Regular visitors to The Value Perspective will be aware that one of our preferred metrics is something called the Graham & Dodd price/earnings (P/E) ratio. Rather than referring to a single year’s profit number, this longer-term P/E ratio uses an average of 10 years’ profits to try and smooth out the inevitable peaks and troughs of the economic cycle.
While researching a question from a journalist, we recently ran off the Graham & Dodd valuations of European, US, UK and Japanese markets and each of their respective constituent sectors. To be honest, this was no great hardship as we had set up these spreadsheets some years ago – duly highlighting the credit crunch trough valuation for each sector in case, at some point, it proved an interesting number.
Given market increases, the credit crunch lows are of increasingly less practical use except for one striking instance – pretty much everywhere in the world the oil and gas sector is now back to its credit crunch trough valuation. To be clear, that is not the same as saying prices are back to their 2009 levels but, with five years of profits dropping out of the Graham & Dodd number to be replaced by five new ones, valuations are.
At a ratio of 10x, the UK oil and gas sector is just 1% above the 9.9x on which it stood in 2009 while Europe, on 9x, is at exactly the same level. For its part, at 13x versus 12.7x, Japan is within 4% of where it was five years ago while the US is slightly higher. Here on The Value Perspective, that should be like Christmas for toddlers and yet we do not find ourselves particularly enthused. Why is that?
As investors who are unconstrained by a benchmark index and think in terms of absolute as opposed to relative returns, the oil and gas companies may now be superficially attractive but they do not have what we actually care about – cash. Much as we respect the metric, the Graham & Dodd P/E focuses on profits but profits do not pay a dividend and they do not allow you to reinvest in the company.
What does allow you to do either of those two things is the cash a business is able to generate and, when you look at the cash generation of oil and gas companies, it is significantly worse than their profits. That does not mean they are expensive or even unattractive as such but it does mean they are significantly less attractive than they appear at first glance.
In a recent note to investors entitled Bubble watch update, GMO’s Jeremy Grantham neatly sums up the principal issue, observing that in 2013 – and despite spending nearly $700bn (£450bn) globally, up from $250bn in 2005 – the oil industry found just four and a half months’ worth of current oil production levels.
That represents a 50-year low and means these businesses are having to spend hand-over-fist to have any hope of even holding current production steady. The capital expenditure involved in oil and gas exploration and, as and when discoveries are made, developing the sites leads to significant deterioration in the sector’s cash generation – and, as we have said, the cash is all we care about.
Now, it is of course possible that the oil and gas sector has a ‘eureka’ moment, similar to ones we have seen in various other businesses that had once grown used to spending large amounts of money. The rude awakening of the credit crunch, for example, forced the insurance industry to stop spending on growth because it was not making appropriate returns on that expenditure.
More recently – though for the very same reason – the food retailers had to stop spending on growth and buying new stores and, in due course, oil and gas businesses may come to decide the money they are spending on trying to maintain reserves just does not make economic sense. At that point, they may – may – become a significantly more attractive investment proposition although investors will have to remember this newfound focus on capital discipline comes at a cost and that is declining production.