The Energy melt-down and why I like Gazprom

One of my favourite set-ups in a business includes what I think of as the toxic trio- a business that operates in a hated sector, within a hated country, with a hated currency. If a stock has these three traits there is a good chance it is priced as a bargain.

This is where the quote from Arjun Divecha, head of GMO’s Emerging Markets team, is very apt-

“You make more money when things go from truly awful to merely bad than you do when things go from good to great.”

And it can lead to incredible returns for those willing to hold their nose and wade in.

These three factors are top-down and incredibly hard to forecast, but they often mean revert over time and having them cheap (well below historical averages) at your purchase can offer tailwinds that supercharge your returns.

Gazprom is such a company displaying almost the ugliest combination of these available in markets today- energy, a Russian domicile and the rouble. Before I go into why I think Gazprom is an extraordinary opportunity, I would like to look at these factors and how we got here.

We all know energy has been one of the worst performing sectors in global markets for some time now. Since oil topped out at $115pb in 2015, it has been a widowmaker for those foolish enough (alas) to attempt to be contrarian on the way down.

Many thought that early 2016 had seen the bottom when the price dipped under $30pb, before recovering strongly and trading between $45-60pb for the next several years, but unfortunately it was only the mid-game assault of a brutal bear that climaxed (for now) on the 20th of April. Records were set when the May WTI futures contract sinking deep into negative territory, changing hands as low as -$47pb as storage levels reached capacity and traders paid for the right to give their contracts away.

One hilarious comment from Jake Taylor of Farnam Street Investments summed it up nicely- “Bullish on oil, price target $0”.

Around a decade ago as emerging markets were roaring, energy made up around 15% of the S&P 500. Today it is on life support at just 3%. Coronavirus has crushed demand, just as OPEC+ has hit the accelerator in a fascinating show of real world game theory.

Natural Gas has fared even worse falling from a 2005 high of $19/MMBtu to $1.5MMBtu in early April- a fifteen year bear market. An ever increasing wall of supply has taken nat gas down for the count.

As an example of the value destruction on display in the sector, Antero Resources (which I judged to be a well financed E&P with high quality acreage when I bought it) has fallen from $18 a share to a low of 70c in April. Amusingly, I can claim a four-bagger since this point, which has taken my holding from down 96% to down 84%- not the stuff dreams are made of.

Other (relatively) strong companies in the sector, such as Range Resources and Sandridge Energy have enjoyed similar treatment. Sandridge sucked in Carl Icahn at $16, but even his activist efforts haven’t been enough to stop the stock cratering to $2.

But all of this information is now historical and well disseminated and as we all know, you don’t invest through the rear view mirror. Things may finally be looking up for the sector, as after all- the cure for low prices, is low prices.

I decided to write about energy today after reading Goehring and Rozencwajg’s quarterly letter over the weekend. I consider them the most knowledgeable analysts in the commodities space and I always come away with plenty of food for thought.

Their summation of the recent decimation in energy made for fascinating and potentially heartening reading for long-suffering energy bulls.

They are foreshadowing the end of the US shale industry, and as much as a 75% fall in the US oil rig count from 2019 levels, as a result of the crippling economics at play today.

They also quote Tim Duncan, CEO of Talos Energy, telling The Wall Street Journal: “In offshore, we don’t shut in fields, we shutter them”, to explain the reality that many of the production cuts made across the industry will never be brought back on line due to poor economics.

This leaves the industry with rollercoaster ride ahead of it over the next few quarters, but a drastic supply shortage looming when the temporary demand hit normalises. For those with a long-term view and a strong balance sheet, the future might finally be turning for these businesses. Might some them go from truly awful to merely bad?

Russia has been something of a basket case since the BRIC fad collapsed in 2011 and the emerging market major has been struggling ever since. Political incidents have been too many to number and Putin’s iron grip has made the country uninvestable to the majority of foreign capital.

Bill Browder’s “Red Notice” gives a sobering, if slightly self-serving, view into investing in Russia and the power struggles and corruption within the nation’s oligarchs. The sensible reasons for avoiding Russia are fairly easy to come up with and may be why the prices are so compelling.

As I have written about before, Russia is the cheapest stockmarket in the world trading on a Shiller PE of 5 today. You don’t get to these sorts of valuations without a fair bit of revulsion in the air. But once again, could some of their companies go from truly awful to merely bad? I think it’s possible and I think an investor is being paid to express this view.

I am a big believer in the Peter Bernstein/Howard Marks idea of multiple histories and thinking probabilistically. There are almost certainly possible futures where Russia collapses due to geo-political events. But there is a price for every asset and Russian equities reflect this.

For example, in the 18 months I have owned Gazprom and Mobile Teleysystems, they have paid out a combined 25% of my purchase prices in dividends. Both had also been very strong performers until Covid-19 monstered the markets.

I understand that there is a level of corruption behind the scenes that is probably quite shocking, but latest signs have been of an equity market that knows it needs to reward investors to encourage future capital. One recent example is Megafon, Russia’s second largest mobile operator, delisting from the London exchanges and buying out effected shareholders at a generous premium.

The rolling train wreck of Russian politics has also smashed the Rouble which has lost 2/3rds of its value against the Dollar since 2008. This is a net benefit for Russia, whose raison d’etre is obviously exporting energy to Europe and the world at large. It also creates a cheaper entry point for willing foreign investors.

An interesting thought experiment- if the Rouble alone ever traded up to its pre-GFC high, Russian equities would be a triple in foreign terms, without any improvement or multiple expansion. This may seem unlikely today, but much like you can’t imagine being hungry when you’ve finished an enormous meal, it is possible in a world of surging energy demand that many of the emerging market energy producers see substantial recoveries in their currencies.

Foreign exchange and sentiment are highly mean-reverting and cyclical. It is easy to forget that EM markets traded at a premium to the rest of the world in 2010.

So to sum up so far. Gazprom- hated sector, hated country, hated currency.

The company itself is the world’s biggest gas producer, a significant producer of oil and active in transportation, power generation and heating. Its CEO, Alexey Miller, has been in the position since 2001. Gazprom is just over 50% owned by the Russian government and has a mandated monopoly to export Russia’s gas through its significant network of pipelines and boasts 17% of the world’s gas reserves and 12% of global production.

This has historically been mostly to Europe (it provides more than 1/3 of Europe’s suppy), but has been seeing steady demand pick up from Asia, through its Sakhalin 2 LNG plant and newly completed Power of Siberia pipeline.

The company simply has geographic advantages which are impossible to replicate. Material from Gazprom’s 2019 investor day presentation (https://www.gazprom.com/f/posts/62/880637/investor-day-2019-presentation.pdf) show the company’s share of gas supply to Europe increasing steadily, as North Sea supply declines.

Gazprom also produces and transports oil through its subsidiary Gazprom Neft, which is the third largest player in Russia. Most of its operations are domestic, but it also has a presence in Iraq, Venezuela, Angola and Serbia among others. It operates 1800 filling stations in Russia and exports its oil to 78 countries.

Oil made up 37% of Gazprom’s revenue in 2019, gas was 56% and electricity and heating was 7% (https://www.gazprom.com/f/posts/25/691043/gazprom-ifrs-4q2019-presentation.pdf). This mix is balanced and poised to do very well as economies recover and demand normalises later in 2020 and into 2021.

Gazprom has traditionally had much higher cap ex per production unit than most of its peers. In my mind this makes more fat to cut now that the company is becoming more shareholder friendly.

Most people remain sceptical of this, but its not logical that a board intent on hoarding its cash and screwing foreign shareholders would be paying out steadily increasing dividend streams. This seems like a case of the entrenched way of thinking trumping the reality right in front of investors today.

I don’t normally think a high dividend payout is a good idea in a cyclical company, but in Gazprom’s case, its balance sheet strength should allow it to sustain its dividend. A cut during this energy melt-down is likely, but a normalisation of energy prices should see dividends rise strongly again.

One striking thing about Gazprom is that it has remained free cash flow positive each year since 2007, even during the energy blow out of 2016 and while funding projects like Power of Siberia. This shows the power of its monopoly pipelines and geographic advantages. I can’t imagine that FCF will be positive for 2020, but if you rule out energy companies with negative free cash flow this year, you won’t have many to choose from. This is what an industry in crisis looks like.

The valuation is the most tantalising piece of the Gazprom puzzle. The company sells for 4x 2019 operating profit and 3.5x 2019 earnings. 2019 profitability was already reflecting plummeting energy prices through the last third of the year. I believe they understate normalised earnings the company will return to when prices recover.

Its Enterprise Value is currently 7.5 trillion roubles, giving Gazprom an EV/EBITDA of 4x today*. Investors who can look through this years heavily impacted earnings are being given the chance to buy at extremely low prices. Gazprom’s ADR OGZPY has already fallen from $8.50 in January to $5 today, reflecting this negative sentiment.

The business should see its competition hollowed out considerably as current energy pricing wreaks havoc in the space. At net debt/EBITDA of 1.8x* and comfortable interest coverage, I believe Gazprom is a cheap name you can buy with safety while the washout unfolds.

My fair value today is 8x 2019 earnings or $14 per ADR. I think a realistic 5-7 year bull case involving currency mean reversion half-way back to 2008 levels, an EV/EBITDA multiple of 8x (assuming net debt grows to 6 trillion roubles) and modest growth in earnings (eg. 2025 EBITDA of 2.5 trillion roubles) would value the company at $23 per share.

In my opinion these estimates are quite realistic and even conservative as investor sentiment improves towards the emerging markets and energy. In the meantime I expect to have received my purchase price back in dividends by 2025.

I bought OTC:OGZPY at $4.26 in September 2018, it is currently 5% of my portfolio.

Guy

PS. As Always, please don’t take this as investment advice. I am not an investment advisor or professional. I am just writing about my experiences and happy to take any comments or criticism on board. Always seek professional advice when considering your own situation.

*EV=4.4 trillion rouble market cap + (3.1 trillion rouble debt-700 billion r cash), 2019 EBITDA=1.9 trillion roubles

**Gazprom doesn’t include bank deposits in cash and equivalents on it’s balance sheet. When these are adjusted for, Net Debt/EBITDA falls to 1.4x.