by Shawn Narancich, CFA
Executive Vice President of Research
Irrational Exuberance?
With some 90 percent of the S&P 500 having now reported third quarter earnings, investors have responded favorably to a plurality of companies delivering better than expected numbers. For those companies beating expectations — approximately 75 percent of all reporters so far this earnings season — stock performance over the two days following has been more favorable, averaging a 2 percent price gain twice that seen in response to such earnings reported over the past five years. Similarly, for those companies missing expectations, the downside in stock prices has been less punitive. Factors such as magnitude of the beat, the earnings outlooks offered, and the quality of earnings reported also matter, but the point is that investors seem to be greeting quarterly results more enthusiastically this time around. Whether the economic and earnings outlook ultimately justifies such near-term optimism, equity investors have now enjoyed five straight weeks of gains that have propelled stocks to fresh highs on the S&P 500.
Old School Titan
As investors react to the latest earnings and potential trade war détente with China, we take note of a “rich” irony emerging at year end. While tech stocks have the led the market higher in 2019, a company hailing from the market’s worst performing sector — energy — stands to become the world’s largest publicly-traded company. Despite subdued oil prices, Saudi Aramco is forging ahead with plans to go public by December and has begun what is known as “book building” to determine the company’s price tag. The company’s earnings power is impressive: Saudi Aramco reported net income of $111 billion last year, exceeding the profits of market cap leaders Amazon, Apple and Microsoft combined.
The leadership of Saudi Arabia is targeting the sale of a small 2-5 percent stake in Aramco at a price valuing the company at $2 trillion. ESG conscious investing emphasizing greater use of renewable power and less fossil fuels could dampen its reception. As we see it, Saudi Aramco is unlikely to garner the implied valuation of 18x earnings. But even at a valuation several hundred billion dollars less, Aramco stands to push aside the world’s technology bellwethers for market cap bragging rights.
As the IPO process unfolds, one thing is certain — Saudi Arabia would clearly like to see higher oil prices. To oil companies’ chagrin, the commodity has remained largely rangebound over the past couple years, with more than its fair share of volatility.
We are underweight the energy sector and the beta-facing producers and service companies therein because oil prices have not been able to sustain what we have viewed to be mid-cycle prices around $70 per barrel. Granted, the landscape is changing amid an increasingly mature U.S. shale resource and a change of heart by investors clamoring for less growth and more cash. While U.S. production growth has helped underpin lower-for-longer oil prices, capital spending in the U.S. is now declining.
Black Gold?
Amid ongoing declines in the rig count, will less investment in U.S. oil fields finally produce a sustained rise in oil prices? Assuming global economic expansion continues, oil demand should once again rise in 2020. But, just as U.S. production growth is set to wane, we see several large deepwater oil projects in the queue that could again forestall a sustainably higher price. The Johan Sverdrup project in Norway’s North Sea, renewed production growth offshore Brazil and new Stabroek block production from French Guiana stand to combine for over 1 million barrels/day of new production next year. Assuming sufficient reinvestment elsewhere, these projects alone appear capable of meeting additional demand in 2020.
Week in Review and Our Takeaways:
Stocks traded to new highs amid constructive earnings and dampened trade tensions
Saudi Aramco is preparing an IPO that stands to make it the world’s largest publicly-traded company