I'm Michael Roomberg, a portfolio manager with Miller/Howard Investments. This video is the second in a three-part series on timely issues related to North American energy focusing on Midstream Pipelines and MLPs, Energy Stock Valuations, and Natural Gas Demand Growth.
There are three indices that thematically capture the primary North American–focused energy subsectors in which we invest. These are the Revere Natural Gas Index, which represents the upstream, the Alerian MLP Index, which represents the midstream, and the S&P Oil & Gas Equipment & Services Select Industry Index, which represents the enabling companies of the shale revolution. Given our North American focus, we generally access "energy beta" via stocks that are mainly found in these three indices—which do not include the global oil major companies that predominate the more widely followed S&P 500 Energy Index.
From the beginning of 2017 through the end of the third quarter of 2018, North American energy stocks have significantly lagged these large global counterparts. Each domestic-oriented index (that I just referenced) has lagged the globally oriented S&P 500 Energy Index by as much as 29% over this period.
So one natural question is whether this lag is justified by inferior underlying performance at the North American energy companies in which we invest, relative to their global peers. We don't think that's the case, because most of the lag is explained not by an absence of earnings growth at the companies but to earnings multiple compression—investors are simply paying less today for North American energy earnings compared to the beginning of last year. Since January 1, 2017, the EV/EBITDA multiple of S&P 500 energy index has compressed by as much as 12%, as earnings have risen faster than stock prices. This compares to a 23% decline in the earnings multiple for the Revere Natural Gas Index (the upstream index), and 18% for the S&P Oil & Gas Equipment & Services Select Industry Index over this period, according to Bloomberg data. This multiple compression explains substantially all of the lag of the upstream E&P stocks, and a significant part of the equipment & services' lag.
So, while North American energy companies have indeed fundamentally recovered, we believe that investors have simply overlooked this recovery relative to their global counterparts, as reflected in company stock prices. To the extent that this reverses, it would provide a tailwind to North American–focused energy stocks. Simply put, when it comes to relative valuation—shale is on sale!
EV/EBITDA: A ratio that compares a company's Enterprise Value (EV) to its Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA). The EV/EBITDA ratio is commonly used as a valuation metric to compare the relative value of different businesses.
MLP: Master Limited Partnership is a type of business venture that exists in the form of a publicly traded limited partnership. It combines the tax benefits of a partnership—profits are taxed only when investors actually receive distributions—with the liquidity of a public company.
Revere Natural Gas Index: The ISE-REVERE Natural Gas Index consists of securities that derive a substantial portion of their revenues from the exploration & production of natural gas. The index was created with a base value of 25 as of December 29, 2000.
Alerian MLP Index: A composite of energy Master Limited Partnerships calculated by Standard & Poor's using a float-adjusted market capitalization methodology. The index is disseminated by the New York Stock Exchange real-time on a price-return basis (NYSE: AMZ). The corresponding total return index is calculated and disseminated daily through ticker AMZX.
S&P Oil & Gas Equipment & Services Select Industry Index: S&P Select Industry Indices are designed to measure the performance of narrow GICS® sub-industries. The index comprises stocks in the S&P Total Market Index that are classified in the GICS oil & gas equipment & services sub-industry.
S&P 500 Energy Index: The S&P 500® Energy Index comprises those companies included in the S&P 500 that are classified as members of the GICS® energy sector.