A Closer Look At The Investment Thesis Underlying Vivek Ramaswamy’s New ETF Named DRLL

XLE is a close substitute for DRLL and is only a fourth as expensive. DRLL’s claims that oil and gas equity prices will go up by 2X-3X assumes that the Ukraine induced spurt in oil prices is the new normal for the future. The evidence does not appear to support that assumption.

Vivek Ramaswamy is well known for his attacks on “woke” capitalism. His firm, STRIVE, just launched an ETF named DRLL which started trading this week. As is somewhat obvious from the ticker symbol, DRLL is a bet on the fortunes of the oil industry. In this piece, I consider the prospects of this bet. I am not as interested in the political back and forth but more in the arguments underlying the investment thesis. And, for the record, before someone asks me whether I have skin in the game, I want to clarify I have none as I do not own DRLL or XLE or XOM except via index funds.

DRLL’s prospectus states the following:

“We believe the United States is poised for a “Great Reversal” between the U.S. energy sector and U.S. technology sector. U.S. energy stocks have room to appreciate 2-3x in value over the next 12-24 months. U.S. energy companies trade at P/E of 12.8, below its 30-year average of 20.8 and the current S&P 500 P/E of 20, due to ESG-driven investment consensus about transition from fossil fuels. From June 2018 – June 2022, U.S. energy sector earnings per share rose 93%, while stock prices dipped 3%. By contrast, U.S. tech sector earnings rose 73%, yet stock prices rose 82%. U.S. energy stocks need to appreciate >2x to make up for this disparity alone, not counting other tailwinds.”

DRLL’s anti-ESG mission is centered around three initiatives:

1. Calling on energy companies to evaluate all current and future internal investments exclusively based on financially measurable returns on investment, without regard to any other social, political, cultural, or environmental goals.
2. Asking companies to increase their total amounts authorized for capital investments in oil and gas exploration and production in 2023 based on growing domestic and international demand for carbon-based energy, at the discretion of boards to determine the magnitudes of such increases.
3. Rescinding Scope 3 emissions reductions unless boards demonstrate that Scope 3 emissions reduction commitments increase shareholder value.

The sector breakdown report of stocks held by DRILL suggests a big tilt in Oil & Gas which constitutes 76.8% of DRLL’s portfolio, followed by holdings in Pipelines of 9.0% and Oil & Gas Services at 5.9%. DRLL’s major holdings, sorted on portfolio weights, include Exxon Mobil Corp (22.0%), Chevron Corp (16.5%), ConocoPhillips (6.8%), EOG Resources Inc (3.5%) and Occidental Petroleum Co (3.3%).

Although the investment case is couched in terms of going long on oil and short on technology, DRLL does not appear to actually hold or short technology stocks. Hence, to stay focused, let us ignore the investment case for technology and focus instead on oil and gas firms.

XLE is a close substitute for DRLL

There are at least 32 oil and gas ETFs in the market. The biggest ETF, with assets under management of $37 billion relative to DRLL’s roughly $300 million, is XLE, the State Street product. XLE looks like a close substitute for DRLL. XLE’s top holdings include Exxon (22.73% of assets), Chevron (20.99%), Conoco Phillips (4.92%), Occidental Petroleum (4.73%) and EOG Resources (4.38%).

XLE is way cheaper than DRLL

More interesting, XLE’s expense ratio is merely 0.10% relative to 0.41% of DRLL’s. One has to wonder what distinguishes DRLL from XLE and the other oil and gas ETFs?

Is it the marketing buzz created by Vivek Ramaswamy’s well publicized political stance against ESG? Is it the willingness to introduce proxy proposals to rescind ESG considerations such as elimination of scope 3 reductions? Incidentally, many, if not all of DRLL’s oil and gas firms have not explicitly taken responsibility for scope 3 emissions in any case.

Remarkably, the net fund inflows into XLE in the last year are a negative $116 million. If oil and gas indeed has as much upside, why did we observe significant outflows of capital from XLE?

XLE’s price-earnings ratio is 16.64 as of 9/2/22. DRLL’s prospectus claims a P/E ratio of about 12.8 for the oil and gas sector, below the 30-year average of 20.8 and current P/E for S&P 500 for about 20. Some of this reflects slightly dated data in the DRLL prospectus.

Why DRLL’s comments on stock prices of oil and gas firms not keeping up with earnings is somewhat misleading

DRLL’s comparison of P/E ratios of oil and gas firms across time and especially to that of technology firms and the S&P 500 is a bit misleading. For the so-called lost decade in the oil industry between 2010-2020, earnings in the oil industry were negative or negligible because oil prices were trending at historic lows.

Oil prices affect the earnings of an oil and gas firm in two immediate ways. First, when oil prices fall a lot, as was the case before and during 2020, accounting rules require write-downs of oil assets on companies’ balance sheets. These write downs reduce earnings. Second, when oil prices go up, as in 2021 and 2022, revenues of oil firms (simplistically quantity of oil sold times market price for oil) shoot up but exploration and drilling costs per barrel of oil remain relatively unchanged.

Hence, the massive percentage increase in earnings during the 2018-22 period reported by DRLL simply reflects a low or negative base of earnings in the pre-2021 world followed by a steep increase in earnings reflecting higher oil prices in the post-2021 world.

Stock prices of oil firms, on the other hand, more or less reflect concurrent movements in oil prices. Oil prices, from June 1, 2018 to February 24, 2022, were up a tiny bit and so was XLE, our proxy for DRLL’s holdings. Since February 24, 2022, oil prices have pulled way but oil and gas stock prices have not kept up. What happened on February 24, 2022? Russia invaded Ukraine.

One can read the divergence of oil prices and stock prices of oil and gas equities as a signal that the stock market does not expect the oil price run-up to last forever. In other words, the stock market is likely to give credit to the massive earnings that oil and gas firms can make over the next year or so due to high oil prices. However, the stock market is telling us that a $100 plus per barrel of oil price is not likely to be the new normal for the near and longer term.

What would it take for XOM to double or triple its valuation, as claimed by DRLL?

DRLL claims that there may be a 2-3X upside in oil stocks over the next 12-24 months. How does one assess this claim?

To keep the analysis simple yet relevant, let us focus on testing this hypothesis for DRLL’s largest holding: Exxon Mobil (ticker XOM). As a caveat, what I am about to attempt is a back of the envelope valuation estimate for XOM. One can get fancier and produce a 20 or a 200-page report on such valuation. My goal is to restrict the analysis to two pages.

XOM’s market capitalization as of 9/2/22 is $400 billion. If we were to add its liabilities of $163 billion, we would end up with total market value of XOM’s assets (also known as enterprise value) of $563 billion. What would it take to double the equity value to $800 billion and hence end up with an enterprise value of $963 billion? To answer that question, one has to look at XOM’s fundamentals.

The value of Exxon’s reserves

As per Exxon’s 2021 annual report, as of December 31, 2021, XOM has 18.536 billion barrels of oil and gas equivalent in the ground in terms of both developed and undeveloped reserves. Exxon’s 2021 output was 1.393 billion barrels of oil and gas equivalent. Hence, Exxon has approximately 13 years of oil and gas equivalent left in the ground (18.536/1.393).

Let us try to value these deposits. The sale of 1.393 billion barrels of oil and gas equivalent led to a post-tax profit of $23 billion in 2021 for Exxon. This is the combined profit made from three segments (upstream, refining and chemicals). Of this, $15.7 billion, rounded to $16 billion, relates to upstream profits. The other two segments account approximately for the remaining $7 billion of profit.

So, what is the margin per barrel of oil and gas equivalent sold? ExxonMobil’s 10-K (page 61) tells us the average price realized per barrel of oil is $61.89 per barrel of oil and $4.33 per thousand cubic feet of gas. Converting gas to oil at the industry standard conversion rate of six million cubic feet per one thousand barrels for simplicity, Exxon made roughly $11.48 or $12 rounded a barrel of oil and gas equivalent ($16 billion of upstream profits/1.393 billion of O&G equivalent).

Hence, assuming that the Exxon can realize the same $61.89 oil price per barrel in the near-term future, the reserves are worth $12 of profit per barrel times 18.536 billion barrels equivalent or $222 billion. Assume that the refining and chemicals income stream of $7 billion repeats forever and is valued at XOM’s latest P/E ratio of around 10. That yields a value of $70 billion. Hence, the combined value of Exxon’s three businesses, when the oil price realized per barrel is $61.89, is around $292 billion. Add the liabilities of $163 billion and the enterprise value of Exxon, assuming a $61.89 oil price, is $455 billion.

Why then is the current enterprise value of Exxon only $563 billion?

First, oil prices have of course gone up a lot since 12/31/21 when the accounting data on reserves was released. The average price of West Texas grade Intermediate for the first seven months of the year 2022 is around $101 per barrel. That is an increase of roughly $40 per barrel relative to the 2021 average of $61.89. Assuming extraction and other costs do not change much with oil prices, Exxon’s reserves should then be worth $720 billion more ($40*18.536 billion barrels more). That is, Exxon’s enterprise value ought to be the sum of the $563 billion as of 12/31/21 and the Ukraine induced kicker of $720 billion or $1.283 trillion. Of course, extraction, drilling and other costs do go up by at least the rate of inflation but I have ignored cost inflation for now. So, $1.283 trillion is a generous valuation by any yardstick.

Second, assuming stock markets have valued Exxon correctly, one can back out the long run oil price projected by the stock market. How? Compare the enterprise value of Exxon from the $61.89 average oil price of 2021 ($455 billion) with that of today ($563 billion). That change yields a stock market imputed average long run oil price, given today’s information, of $67.71 per barrel ($108 billion of added enterprise value/18.536 billion barrels yields $5.82 added to $61.89).

Of course, DRLL’s whole thesis is that the market wildly undervalues Exxon and other oil stocks. An alternate hypothesis is one or both of these claims is not sustainable in the future: (i) the current realized average price of $101 oil price in early 2022 is the new normal; or (ii) Exxon can perpetually produce the same quantity of oil and gas as it does today, given the inexorable march of decarbonization.

A case for why the market might think current oil prices and quantities extracted may not be sustainable

As is obvious by now, DRLL’s whole thesis boils down to a bet on the trajectory of oil prices. As I write this, a barrel of West Texas Intermediate (WTI) grade of oil trades at around $87 a barrel. The EIA (U.S. Energy Information Agency) forecasts the 2023 price of WTI grade of oil at $89 a barrel. Fitch Solutions expects $85 a barrel in 2024 and $88 a barrel in 2025 and 2026. The IEA (International Energy Agency), an autonomous inter-governmental agency, forecasts that even if by and large nothing is done to resolve climate change in terms of reduced oil and gas production, oil would trade roughly at $77 a barrel in 2030. Notably, none of these forecasts suggests a price higher than the early 2022 average of $101 a barrel. Let us not forget that these future oil price estimates will fall further if measured in today’s dollars given that inflation is a non-trivial concern these days.

Bottomline, if you take these forecasts and the current downward drift of oil prices somewhat seriously, the oil and gas sector does not appear to be wildly undervalued. Hence, DRLL’s claims might perhaps work at best over the next six months or a year depending on how the German winter and Russian gas situation evolves. It is somewhat harder to buy DRLL’s claim in the near and longer term.

If an investor indeed wants to bet on how the geo-political situation affects oil prices in the near term, she might want to buy DRLL. Or XLE as its expense ratio is a fourth of DRLL’s.

Comments welcome, as always.