Get Ready for $100 Oil in 2022
Plus my top two non-energy picks for the New Year
Welcome to the first Ross Report of 2022!
Today, I’m kicking off the New Year with two exciting new actionable investment ideas.
But first, let’s review the key theme that worked in 2021, and one which will likely continue working in 2022 - energy. In this article, I’ll make the case for crude oil reaching $100 per barrel in 2022. This should set the stage for continued outperformance among top tier energy stocks.
Let’s get started…
A Rare Value Opportunity in Today’s Market
Valuation is destiny in the stock market. And for investors with exposure to the broader U.S. stock market, like the S&P 500, history suggests a bleak future of negative returns given today’s stratospheric valuations:
The energy sector offers a lone bright spot of value. Whether we’re talking exploration and production companies (E&Ps), refiners, or midstream operators, you can find double-digit free cash free flow yields across the board.
As one example, I recently made the bullish case for midstream company Enterprise Product Partners (EPD). In the article, I explained how the business would likely offer investors a 15% compounded return under conservative assumptions, with upside to 20 - 30% annual returns under more optimistic assumptions. A big part of the thesis here relies upon Enterprise paying out a growing distribution yield to investors.
Yesterday, Enterprise management announced a 3.3% boost in its quarterly distribution. The company will now pay out $1.86 per year to investors, solidifying 23 consecutive years of distribution increases - a trend I expect will continue for years to come. Management also took advantage of the depressed unit price in the fourth quarter to repurchase $125 million of the company’s common units.
In short, the bullish thesis remains intact, and Mr. Market is starting to notice - with EPD units up 10% in the last two weeks alone.
Longer-term, Enterprise remains my favorite “sleep well at night” energy pick. Regardless of where oil or gas prices go next, the business will likely continue growing cash flows and rewarding investors with a growing distribution.
But here’s the thing…
If oil goes to $100 per barrel, you can do a lot better than “sleep well at night.” In that scenario, companies with more direct commodity price exposure could offer much more upside. Specifically, I’m talking about the exploration and production (E&P) sector.
Paid Ross Report subscribers get access to a full portfolio of energy picks, including oil-focused E&Ps that are outperforming the market, and which I believe have a lot more upside in store for 2022. Click below to access the full portfolio today:
Next, let’s review bullish supply/demand backdrop for oil in 2022…
Here’s How Oil Could Hit $100
Starting on the inventory side of the equation, the global oil glut created in the wake of the COVID-19 outbreak has officially been erased. Today, global crude stocks sit near the bottom of their historical range. Looking ahead, the U.S. Energy Information Agency (EIA) projects global inventories will remain depressed throughout 2022:
Notably, when this forecast was made in early December, the EIA assumed a potential demand hit from the Omicron variant of the COVID-19 virus, noting:
“The potential effects of the spread of this (Omicron) variant are uncertain, which introduces downside risks to the global oil consumption forecast.”
With the benefit of an extra month of new data, we now know that the Omicron has failed to make a major dent in global oil demand. Meanwhile, there’s a potential upside case from Omicron.
Of course, the usual caveat before proceeding: I’m no virologist. So take my COVID pontifications with a large grain of salt. With that said, here’s one hypothesis that appears increasingly likely…
Omicron Could Mark the Beginning of the End of COVID-19 Economic Restrictions
Historically, it’s not uncommon for viral pandemics to end from the dominance of a milder form of the virus. Specifically, you need a variant with greater transmissibility, but lower-symptom severity. Preliminary evidence indicates that Omicron could fit this bill.
First, we know that the Omicron variant is highly transmissible and has become the dominant strain in many regions, including over 95% of all U.S. COVID-19 cases. Meanwhile, without downplaying the severity to the virus, it appears that Omicron is a milder form of the COVID-19 virus. We can see this in the fact that COVID case counts have exploded to new record highs in places like the U.S., while hospitalization and fatality rates remain well below the highs.
From my understanding, the growing dominance of a milder viral strain is exactly how the Spanish Flu burned itself out. If Omicron produces such an outcome, that’s obviously a massive upside surprise for crude oil demand in 2022.
Even without this outcome, the data shows that world is increasingly learning to live with COVID-19. Economic and travel patterns are gradually returning to normal around the globe, including a robust recovery in jet travel - the key lagging sector throughout the pandemic. That’s why current estimates from major forecasting agencies, including the EIA, project new record highs in global crude demand in 2022.
Meanwhile, things look even more bullish on the supply side of the equation.
Global Oil Supply: Most Bullish Outlook in Over a Decade
The plain reality is that oil production requires capital. And capital investment into fossil fuel development has been running dangerously low for two years running:
After more than a decade of excess oil supply, the world has grown accustomed to oversupply risk in the oil market. However, capital starvation is now setting the stage for potential supply shocks as the key tail-risk going forward.
We can see clear evidence of capital impairment across the board, including in the U.S. shale patch. Despite oil reaching as high as $85 per barrel in 2021, U.S. production remains 1.5 million barrels per day below pre-COVID highs. This is a 180 degree inversion from the shale boom era, when $60 oil was enough to incentivize new record highs in U.S. production.
All signs indicate further shale capital restraint into 2022, based on current rig count trends and capex plans from the major American E&Ps.
Of course, the supply impairment in the shale patch has been well covered. The lesser talked about story is a similar development among key OPEC+ producers, like Saudi Arabia. The chart below shows the Saudi rig count falling to the lowest levels in over 13 years in 2021:
Meanwhile, there’s growing chatter that Russia - the world’s 3rd largest oil producer - might also be running up against its production limit, as Bloomberg recently reported:
“Russia failed to boost oil output last month despite a generous ramp-up quota in its OPEC+ agreement, indicating the country has deployed all of its current available production capacity.”
So even as OPEC+ remains on the output hiking path, including the recent announcement of a 400,000 barrel/day increase beginning in February, the big question remains: how much global spare capacity exists to meet record highs in demand this year and beyond?
Throw in the potential for a geopolitical disruption in a major producing region, like Kazakhstan, and $100 oil could be just the beginning of the next leg higher in prices.
Finally, there’s a macroeconomic precedent for a bullish energy view in 2022.
Late Cycle Expansions Favor Commodities, like Crude Oil
History shows that commodities - and energy in particular - enjoy some of their best returns in late cycle economic expansions. Consider two of the most recent economic case studies…
During the final melt up phase of the Dot Com bubble, crude oil rallied from $12 per barrel in January 1999 to a high of $37 per barrel in October of 2000. Notably, crude continued gaining ground for months after the peak in stock prices. And even as the Dot Com bubble crashed, crude stabilized at a lower high, before ultimately enjoying one of the greatest bull runs of all time.
During the late 1990s, investors shied away from commodities investing. There was simply more money to be made buying high-flying tech stocks. Sound familiar? Years of underinvestment in the 1990s set the stage for the “Commodities Supercycle” of the early 2000s. I believe we’ve created a similar set up in today’s market.
Given current supply/demand dynamics, the Dot Com episode could provide a useful template when today’s cycle turns - where energy enjoys a certain degree of stability, even during a broader bear market in equities.
Next, consider the case of the Housing Bubble. When real estate prices peaked in 2006 and started rolling over, this marked the beginning of a parabolic rally in crude oil. Starting from the already-elevated price of $50 per barrel in January 2007, crude prices surged to an all-time high of $147 by July of 2008. Soaring inflation, partially caused by higher energy prices, ultimately helped pop the Housing Bubble.
The inflation outbreak that helped pop the asset bubble in 2008 might also provide a useful template for what to expect for the broader financial markets 2022 and beyond.
Further supporting the idea of a late cycle U.S. expansion is the Treasury yield curve. Specifically, the spread between 2 and 10-year Treasuries. This spread has inverted (i.e. gone negative) before every major recession of the Post-War era. The compressing yield curve started throwing off warning signs in 2021, although there’s still some ways to go before reaching a curve inversion:
Importantly, stocks can still suffer serious weakness in the absence of an inverted yield curve and/or recession. The fourth quarter of 2018 is a perfect example - the previous Fed tightening attempt, which sent the S&P 500 down 20% in a matter of three months.
Today, with the Fed embarking on another tightening campaign, things could get even uglier. The $5+ trillion in fiscal and monetary liquidity over the last 18 months inspired a full blown mania in U.S. financial markets, making the markets more vulnerable than ever to tighter money.
With record household exposure to the stock market, nearly $1 trillion in margin debt, and the greatest explosion in options trading ever recorded, today’s financial markets sit atop a powder keg of speculative excess. No one can tell you when or where the spark will come from… but when the inevitable explosion goes off, it should surprise no one.
A Challenging Market that Requires Offense and Defense
Today’s market environment presents a great dilemma for today’s investor. Excessive valuations means low or negative rates of return in the broader stock market going forward. Meanwhile, with inflation running at 40 year highs, sitting in cash also means locking in a guaranteed loss.
In my view, this backdrop requires a portfolio that can play both offense and defense. On the defensive side, put options on some of the more overvalued and speculative corners of today’s market - like the technology sector - can offer asymmetric returns during a bear market. With the opportunity for 500% - 1000% gains, a small portion of portfolio capital can produce an insurance-like payout when today’s boom turns to bust.
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On the offensive side, I’ve made the case for energy offering a unique pocket of value in today’s bubble market. Energy also has historically provided one of the best hedges against inflation.
Finally, idiosyncratic value opportunities also exist outside of the energy sector.
Next, I’ll introduce my top two new, non-energy ideas for 2022. Both businesses enjoy a certain degree of economic resilience, compelling valuations and substantial earnings upside going forward.
Let’s begin with the opportunity in the discount retail space. Well-run discount retail chains can offer high returns on invested capital and above-average shareholder returns. Think Ross Stores (ROST), TJ Maxx (TJX) and Dollar General (DG) as a couple of examples.
One of the lesser known opportunities in this space is Ollie’s Bargain Outlet Holdings (OLLI).
Ollie’s - a Hidden Gem in Discount Retail
Ollie’s is one of America’s fastest growing, up and coming discount retailers. With a market cap of just $3 billion, and aggressive growth plans, this under-the-radar company offers excellent upside potential at an attractive price.
Ollie’s is similar to a Ross Stores or TJ Maxx concept. But instead of focusing on discount apparel, Ollie’s specializes in discounted merchandise. Some of its top selling categories include housewares, toys, electronics, beauty and bed/bath products, among others.
Here’s the key that makes this company special: industry-leading gross margins of 40%, or more than 1,000 basis points above its retail peers:
Stay tuned for a future analysis, where I’ll do the deep dive into this unique business model and the competitive advantages underpinning Ollie’s leading margins.
For now, here’s the key - the business not only enjoys great unit economics, but it also has a long runway of growth ahead. Management has laid out plans to more than double the current store footprint over the coming years, which should lead to compounded earnings growth of 15 - 20% going forward.
Historically, OLLI has compounded earnings at an impressive 26% annual rate since going public in 215:
Of course, rapid growth can often come with hiccups. And those hiccups can create tremendous bargain opportunities for long term investors.
One such opportunity was created in 2019, when the company’s aggressive pace of store expansion caused a temporary setback in profitability and same store sales growth. The business rebounded to new highs in profitability in 2020, only to be hit with another short-term setback in 2021: supply chain disruptions.
Again, I’ll defer the in-depth discussion here for a future deep dive article. For now, the bottom line is that I’m betting that today’s supply chain problems reflect a temporary setback in an otherwise tremendous long term business.
And here’s the great news: a short term hiccup has created the best buying opportunity in OLLI shares since the company went public in 2015:
If we look through today’s supply chain hiccups, I believe Ollie’s core business remains as strong as ever with a tremendous growth runway ahead. The long term opportunity here is an earnings trajectory compounding at 15 - 20% annually, trading at roughly 20x trailing earnings.
Finally, discount retailers are some of the most solid businesses to own during recessions. These chains often see an influx of new customers looking to “trade down” from paying top dollar at traditional retailers when the economy turns lower. Given this stable business model combined with an already-depressed valuation, I believe the stock offers a solid margin of safety with significant upside longer term.
Next, let’s consider an opportunity in the biotech space.
Biogen: A Free Call Option with Near Term Catalysts
The next opportunity comes from shares of drug maker Biogen (BIIB), which have fallen roughly 50% from their previous highs in 2021.
The long term opportunity in Biogen comes from the company’s leading position as a drug developer for neurological disease. One of the big opportunities for Biogen comes from discovering potential treatments and/or a cure for Alzheimer’s. The disease currently impacts roughly 6 million Americans, and experts predict the number could grow to 14 million Americans by 2060.
The current weakness in Biogen shares is due to challenges with the company’s breakthrough drug designed for treating Alzheimer’s - Aduhelm. Things started off great for Aduhelm, when the drug secured FDA approval status on June 7th, 2021. Biogen shares soared from around $270 to well over $400 per share in the wake of the news.
However, Biogen’s fortunes reversed as the medical community began questioning the drug’s effectiveness, as well as its high initial price of over $50,000 per year. Here again, I’ll save the deep dive for future articles. The key summary for the moment is that the share price wipe out in the wake of these challenges has priced in an absolute worse case scenario for Aduhelm, and more. Biogen shares now trade well below the $270 level from before the original Aduhelm FDA approval news:
Now here’s the thing…
Even assuming a worst case scenario for Aduhelm sales, and simply valuing Biogen’s core business of existing drugs, the stock is arguably fairly priced today at a low-20s trailing price to earnings multiple. Meanwhile, the business offers substantial upside optionality going forward.
First, there’s plenty of reasons why Aduhelm may not end up as a total bust. And even if we write the drug off completely, Biogen’s not a one trick pony. The company has several other catalysts for future earnings growth beyond Aduhelm. Chief among them is another Alzheimer drug in Biogen’s pipeline - BAN2401, which should be releasing key clinical trial data later in 2022. This drug carries none of the baggage associated with Aduhelm, and could offer the same kind of upside potential we saw with the initial surge in Biogen shares on the Aduhelm FDA approval news.
So, the bottom line is we can buy the existing business at a little over 20x trailing earnings - a level Mr. Market has defended for the past five years, and which I believe offers a substantial margin of safety.
That sets the stage for a number of potential near term positive catalysts, including any positive news at all on Aduhelm plus the potential for BAN2401, the other key Alzheimer’s drug in Biogen’s portfolio.
Finally, because of the attractive valuation and idiosyncratic drivers in this story, I believe Biogen will enjoy a certain degree of resilience and independence from the broader macro economic environment. As such, I’m comfortable owning Biogen shares today, even if macro economic storm clouds may be gathering on the horizon.
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