Gold the Current Star, but All Will Be Well With Oil
Oil prices languish while gold shines, but for long-term investors, we see value in energy companies over gold miners.
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Oil prices continue to languish near their lowest price levels of the past 20 years. Prices have been driven down by a combination of lower demand for oil products as a substantial amount of the developed world is operating under some degree of shut-in orders and a price war between Saudi Arabia and Russia. Even following a recent agreement by OPEC Plus to cut production by 9.7 million barrels per day in May and June 2020, by 7.7 million barrels per day from July through December 2020, and by 5.8 million barrels per day from January 2021 through April 2022, we continue to think that oil prices will remain low in the near term. According to a recent report published by DBRS Morningstar, "OPEC Plus Production Cuts: A Much-Needed Step, but Not Enough to Stem Near-Term Coronavirus-Related Pressures," the announced cuts by OPEC Plus are significant but will not be enough to offset the unprecedented collapse in crude-oil demand in the near term. Assuming that OPEC Plus holds to these production cuts through April 2022, the overhang of inventory that has built up in recent months could then be drawn down in a relatively short period of time after economies reopen and lift the price of oil back up.
In our equity valuation models, we utilize the current market two-year forward oil curve for our price assumptions and then adjust our price deck toward our midcycle price forecast. As such, we view energy as being the most undervalued sector across our coverage universe; the sector's median price/fair value is only 0.58. For greater detail on our price forecast from our equity research team, please see "Virus, OPEC+ Oversupply Fears Weigh Heavily on Oil Prices, Gouge Energy Stocks." Among the major oil companies, Exxon Mobil (XOM) and ConocoPhillips (COP) have Morningstar Ratings of 5 stars as both are currently trading at about half of our fair value estimates.
In the energy sector, we recently lowered our fair value estimates across those companies that provide services and products to oil producers, as detailed in "Lowering Oilfield Services Fair Values." The lower valuations were driven by a decline in our estimates for capital-expenditure spending in exploration and production; yet, even after we reduced our fair values, many of these oil-services companies remain among the most undervalued across all of the stocks we cover. For example, Schlumberger (SLB) and Halliburton (HAL) are currently trading at only one fourth of our fair value estimates, which we think provides a huge margin of safety for investors. Both companies have a narrow Morningstar Economic Moat Ratings, although we note that Halliburton's moat is on a negative trend.
While oil prices remain in the doldrums, gold prices have shone brightly. Gold prices have risen 14% so far this year, with most of that gain occurring over the past three weeks. The price gain has been driven by concern that the $2.2 trillion stimulus program in conjunction with the Federal Reserve's expanded quantitative easing program could drive inflation higher. In fact, the demand for physical gold (coins and bars) has driven the premium that buyers pay over the spot rate higher than at any time over the past decade.
While demand for gold has skyrocketed higher, the bond market is not pricing in any meaningful increase in future inflation expectations. For example, the 5-Year, 5-Year Forward Inflation Expectation Rate is currently only 1.51%. This rate is the market implied average rate of inflation expected over a five-year period that begins five years in the future (that is, the projected inflation for 2026 through 2030), which is derived from stripping out the differential between coupon and inflation-protected Treasury bonds.
Over the next few years, we expect gold prices to fall to our real midcycle price of $1,250 per ounce in today's dollars, which is roughly $1,370 per ounce in nominal dollars. Based on these price forecasts, we do not see any margin of safety in the prices of the major gold miners. The gold miners under our coverage are rated only 2 or 3 stars. Furthermore, we do not rate any of the gold miners as having an economic moat or long-term, sustainable competitive advantages. For investors who still have an interest in the gold sector, Agnico Eagle Mines (AEM) is currently rated 3 stars and is the most fairly valued in our gold-mining coverage. In the mining sector, we see much more value in 5-star Compass Minerals International (CMP), which we assign a wide moat rating. The company's rock salt mine in Ontario is the world's largest active salt mine, and its geology and location provide the company with a low-cost advantage over its competitors.
For greater detail into our view of gold prices, please see "Changing Tastes Will Dull Gold Prices."
Disclosure: This article has been written on behalf of Morningstar, Inc., and is not the view of DBRS Morningstar.
David Sekera does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.