The 10-year US Treasury note has traded at the following yields so far this year:

1/1/21 0.93%

2/1/21 1.09%

3/1/21 1.45%

3/19/21 1.74%

3/31/21 1.74%

4/1/21 1.69%

5/1/21 1.63%

6/1/21 1.62%

7/1/21 1.48%

yesterday 1.29%.

The two mid-/late-month quotes in March mark the height of the runaway inflation fear that gripped the market earlier in the year. The subsequent movement of Treasury yields illustrates how far away we’ve come over the past month or two from the near-hysteria of late winter.

Still, the essential issue in today’s bond market remains unaddressed by investors. If we think that the long-term level of inflation is a 2% yearly rise in overall prices, current Treasuries are providing no real return to holders. In fact, the 10-year pencils in a 70bp annual real loss from holding them to maturity. So why should Treasury yields be falling, i.e., why should Treasury prices be rising?

Could this be the least-bad choice for investors? If we’re talking about mutual fund or pension fund managers who have specific instructions that limit their ability to stray from long-dated high-quality fixed income, maybe so. For you and me, however, probably not.

Nor is there any evidence I can see that the overall economy is about to enter recession. Yes, we’re seeing the first signs that the shortages of just about anything one might want to buy are beginning to ease. But I’d argue that’s a good thing–and a reason to run to stocks rather than flee to Treasuries.

Two possibilities that I see:

–technical buying, meaning large investors mistakenly betting heavily, on margin, that Treasury prices would continue their March swoon and now being forced to unwind their short positions by repurchasing the bonds they’d previously sold

–foreign buying. In a non-US world of zero or negative nominal yields, 1.3% might actually be a good deal. To the extent that the Biden presidency is defusing the idea that today’s US is following the path of 1930s Germany, thereby diminishing the capital flight trade, foreigners might anticipate the additional plus of a currency gain.

performance

Energy stocks were the best performing group in the S&P 500 during the first half of this year, gaining 42.4%. That advance follows a loss of -37% for full-year 2020, however. This means that despite its fabulous rise so far this year, Energy remains a bit more than 10% below its level of 18 months ago.

two professional approaches to the sector

Energy is one of the smallest sectors of the eleven in the S&P, making up only 2.8% of the whole. For a professional investor without either deep knowledge and experience with the sector or access to a trusted analyst who has, this is too small to waste one’s time on. The two likely approaches: neutralize the sector, that is, have holdings that mirror sector performance well enough that you won’t make either gains or losses; or ignore the sector entirely, on the argument that it’s so small that it won’t affect results one way or the other.

The second tack would have gained a portfolio about 100 basis points in performance in 2020, most of which would have been lost back to the index in 1H21.

In either case, the more important question is what the pm does to help or hurt the portfolio in the time not used in thinking about oil and gas.

what’s at stake in the oil and gas industry

economics

–in the late nineteenth century, coal began to replace firewood as a fuel. At the end of WWII, oil and natural gas began to replace coal. Now renewables are beginning to replace oil and gas. That’s the way the world works.

–generally speaking, the higher the price of oil and/or the lower the price of renewables, the faster the substitution will take place.

–ex the US, the major world oil producers are by and large third world countries ruled by hereditary elites and radically dependent on oil revenue to keep their economies’ wheels turning. Saudi Arabia is in the unique position, however, that it has enough reserves to keep producing at current rates into the next century–vs., say, ten or twenty years worth for everyone else in OPEC+.

This means that Saudi Arabia has a different approach to oil pricing than the rest of the cartel. Aor Saudi Arabia, 100 years of production at $60 a barrel is infinitely (actually, closer to 4x) better than 20 years at $100 followed by replacement by renewables. The rest don’t care that much about prolonging the oil era, since their oil reserves run out much sooner. They’re all in on maximizing current prices because the long-term implications of doing so aren’t important. This is the heart of the current pricing dispute.

the stocks

–the US Energy sector breaks out into large integrated firms–mostly multinationals; a large number of smaller domestic exploration companies, and a small number of refiners. Exxon-Mobil (XOM) makes up about 30% of the sector weighting.

In contrast to foreign oil majors, which have long since begun to shift their emphasis away from high-cost oil and gas exploration in remote areas toward renewables, XOM in particular stands out as a vocal holdout for the old way of doing business. In my view, this strategy is throwing good money after bad. Activist investors appear to be having surprisingly good success is wresting control of the board of director away from a deeply change-resistant management.

Refiner/marketers act in an inverse way to the integrated majors. They’re a bet on flat-to-down oil quotes, since lower pump prices presumably create more driving. This means more unit volume at the pumps and more trips to the convenience stores that most of today’s gas stations have.

In my experience, the smaller exploration companies are a mixed bag of investment home runs and strikeouts (I was deeply involved with these stocks for about six years early in my working career). The income statement isn’t much help. The value of reserves, the value of unexplored acreage, success of drilling efforts, the amount of financial leverage and the details of bank loan covenants are more all important, in my view. Most of this information is in the footnotes to the financials. Learning how to interpret them takes some time, but the payoff can be very large. Arguably, though, these are the energy companies that are least able to transform themselves to deal with the threat of renewables.

what I’m doing

I’m ignoring the sector. I’m more interested in tech and in consumer discretionary names, where I think I may have something of value to add. My biggest concern, however, is the most ephemeral factor–market sentiment. As I suggested above, I think oil and gas are the latest in a long line of energy sources to be superseded by technological change. Add in a pinch of tobacco-ness, too. That is, one day we’ll wake up to find the stock market has changed its view of the industry from being glamorous J R Ewing wildcatters to being the new choppers of firewood. PE multiples will compress, more so as ESG risks come more into play.

I don’t think this change of heart is imminent, especially in the current react-to-the-news-don’t-anticipate market we’re in. Mixing my metaphors wit abandon, I see more fertile fields to plow and don’t want to be around when the wind changes.

I’ve just updated my Keeping Score page for June, 2Q21 and the first half. I come away thinking the S&P has made a whole year’s gains in the first half and that Consumer Discretionary is the one sector I find more interesting than before I compiled performance figures.

Happy Fourth of July!!