Geopolitics & the State of Energy Markets Today
As analysts and capital allocators, we strive for objectivity when assessing global events and the associated impacts on the businesses we evaluate. At times, this requires us to approach tragic circumstances with a rationality that does not reflect how we feel as individuals, nor how we feel about those directly affected. The Russian invasion of Ukraine is one such event.
In light of the tremendous suffering that has been inflicted on Ukrainians in recent weeks, it feels callous to focus on how the conflict will impact a company’s bottom line. We do so because we take both the gravity of these events and our role as stewards of our clients’ capital seriously. With this in mind, we remain committed to assessing current events with a long-term perspective to better understand the opportunities and risks facing the businesses in which we invest.
Many global economic sectors have gone through a period of dramatic upheaval over the past few weeks, with the oil and gas industry being one of the most affected. Russia is one of the world’s largest oil and gas exporters, and the world has discovered that these hydrocarbons are both key industrial inputs and geopolitical bargaining chips. As Russia commenced its invasion of Ukrainian territory, governments around the world began imposing sanctions on the Russian economy to apply pressure to the Russian government without escalating the conflict with direct military action. At the heart of the Russian economy are the oil and gas that flows from the interior of the country through pipes into Europe and Asia and onto ships bound for the wider world. These commodities are the Russian government’s greatest source of revenue, but they also feed a global economy that is hungry for cheap energy after two years of COVID-induced lockdowns. Even governments that are actively arming the Ukrainian military are reticent to shut off the oil and gas their economies rely on to function.
Oil-consuming countries realize that the global energy industry does not possess the spare production capacity to quickly replace Russian barrels should they be completely embargoed. Oil producers, conversely, do not want to be left trying to sell money-losing barrels if they pump more oil only to find that Russian production is still viable and available on the world market. In other words, we are in an acute moment of incremental oil supply being driven by political considerations instead of technical constraints. Our initial reaction is to look to history for insight, albeit with an appreciation for how much and how quickly the world has changed.
The Yom Kippur War in 1973 stands out as a conflict that triggered a massive realignment of global trade flows without industrial infrastructure being directly affected. The US provided aid to Israel during the conflict, infuriating the Arab nations allied against Israel and instigating the Arab oil embargo of the US. In 1978, the Iranian revolution gave rise to the second oil shock in a decade as the Iranian government collapsed and Iranian crude flows plummeted. In 1990, the invasion of Kuwait by Saddam Hussein’s Iraq gave rise to yet another sharp rise in crude prices. That invasion ultimately resulted in Operation Desert Storm, with an allied coalition pushing the Iraqi army out of Kuwaiti territory. A brief look at these recent conflicts in large oil-producing regions illustrates that kinetic confrontation near, or indeed because of, large oil and gas deposits is tragically commonplace.
Outside of armed conflict, geopolitical and technological revolutions can also massively influence oil production and trade flows. In the final year of the USSR (1991), Russia produced over 9.5 million barrels of oil per day.1 Through neglect, mismanagement and underinvestment following the collapse of the Soviet Union, production in the newly formed Russian Federation fell to just over 6 million barrels per day by 1994, and production did not return to 1991 levels until 2005. In recent years, the shale revolution has fundamentally changed the supply and demand balance of oil markets, as US domestic oil production more than doubled between 2010 to 2019. This rapid production increase made the US the world's largest crude oil producer and dramatically lowered the price of petroleum products for consumers. One lesson we draw from even a brief look at the history of oil markets is that change is constant.
How, then, can we get comfortable investing in the energy industry when uncertainty and volatility are ever-present? As bottom-up investors, we focus on understanding the fundamentals of businesses, one business at a time. When we gain conviction that the market price is meaningfully below our estimate of a company’s intrinsic value, we look to acquire shares and hold them for the long run. In the energy industry, we believe this bottom-up approach allows us to build a picture of how oil and gas producers fit into the larger energy markets while also informing our view of where energy markets are headed. Once we establish an understanding of a business and the market for a commodity, we then look to partner with management teams that we believe share our perspective, doing so at a price that reflects a wide margin of safety in case we’re wrong. We believe that the extreme ups and downs of the last two years have done nothing but highlight the importance of partnering with rational management teams operating low-cost assets in a sustainable and responsible way.
Across our portfolios, we hold shares of Chevron, ConocoPhillips, Coterra Energy and Civitas Resources, which we believe exhibit all the characteristics we look for in the exploration and production segment of the energy market. Though our holdings vary dramatically in tenure, market capitalization and geographic focus, we believe each investment allows us to participate in strong returns alongside talented management teams in a financially conservative and operationally responsible manner.
As we look to the future, we do so with humility in our ability to foresee how today’s conflict will play out in both the short and long term. As investors, we spend much of our time trying to be right and the rest of our time planning for when we’re wrong. The tragic and disturbing events over the last few weeks are a reminder of how fragile the investment landscape can be, and we will adjust our views as facts change. We will continue to focus on understanding the things that we can know and control, while holding great respect for the things we cannot.
As of 28 Feb 2022, Diamond Hill owned shares of Chevron Corp., ConocoPhillips, Coterra Energy, Inc. and Civitas Resources, Inc.
The views expressed are those of the author as of March 2022 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.