The market is simply not valuing resource companies at reasonable levels given any plausible base case for how the world might play out, in our opinion. With oil prices up around 65% and natural gas prices up hundreds of percent since the beginning of 2020, Shell, a bellwether for the oil and gas industry, is more or less flat. With the movement in oil and gas prices, one would have expected Shell’s stock price to surge. It didn’t, however, leaving Shell at very attractive valuation levels. At commodity prices as of the end of the first quarter, Shell would be cranking out free cash flow yields of 22-23% for the next few years according to our models (see Exhibit 5).
And it’s not just fossil fuel companies. U.K. listed mining titan Glencore weighs in at free cash flow yields of around 24% over the next few years, while major U.S. fertilizer player Mosaic tilts the scales at almost 30%. If you’re willing to venture into smaller cap names and/or emerging markets, the disconnects can become even larger. To put these yields into perspective, the free cash flow yield of the S&P 500 was around 4% in 2021. Think about these numbers. If commodity prices were to stay at current levels, many of the largest commodity producers on the planet could pay down all their debt and buy back all their shares in just a few years and keep their billions and billions of dollars of cash flow for themselves.
The implication of these deeply discounted valuations is that investors don’t need commodity prices to continue to rise in order to expect strong returns. In fact, flat commodity prices would be brilliant. Stable commodity prices from this point would lead to hundreds of percent returns, in expectation, for many resource equities.
Given the disfavor the resources sector finds itself in, it’s hard to predict what, if anything, might bring valuations back to more “normal” levels. As an investor, however, it’s not clear that it matters all that much. If the market starts to appreciate the cash flows resource companies are kicking off and applies a higher multiple to them, investors will be rewarded with a quick win. However, in the absence of improved sentiment, the resources sector will continue to pile up the profits…and investors will continue to own their share of those profits. If valuations remain depressed, investors will benefit from a combination of high dividend yields, special dividends, share repurchases, and M&A activity. While the exact mechanism is unknown, if you invest in profitable businesses at attractive valuations, you will be rewarded.