While it might be surprising, gold has outperformed the broad stock market indices (such as the S&P 500 and the NASDAQ) since their peak in 2021. Both indices are still below their highs, while gold is very close to reaching all-time highs.
The following chart illustrates gold’s outperformance of the S&P 500 since 2021, represented by the red descending line (when the chart declines, gold outperforms the general stock market). The recent uptick in the S&P 500 this year towards the red line is what I believe to be a counter-trend rally, one that will succumb to gold’s (and Bitcoin) and commodities’ outperformance since they are historically beyond cheap.
The horizontal red line drawn from 2018 to 2021 on the chart marks a significant double top for the S&P 500 against hard assets. Since 2018, the S&P 500 priced in gold has experienced zero growth. This implies that it is highly unlikely for the S&P 500 to surpass the performance of real assets in the coming years, given the prevailing market conditions, fundamentals, and this substantial technical shift toward commodities.
The current counter-trend rally in equities, led by mega-cap tech stocks with inflated valuations, has been fueled by the excitement surrounding artificial intelligence (AI).
However, there is an old investing axiom that states, “What the wise man does in the beginning, the fool does in the end.” Purchasing large companies, especially trillion-dollar companies, at 30 to 200 times earnings has never been a recipe for long-term success.
For instance, let’s consider Nvidia, a popular AI chip stock. Even if it achieves its aggressive 2027 analyst consensus revenue and operating income targets, it would still be selling at over 20 times 2027 operating earnings, or 25 times fully diluted earnings in 2027. Presently, Nvidia is selling at over 200 times earnings, despite being a trillion-dollar company.
As the blow-off top peaks, it is highly probable that large-cap technology is nearing the end of its current reign. Similar to the aftermath of the 2000 tech bubble, it could take years for these companies to work into their current valuations after a correction.
In general, the fundamentals of large-cap technology companies do not appear economically rational when compared to alternative investments that offer faster cash-on-cash economic paybacks than these excessively priced tech giants.
For instance, I estimate significant outperformances such as doubles, triples, and more, in high-quality oil and gas producers over the next couple of years. These investments also come with a wide margin of safety.
One such holding is CNX Resources, a natural gas producer with a solid moat as a low-cost producer. It is experiencing annual growth of 15% to 20% in earnings per share and currently offers a free cash flow yield of over 10% during the natural gas cycle’s downturn. This indicates that free cash flow is poised to surge over the next few years.
Instead of paying a premium for growth in large-cap mega tech, high-quality oil and natural gas producers are rewarding shareholders through substantial share buybacks and dividends. Although share buybacks may not be noticeable on a day-to-day basis, they are extremely accretive to shareholders.
To put it into perspective, if a company repurchases 50% of its shares and the price-to-earnings multiple remains flat, it results in a 100% return. A buyback of 67% of shares translates to a 300% return, 80% cancellation equates to a 500% return, and at 90% buyback, the return becomes 1,000%.
Since late 2020, CNX Resources has already repurchased 27% of its outstanding shares. I estimate that they will buy back another 25% within the next two years, and the share price should see its first 100% return. CNX is hardly alone in this endeavor within the fossil fuel industry.
While the oil and natural gas industry may seem mundane to many, FMT believes that the returns in this industry will be highly rewarding over the next few years. With little incentive to expand production due to various reasons, the majority of the fossil fuel industry is now focused on maximizing shareholder returns. Despite lower spot prices (WTI Oil at $70 and natural gas at $2.5), the industry is selling at attractive prices.
However, I believe there is a high probability of an energy crisis by 2025, and if this occurs, returns could become astronomical compared to the example of CNX mentioned earlier.
Warren Buffett’s only major investment outlays in recent years have been in Chevron and Occidental Petroleum. Occidental Petroleum, in particular, is a company he continues to invest substantial amounts in. It is worth noting that Occidental has a significant presence in the Permian Basin in West Texas, which is the only US Shale basin currently experiencing production growth.
U.S. Shale production has been a bright spot since its discovery in the early 2000s and has been the primary source of global production growth since 2016. However, due to extraordinarily high decline rates compared to conventional oil, production growth in the entire US Shale has already declined to zero in 2023 as fields have peaked and plateaued, except for the Permian Basin, which remains the only source of US Shale growth.
Since 2016, global conventional oil production has decreased from just over 84 million barrels per day (b/d) to 81 million b/d. As the prominence of shale as the world’s primary source of oil production begins to wane, it is likely that oil and natural gas prices will need to rise significantly in the coming years to incentivize exploration and production (this is also extremely bullish for hard assets like silver).
The peak and plateau of the Permian Basin, similar to other shale fields, are only a matter of time. Companies with decent reserves should be highly valued in the next few years.
Recent models from the International Energy Agency (IEA) indicate that the oil market has recently gone into a substantial deficit, and this will expediate a rapid drawdown of inventories. As inventories continue to diminish and supply becomes tight, oil and natural gas present investors with a great opportunity for high convexity.
The markets are currently overlooking this trend because of the conclusion of Strategic Petroleum Reserve releases in February, as well as the full reopening of the Chinese economy following their COVID-19 lockdowns around the same time. Both the Chinese lockdowns and the SPR releases ended in the seasonal petroleum build period of winter. Those headwinds are now becoming tailwinds.
The oil and gas industry are experiencing a significant transformation characterized by declining production levels, supply constraints, and promising investment opportunities.
According to my research, it is crucial for market participants to closely monitor these emerging trends and capitalize on the investment opportunities presented in the evolving landscape of the oil and gas industry.