When should you not buy commodity stocks? When you feel like you must own them. I remember when investors felt they must own oil stocks, when oil prices shot past $100 per barrel and everyone was convinced they were going to $200. Today oil stocks are universally hated, and arguably for the right reasons – the future is knocking on our door and it has electric, not gasoline, vehicles in it.
Today half of oil is used for transportation, so the long-term picture is not bright for oil. But this long term is years and years away. On the supply side, shale oil production has increased supply and turned the US into the largest oil producer in the world.
We are the first to admit that we are anything but experts on oil markets – very few people are. But we have friends who are. They tell us that the combination of geopolitical tensions in the Middle East (we wrote this in December) and a steep decline in shale oil production should lead to much higher oil prices in the near term. (Unlike conventional oil wells, shale wells at first have very high production and then it follows the Thelma and Louise trajectory, falling off a cliff.)
Looking past the short term, though we may not know all the nuances of oil markets, we are quite familiar with capital cycles. When prices are high capital rushes into the market, and despite the “this time is different” cover stories – “Oil prices are going to the moon” – supply ends up exceeding demand and oil prices eventually do the unthinkable: they decline. The opposite happens when oil prices stay low for a long time. The best cure for low commodity prices is low commodity prices.
Low prices make wells that were profitable at higher prices unprofitable. Oil producers gradually start to cut their exploration budgets and reduce the number of wells they drill. Low prices produce low returns, and low returns drive out the supply of capital (debt and equity investors both). Supply drops, prices increase, and the cycle starts all over again. One wild card that may make the present downturn in prices last longer is cheap and abundant capital – it provides a lifeline to projects that normally should not receive lifelines, but it only postpones the inevitable.
We had been looking for a while for a way to invest in oil but could not find anything we liked. We wanted a company that would benefit from a rise of oil prices but would also do fine if prices did not go up or even declined, and that would pay us a sizable dividend for our patience. We wrote about ExxonMobil a few years ago, noting that despite being the bluest of the blue chip oil companies, Exxon had to borrow to pay its dividend.
Then we found Equinor (EQNR).
Equinor is a large Norwegian oil company primarily engaged in upstream oil and gas exploration and production (E&P). It was started by the Norwegian government in 1972, and the government is still its largest shareholder. EQNR has exclusive rights to develop the Norwegian Continental Shelf, a large, productive oil deposit under the Norwegian Sea. This deposit is advantaged because it isn’t as deep as other offshore oil assets – at 300 meters, it is far shallower than more extreme offshore deposits, which can be at up to 10 times that depth.
EQNR breaks even at a project level across their portfolio when oil is $30, and they start to produce free cash flow (meaning they have paid ALL their expenses and fully replenished their asset base) at $50 per barrel. We feel this low cost basis provides us a margin of safety in the stock.
Another appealing aspect of Equinor is their management utilized the downturn in oil prices from 2014 – 2018 to become more efficient. Today, EQNR spends nearly 30% less in operating expenses to produce one barrel of oil than it did when the downturn began.
Our thinking on EQNR is very simple. If oil prices decline a lot – let’s say to $30 – and stay there for a long time (the duration of low oil prices is more important than their level), EQNR may have to cut its dividend. But it is one of the most conservative and financially strong oil companies, and thus will come out even stronger when high oil prices inevitably return. Remember, low oil prices cause high oil prices.
If oil prices stay at current levels, then there is some upside to the stock’s valuation: EQNR is trading at 9-10 times free cash flows and has a mild tailwind as it is growing its production, and thus its earnings, 3% a year. In the meantime, we collect a 5% dividend. And then if oil prices go up, they’ll lift all boats, including EQNR.
Key takeaways
- Cycles, not straight lines: Every oil crisis follows the same capital cycle—high prices invite oversupply and eventual collapse, while low prices drive out capital, cut production, and sow the seeds of the next rally.
- Transportation at risk long term: Half of oil demand comes from transportation, and with EV adoption growing, the long-term picture for oil is dim, even if the immediate oil crisis plays out differently.
- Shale’s fragility: Shale wells follow a “Thelma and Louise” decline curve—fast early output, then a steep fall—making them vulnerable in any prolonged oil crisis. Cheap capital may extend their life, but not forever.
- Equinor’s strength: Unlike ExxonMobil, which borrowed to pay dividends, Equinor enters this oil crisis with low costs, efficient operations, and a breakeven around $30 per barrel, giving investors a margin of safety.
- Three-way upside: In an oil crisis, if prices stay low, Equinor survives and emerges stronger; if prices hold steady, it offers a fair valuation and 5% dividend; and if prices rise, it benefits fully from the rebound.
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