While most market participants are aware that earlier today the price of WTI traded at fresh six-and-a-half-year lows, fewer may be aware that the decline in the price of the S&P 500 Energy sector (shown in blue in the chart below) has been hardly as dramatic. In fact, as of today, the 506.4 trading price is only the lowest since June of 2012, or a three year low. The reason for this "buffered" delay in the falling price of energy stocks is simple: forward P/E multiples (shown in red) have soared. The relationship is laid out in the chart below.
What almost nobody knows is what the energy sector's forward EPS are as of this moment. The answer: at 19.3 in sector forward earnings, down from 50 recently in keeping with the collapse in the price of oil, one has to go back all the way to the summar of 2004 to find a comparable earnings profile for the energy space (the only difference, back then earnings were soaring, now they are crashing . What is more stunning, is that not even during the peak of the 2008 financial crisis did energy earnings drop this much!
This means, quite simply, that the reason energy stock prices are where they are is entirely due to the PE multiple, which at 26.3x, has only been higher once: during the dot com bubble.
Which brings us to the topic of this post: if energy investors tire of awaiting the price of oil to rebound as energy earnings remain stagnant at decade lows of around $20, and if as a result they decide to finally punish the energy sector multiple, and take it down to its 15 year long-term average of 13.6x, nearly half where it is now, what would happen?
We present the answer on the chart below: it shows the current price of the S&P energy sector juxtaposed with where the sector would be if one applied a 13.6x multiple to every EPS data point in its history. Not surprisingly, it reveals an energy sector trading at 262.3, about 50% below the current price. It means that the current energy sector price of 506, which is 93% higher to the implied price, has a long way to drop if and when multiple mean-reversion finally sets in.
What could catalyze such a mean reversion? Goldman's David Kostin gave us the answer over the weekend:
"In prior tightening episodes, the P/E multiple has contracted by an average of 8% during the first three months following an initial Fed hike."
A rate hike which many expect will take place in September, or at the latest December. And that is 8% for the entire market, which means it is very likely that the PE multiple for the most battered sector, energy, will contract far more.
And worst of all, until this moment the primary reason for the generous energy sector PE was the continuing easy access for energy companies to junk bond financing. As we noted earlier today, this is no longer the case as financing to US shale companies has completely dried up, when this year's dead cat bounce proved to be a fleeting mirage.
This also means that the next round of capital raises for energy companies will come by way of massively dilutive equity issuance, which if there is again no surge in oil prices, will be promptly followed by the terminal source of funding: DIP loans.
We leave the question of how capable the rest of the market would be to ignore another 50% tumble in energy stock prices, open to discussion.