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Russia’s war campaign has jarred the Western world into the realization that energy independence is necessary.
By taking advantage of German dependence on Russian natural gas, Russia has weaponized its energy industry and changed the global paradigm. More than a quarter of Germany’s energy is purchased from Russia, mostly in the form of natural gas.
Developed nations must now shift toward energy independence after years of taking a hostile stance against traditional energy supplies including fossil fuels. The U.S., U.K., Germany and other countries have sought to wean themselves off oil and natural gas in favor of renewable sources including solar and wind.
Countries are finding out that energy independence is necessary from a national security perspective, and this new paradigm will take years to implement. That will result in significant upside especially for small- and mid-cap U.S. energy companies and their shares.
Companies that may benefit
Energy stocks have had a stellar run this year, posting the best gains of any industry. For example, the Vanguard Energy Index Fund ETF
VDE,
is up 38% this year, as the Vanguard Information Technology Index Fund ETF
VGT,
which includes companies such as Apple and Microsoft, has fallen 16%. A small-cap energy fund, the Invesco S&P Small-Cap Energy ETF
PSCE,
is up 44%.
Smaller energy companies in particular have come to life after suffering during the early stage of the pandemic. With some up over 200% since the end of last year — including Frank Value Fund
FRNKX,
portfolio company NexTier Oilfield Solutions
NEX,
— can energy stocks extend gains? Absolutely.
Now
DNOW,
Civeo
CVEO,
Dril-Quip
DRQ,
and CVR Energy
CVI,
boast more attractive valuations than their large-cap energy peers and could easily be acquisition targets.
Companies such as those often have little to no debt, high incremental margins and niche businesses poised to benefit from additional capital expenditures.
The energy sector has been underinvesting in new supply for years. How much can the industry recover? The Baker-Hughes rig count has been increasing steadily from its trough of 200 U.S. rigs in 2020. Today the number of stands at 689. However, in 2015, the rig count peaked at 1,600!
Though today’s rigs are more efficient, the market must contend with the two-headed dragon of demand from a post-Covid travel recovery while supply decreases from rogue nations including Russian, Venezuela and Iran. Removing supply from an undersupplied market means there is room for energy company stocks to run higher.
Ramping up oil-capital projects in developed countries will take years, and this will result in outsized energy company earnings for years even if the Ukraine war ends tomorrow.
What it will take to replace Russia
If the U.S. and its allies are serious about energy independence, government leaders need to shun rogue sources like Russia, Venezuela and Iran, and instead focus on securing homeland supplies. Drilling, supporting and distributing these projects will require access to capital, fixing supply chains and finding qualified workers.
None of these are quick fixes, which could cause energy prices to remain elevated for an uncomfortable amount of time. In fact, U.S. production peaked at 12.3 million barrels per day in 2019, and sank 10%, or to 11.1 million, in 2021. With Russia producing around 10 million barrels per day, it is clear countries like Canada and the U.K. will also need to significantly increase production.
Stock picker’s paradise
Energy stocks make up less than 4% of the S&P 500, and indexers cannot access the potential upside in these companies, let alone the superior upside potential in smaller companies. Even advisers running benchmarked portfolios will have great difficulty outsizing energy relative to the indices they hug.
The Frank Value Fund has over 15% of its assets in energy stocks, or roughly four times the average passive investor’s exposure. We are benchmark-agnostic, meaning our process permits large allocations to sectors such as energy when valuation, quality and opportunity align like they are today.
Brian Frank is chief investment officer of Florida-based Frank Capital Partners LLC and portfolio manager of the Frank Value Fund.
