There are a few industries that I choose not to investigate: guns and tobacco. Some people may say that this limitation is foolish, and “what if there is significant opportunity in those sectors?” I do not care about the politics of either, but I know that both guns and tobacco kill people. Simply, I do not want to invest in that sort of thing. Although, it becomes tricky when I think about the Oil & Gas industry. Previous to my experience in investments, I probably would have stayed away from Oil & Gas at all costs because of the harmful climate change element. However, the United States has been able to support the world with its Oil & Gas production amidst the War in Ukraine, and American oil may be saving lives. Ultimately, I have become interested in Coterra Energy (CTRA), a Texas Oil & Gas Exploration and Production company.
Warrior Stock Screen
As loyal Achaion.com followers know, I conduct Warrior Stock screens on a weekly basis to see what is happening in my corner of the market. When I am looking at my screens, I search for patterns, especially industry-wide trends. Recently, I have had mild success investing in companies that have been unfairly part of basket sell-offs (when multiple companies sharing a common factor decrease in share price).
In mid January, I started seeing Oil & Gas Exploration and Production companies popping up. As usual, I did not react quickly because energy is outside of my current circle of confidence. Out of the original five or six companies, I liked Coterra because it was the only one that produced positive free cash flow over the last five years. The rest only produced positive FCF in late 2021 and early 2022 amidst those enormous gas prices (I’m sure you remember those).
As the weeks went by, more and more Oil & Gas EP companies kept adding to the list. By March 12th, 20+ names showed up on the screen.
What’s going on in Oil & Gas?
Oil Prices
Oil & Gas producers are highly correlated with Oil & Gas prices and the costs associated with drilling and fracking. Their business models surround the volume that they are able to collect per day and the market value they can sell the quantities. These companies find their competitive edge through diversified drilling locations, cost efficiency, and well productivity.
Below is a graph of Crude Oil over the past year:
Clearly, the price of gas has fallen from its $120 price per barrel in early June to a 52-week low of $68 today (March 15, 2023).
Below is a comparison of the S&P Oil & Gas Exploration & Production index compared to Crude Oil over the past year.
Both entities trade very close to each other. As Crude Oil turns down, Oil & Gas EP companies seemingly follow suit instantaneously.
The question becomes what’s driving oil prices down?
Banking Crisis, Imminent Recession Fears, Lower Economic Activity, Panic?
In general, Energy possesses the highest beta (~2.0) of the sectors. Meaning energy will do twice as well in good times and twice as poor in bad times.
Before the Silicon Valley Bank Crisis, the hype surrounding a soft landing simmered due to stickier inflation data. The CPI was still falling but not at the same clip. Investors were already shifting towards safer assets.
Amidst the Silicon Valley Bank fallout, the market can not make sense of the economic situation. The Fed’s number one enemy for the past year and a half has been inflation and inflation alone. Now, it has to deal with banking regulations and the other potential ramifications of its speedy interest rate hikes (SVB’s collapse was not the Fed’s fault by the way). The Street is expecting a 25 bps hike in March instead of the previous 50 bps belief.
As a result of the turmoil, traders are speculating that economic activity will take a significant downturn and the oncoming recession is at our doorstep. This sentiment can be seen in the softer oil prices because oil prices are extremely connected to economic activity.
Introduction to the Investment Clock
Think about the economy like the four seasons:
Spring = Growth:
In spring, the days are getting longer, temperature is getting hotter, and people are becoming happier. In the economy, this season is growth. Gross Domestic Product (GDP) is growing, and inflation is consistent. Risk-on sectors tend to outperform the market such as Tech, Financials, Materials, Industrials, and Consumer Discretionary. We were in a growth phase coming right out of Covid.
Summer = Inflationary:
In summer, it is really hot out. It is nice to be outside but sometimes the heat can be unbearable. In the economy, this season is inflationary. GDP is growing, but inflation is beginning to sky rocket. Prices are getting out of hand. Typically, people are getting paid more to compensate for the higher prices. Energy is the best performer in this environment since higher prices tend to mean higher oil prices.
Fall = Stagflation:
In fall, the days are getting shorter, temperature fluctuates, and people are getting ready for winter. In the economy, this season is stagflation. GDP is not expanding, but prices are still on the rise. Investors tend to favor defensive, risk-off sectors such as Utilities, Consumer Staples, Health Care, and Real Estate. Moreover, Energy still does well because oil prices remain elevated.
Winter = Deflationary/Recession:
In winter, the days are short, outdoors are too cold, and people are miserable. In the economy, this season is deflationary (recessionary). GDP is falling and prices are falling. Normally, investors opt to avoid equities and move towards bonds. In this environment, people expect the Fed to cut interest rates thus boosting bond prices.
As investors, we want our portfolios to be ahead of the curve of the investment clock to have the first mover advantage.
Application of the Investment Clock: Over-Pessimism?
Currently, investors could be pricing in an imminent recession/deflationary environment (winter), which is responsible for the sharp decrease in oil prices and the sell-off of Oil & Gas EP companies.
If over-pessimism is responsible for the decrease in price, then there could be an opportunity to take advantage of the self-fulfilling bears. However, the bears could inevitably be right. The cards are stacked in their favor. The economic banking panic, continued interest rate elevation, and leading indicators understandably cause portfolio fears. Offloading energy assets probably make sense. Right now, I can hear professor yelling, “Do not fight the Fed!”
Nevertheless, this opportunity presents an interesting time for those who think those fears are excessive to invest in strong companies in risk-on sectors such as Oil & Gas Exploration and Production. As the Russian energy supply continues to dampen, the need for American oil will carry on. You can’t make money doing what every one else is doing.
Coterra Energy Inc. (CTRA)
Key Financials (as of 3/15/2023)
- Market Cap: $19,122.0 mm
- Enterprise Value: $21,059.0 mm
- P/BV: 1.03x
- EV/EBITDA: 3.7x
- Current Stock Price: $22.78
Company Overview
Coterra Energy (“the Company”, “Coterra”, or “CTRA”) is an independent oil and gas company focused on the development, exploration, and production of oil, natural gas and NGLs (Natural Gas Liquids). CTRA merged with Cimarex in 2021, which led to an increase of ~400 million shares.
The Company’s assets are concentrated in areas with known hydrocarbon resources (oil rich land), which are suitable for multi-well and repeatable development programs. Geographically, the three main drilling sites are the Western half of the Permian Basin in Texas (Delaware Basin), Marcellus Shale in Pennsylvania, and Anadarko Basin in Oklahoma.
Coterra sells its product at market-sensitive prices to a large portfolio of customers. In 2022, two customers accounted for 24% of sales (13% and 11%). In 2021, no single customer accounted for more that 10% of sales. However, management guided that they do not see this as an obvious risk. If one of its major customers decreased its orders, the Company believes that it would not be hard to find buyers.
CTRA is positioned to deal with increased costs in a potentially poor economic environment. The Company is known for strong cost effective operations, flexible capital deployment, and positive free cash flow generation.
In 2022, Coterra used its excess cash to pay down debt and return cash to shareholders. The Company paid down $874 mm in long term notes and reached a Net Debt/EBITDA ratio of 0.2x. It returned 85% of its FCF to shareholders through fixed and variable dividends (50%) and share repurchases (35%).
Shareholder Free Cash Flow Returns Plan
Prior to the Q4 2022 earnings call, Coterra announced a three year growth plan. The plan guided for around $2.0 B in capital expeditures, 5% growth in oil production, and 0-5% growth in gas production yearly.
In addition, the announcement included guidance on capital allocation and returning FCF to shareholders. Shareholders should expect 50% or more of FCF to be returned via dividends and share repurchases. In the earnings call, management mentioned a 33% increase in the fixed dividend but advised shareholders to expect more share repurchases than variable dividends in the future. The Board authorized a $2.0 B share repurchase plan, which will be executed over the next 18-24 months. However, management has guided that it will be consistently aggressive with the share repurchases.
Equity analysts have noted that the goal in 2022 was similar (return 50% of FCF), and the Company returned 85%. If Coterra surprises returns expectations in 2023, then the capital allocation could serve as a catalyst for share price expansion.
Risks
A significant portion of the Companies expected oil and gas production for 2023 is unhedged, which leaves it vulnerable to market price fluctuations. Recently, this factor is probably largely responsible for how the company has slid in share price since the drop in Crude Oil.
As mentioned before, if the economy takes a tremendous nose dive, CTRA and other Oil & Gas names will underperform significantly.
In addition, Coterra’s undeveloped acreage in the Permian Basin will decrease to nearly zero by 2024, which means that its future growth could be questioned. However, the Company possesses plenty of other undeveloped lands across the United States.
Summary
In essence, there are a significant number of economic headwinds over the next 6-18 months for CTRA. However, the Company is focused on profitable operations, returning cash to shareholders, and balance sheet health. Given the substantial pessimism shadowed over the Oil & Gas Exploration and Production industry, CTRA could be a healthy company that is being oversold given its profitability and consistent FCF returns.
Continue the Research
A large reason for my interest in the Oil & Gas industry is Warren Buffet and Berkshire Hathaway’s investment and reinvestment into Occidental and Chevron. Warren Buffet’s apparent faith in sustained higher oil prices juxtaposes the sell-offs that continue to occur.
Looking into CTRA and the Oil & Gas industry was a huge exercise for me. I do not recommend going into energy unless you have a strong understanding of the macroeconomic factors at play in the market. There is still a lot for me to learn, and that is why I will continue the research.
You should consider continuing the research, too. I would not be surprised if there was a safer option that CTRA out there.
At the moment, an energy play is extremely contrarian. Please know what you are doing before getting into anything. Even so, nobody can be truly certain of what is going to happen next.
If you have more questions or want to talk all things CTRA, do not hesitate to reach out on twitter, instagram, or shoot me a text.
Employ your curiosity.
-Maximus Beach
Learn more about Maximus Beach’s background here.
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