The Only Inflation Hedge Left

By Stephen Hester, Chief Analyst, Wide Moat Research

Since 2019…

Prices at the grocery store are up 30%.

Used cars are 50% more expensive.

Home prices have increased 59%.

One ounce of gold needs 90% more paper dollars to buy.

Bottom line, things are a lot more expensive than they were a few years ago. Inflation has battered everyone's finances. And caused most classic inflation hedges to rocket in value. That includes real estate, precious metals, and, unfortunately, the things you and I buy daily.

But there's still one extremely undervalued part of the markets that has been hiding in plain sight. Today, I'll share the smartest way to profit from it.

Crude but Effective

At this point in 2019, WTI crude oil traded around $65 a barrel. Today, it's $70 to $72. Compared to just about everything else, crude oil prices have been "frozen" in time.

Crude oil had a great run from $60 to $120 in the years surrounding the pandemic. But unlike real estate, gold, and most commodities, it currently trades around pre-pandemic levels. Oil is easily the most undervalued "real asset" we cover at Wide Moat Research.

While we focus on generating high levels of income from the highest quality companies, there is a lot more to it than researching individual companies. Understanding the dynamics of different markets, like oil and natural gas, is key to separating companies that are great values from value traps.

I believe there are several factors that will push oil higher. Tensions in the Middle East have rarely been this bad outside of wartime. Targeted strikes on Iranian energy infrastructure will remain a risk for some time. China's unprecedented stimulus program is expected to force the nation's annual GDP growth back toward 5%. As the second largest consumer of oil behind only the U.S., a revitalized Chinese economy is a major tailwind for oil prices.

But why haven't inflation and heightened risks in the Middle East already pushed oil higher? As my wife always jokes when I bring up the markets: Supply and demand.

Oil Market Fundamentals

The U.S. recently surpassed pre-COVID production levels and is now pumping 13.5 million barrels a day of black gold into global markets. That's 17% of the world's output. Unlike the U.S., global output has declined from 82.5 million barrels a day to 81.1 million barrels in the past five years. Without outperformance from U.S. drillers, prices would undoubtedly be a lot higher. No other country, not even Saudi Arabia or Russia, can come close to current U.S. production levels.

But U.S. production isn't likely to grow unless oil prices do. Inflation has greatly increased the cost of labor, materials, and land leases required to drill. Yet oil prices haven't budged in five years.

Breakeven prices on new wells are $59 to $70, depending on the region. Because of the timeline to acquire new leases, drill the vertical and horizontal portions of the well, and then bring production online, much of today's output is from wells drilled years ago.

Current oil prices are way too close to the breakeven cost for drillers to ramp up production beyond already record levels. I've always enjoyed learning about energy economics and engineering. So much so that I chose to study petroleum engineering in graduate school at the University of Texas.

And even if oil prices soar, it'll take another couple of years before new projects add supply. This lag between investment and production (although much shorter than it used to be) is a major reason why crude oil prices are volatile.

How to Take Advantage

Investing in commodities directly is easier said than done. Short of filling your swimming pool with crude oil, there isn't a good way to own it directly.

The futures market requires making a bet on a specific contract. And like options, futures contracts are tied to an exact price at a date in the future. If you don't get all the pieces just right, it's easy to lose money, even if your thesis is mostly correct. And since a single futures contract represents one thousand barrels of oil, you better be right. So, unless you are a futures trader, investing that way isn't best.

Fortunately, we don't need to mess with oil futures. I know a way to achieve similar potential gains with much less risk (and even earn a dividend along the way). According to JP Morgan's most recent market report, the energy sector is priced at just 12.6 times forward earnings, which is the lowest (cheapest) of the 11 major sectors. And despite the S&P 500 Index trading at nosebleed levels, the energy sector is priced below its 20-year average.

Instead of gambling on oil futures, we can find similar upside potential using quality energy companies. Oil service company Halliburton Company (HAL) carries a $25 billion market capitalization, and it is trading 44% below the consensus analyst price target.

For those looking for more income, the midstream segment is also attractively valued. Equitrans Midstream (ETRN) is trading at a 51% discount, according to Morningstar. Neither of those are our favorites, but they are among the cheapest and, we believe, offer more near-term upside than crude oil.

Why Wall Street Always Wins

I learned a lot from Wall Street during my 10-plus-year career as an institutional due diligence officer. I worked with some of the biggest firms, and it was my job to understand every aspect of their investment process and strategy. I had countless "off the record" conversations with their management teams and learned things you won't find in any book or MBA classroom.

Early on, I noticed Wall Street only makes an investment if they have multiple ways to win. They never put all their chips on a single bet. They select opportunities with three or four catalysts, any one of which gives them a likely win.

The situation is the same here. Crude oil is undervalued. Energy companies will rise in value if oil does. Second, the whole energy sector is undervalued versus the rest of the market and its own historical averages. If that normalizes, energy companies will win again.

Lastly, many individual oil companies are heavily discounted. There is significant upside potential even if crude prices and the overall sector doesn't move much. By choosing the right company in the right sector at the right time, we can stack the odds heavily in our favor.

Regards,

Stephen Hester
Chief Analyst, Wide Moat Research