Raymond James, LLC, as of 02.28.2022

This means the rig count has to go up. It bottomed in July 2020 at 276/1,030 (North America / World) and has since climbed to 886/1,632. This seems like a huge jump but put in the context of the all-time high in 2011 of 2,740/3,722, it pales in comparison. Given the vast increases in drilling efficiency and speed, there is no reason to expect absolute numbers will approach 2011 levels. But it is reasonable to think rig counts must rise to offset natural production declines, stem the drop in DUC count and satisfy global demand.

Conclusion 

In terms of energy markets, the conflict between Russia and Ukraine is currently getting all the attention. But as we’ve discussed, there are fundamental issues at work which give us cause to be an oil bull long past the (hopefully soon) conclusion of this war. As COVID reaches the endemic phase, oil demand has come roaring back and is forecasted to surpass its 2019 highs this year². At the same time, we think the chronic underinvestment in oil supply both domestically and internationally has created a situation where demand can’t easily be met in the near-term, at least not in a meaningful way as to build the inventory depletion of the last year. As a result, we remain bullish on oil price and the companies that produce it. We have been overweight energy in our Compounders stock sleeve since the beginning of September 2021 and we seek to maintain that position. 

While a global peace would certainly take the hostility premium out of oil, we expect that these longer-term factors should keep the floor above $80/bbl, perhaps for the next year or two to come. Domestic operators have become extremely efficient at producing oil, generating free cash flow at levels below $50/bbl. It is hard to imagine a perpetual environment where that type of economic rent is allowed to exist, and prices should eventually settle around the $65/bbl mark. Until then (and even after), domestic E&P companies generate tremendous free cash flow and have developed shareholder-friendly return policies, making them some of the highest-yielding companies in the index. Moreover, we have gotten more bullish on oil field services, as a dwindling DUC well inventory and the need for more production will drive a higher rig count and related services, even as operators pledge fiscal discipline. 

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2202-35.

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