Easing Inflation is Transitory and Oil and Gas Stocks Cheap
Contributed Opinion

The market narrative still has it wrong. The belief is that inflation will continue to decline; hence interest rates with follow suit and decline.

I believe inflation is entrenched, and it is going to be much harder to bring down than the markets believe. In the chart below, you can see that core inflation is more stable and persistent than overall inflation.

The main reason that inflation came down in March is that the yearly numbers are compared to much higher energy prices that began in March 2022.

You can see it clearly on this chart of oil prices. Inflation is now measuring US$70 oil in March 2023 to US$110 oil in March 2022, so naturally, energy is now pulling inflation numbers lower.

This easing of inflation is just temporary and will last until around August, assuming energy prices do not rise. By August, we will be comparing the current energy prices against US$80 to US$90 oil in August 2022.

This next chart breaks down inflation by category, and the energy sector decline is obvious. Also note that things you pay people to do, like make food for you at a restaurant or fly you across the country. Prices are rising accordingly, particularly across airlines, transportation, and restaurants. It suggests consumer demand is still too high — first chasing limited goods and now chasing limited services, leading to increases in prices.

Gasoline prices were down -17.4% in the last CPI data, but these prices typically rise with the summer demand, and you can see in the chart below that gasoline inventories are at precariously low levels.

This next chart is distillates that is mostly diesel fuel, and these inventories are low as well.

Any further supply disruptions like world geopolitical events, refinery problems, hurricanes, and energy could easily start adding to the inflation numbers in the last half of 2023.

S&P Global's April Flash U.S. Composite PMI rose to 53.5 — the highest reading since May 2022 — for its third straight expansionary reading. Services activity growth reached its highest level in a year, increasing well above market expectations to 53.7.

It appears the decline has ended, and purchasing managers see a more resilient economy. Manufacturing PMI beat expectations more modestly, pointing to the first expansion in factory activity in six months.

Hedge funds are not buying the declining rate narrative, and they are probably right. They have never been more bearish on U.S. Treasuries.

Leveraged investor net shorts on 10-year Treasury futures have climbed to a record high after increasing for five consecutive weeks.

If the market narrative has it wrong, as I suspect, then owning stocks right now has considerable risk, and we are still in an environment of rising costs, lower margins, and profits.

Expectations for the S&P are at a -6.2% decline. If this becomes the actual decline for the quarter, it will mark the largest earnings decline reported by the index since Q2 2020 (-31.6%). It will also mark the second straight quarter in which the index has reported a decrease in earnings. The chart does not look so bullish, either.

There has been a decent bear market rally from the 3500 low, but the index is close to a resistance level at 4200 to 4300, and we have a wedge pattern developing as well. Will we break lower or higher out of this wedge?

Interesting is that a break over 4200 would also represent +20% in this rally, making it officially a new bull market. However, with the current fundamentals, I won't be buying it. General equities look too risky here, and I prefer buying into a sector that is down and priced low, which brings me to energy.

Oil prices (WTI) started January 2022 at around US$75 and headed higher to around US$120 by June, then declined back to US$75 area by January 2023. Oil is now a bit above US$75, so basically, we have a wash as far as prices go.

However, many oil and gas stocks gave back far more than a wash and were priced back when oil was US$60 to US$65. Most of these same companies reduced debt significantly, so they now have better profit margins. I plan to highlight a few of these companies that I have been following and will start with — Callon Petroleum.

Callon Petroleum

Marketwatch reports that Callon Petroleum (CPE:NYSE) is trading at a P/E of 1.75 and a price-to-book ratio of only 0.74. Granted, this P/E is based on a pretty good year in 2022. However, analysts are predicting earnings of around US$10 per share in 2023 which would give a forward P/E of just 3.5, which is still very low.

Cash flow is another measurement often used to value oil and gas companies, and the price to cash flow is a very low 1.53. The company had net cash from operating activities of US$1.5 billion in 2022.

Granted, 2022 was a very good year, but if we just look at Q4, when oil prices averaged around US$83 to US$84, they had a cash flow of US$372.6 million, and multiplying by four to equate a year is still close to US$1.5 billion. WTI Oil prices averaged US$95 in 2022, and currently, around US$80 is not far off.

I believe we will average between US$75 to US$80 for 2023, and to be more conservative, I will use an even US$1 billion cash flow for 2022, so the stock is trading around two times that. Oil and gas stocks in the past often traded between 5 and 10 times cash flow.

The sector is out of favor and cheap, especially Callon. Callon's fourth quarter production averaged 106.3 MBoe/d (62% oil and 82% liquids), in line with guidance. Results reflect the negative impact of adverse winter weather, which is estimated at approximately 0.6 MBoe/d. Average realized commodity prices during the quarter were US$84.33 per Bbl for oil (102% of NYMEX WTI), US$25.79 per Bbl for natural gas liquids, and US$4.06 per MMBtu for natural gas (66% of NYMEX HH).

The total average realized price for the period was US$62.00 per Boe on an unhedged basis. You can see that they had a US$372.6 million cash flow at US$84.33 per Bbl, so if average prices are US$5 to US$7 lower, it will not be that negative.

What will help in 2022 is Callon paid down US$461.9 million in debt and reduced the leverage ratio, as defined by their credit facility, by over 40% over the last 12 months. They plan to continue paying down debt. I have covered Callon in the past, and for those of you not familiar with the company, this slide from their presentation is a good snapshot. They operate in well-known and predictable basins.

"Callon's fourth quarter and full-year performance drove new company records in profitability and cash flow," said Joe Gatto, President and Chief Executive Officer. "Our results demonstrate what our strong operational team plus a quality, oil-weighted asset base can do, profitably growing production while improving margins and investing less than 60% of our cash flow. We believe our business model is sustainable with a deep inventory of high-return oil projects that adhere to our "Life of Field" co-development model. Our cash flow will continue to be allocated to disciplined reinvestment, further debt reduction, and eventual returns of capital as we pursue shareholder value creation from multiple sources."

I expect Callon will start paying a dividend this year. The company has stated that once they reach debt reduction down to US$2 billion, it will look at increasing shareholder returns.

At these valuations, I don't see a lot of downside risk in the stock unless there is a collapse in oil prices, but with war looking to continue, this does not look likely.

The stock is not much above good support on the chart, so again little downside. The first important hurdle to clear on the upside is a break above US$45.

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Charts provided by the author.

1) Ron Struthers: I, or members of my immediate household or family, own shares of the following companies mentioned in this article: Callon Petroleum.  I personally am, or members of my immediate household or family are, paid by the following companies mentioned in this article: None. My company currently has a financial relationship with the following companies mentioned in this article: None. 

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