BACK TO THE BOUTIQUE INVESTOR BLOG A Fresh Perspective on Energy Adam P. Sues PARTNER, PORTFOLIO MANAGER Yacktman Asset Management’s Adam Sues discusses the firm’s pivot in the energy sector. Read his take on risks and opportunities in the energy industry today. Q. What prompted you to revisit your long-standing underweight in the energy sector? A. In general, we prefer high-quality, high-margin, stable businesses that produce significant free cash flow. Meanwhile, energy companies sell a commodity product and traditionally employ lots of financial leverage while generating cyclical earnings and poor returns on capital. So, for the first 25-plus years of our firm’s history, we largely avoided the energy sector. At the same time, we are always looking for new opportunities and ways to use flexibility to our advantage. We try to stay open-minded and reconsider our views when facts and circumstances change. In this case, the growing supply and demand imbalance in energy warranted a deeper look after years of a brutal bear market. Plus, energy is crucial to the world economy and is vital to the health and happiness of people everywhere. And we think it will remain extremely relevant for much longer than media headlines might suggest. Q. How did underinvestment in energy supply in recent years factor into your thinking? A. From a supply perspective, oil and gas producers have sharply curtailed investment for the past eight years. Looking back, a steep drop in oil prices in 2014 led to a wave of bankruptcies over the next several years. 2017-2018 ushered in a bit of a recovery, followed by an even more abrupt halt with the pandemic. The sudden drop in demand as the world shut down led to negative oil prices and a complete washout in the industry. For historical perspective, consider that energy peaked at 28% of the broad market index back in the 1980s. By late 2020, it had reached an all-time trough at around 2% of the S&P 500®. Such a meager weighting did not reflect the importance of the industry from a revenue or economic impact. Yet so many people—from producers to capital allocators—had been burned and remained unwilling to invest. Over the medium term, we expect a growing demand for energy. So, our question became, “If energy demand is going to persist and we’ve had this growing lack of investment since 2014, how does that gap get resolved?” Q. What are some of the opportunities that emerged as you began to dig deeper? A. We made our first investment in a Canadian oil sands producer, Canadian Natural Resources (CNQ). Historically, companies in the oil sands look more like manufacturers than traditional exploration companies trying to find new resources. The oil is there. And the oil sands industry spent tens of billions in capex building out the facilities, which can run for decades in the future. That meant we could come in as outside investors in early 2021 and reap the potential rewards. We think that CNQ has a very differentiated business model and an excellent management team. When the world shut down in 2020, they generated positive free cash flow and raised their dividend. In fact, they have raised their dividend 20+ years in a row—an enviable track record in any sector, much less the energy industry. Then in 2022, after oil prices spiked materially due to the war between Russia and Ukraine, we took the opportunity to broaden our exposure. When stock prices pulled back in the summer of 2022, we added a basket of U.S. exploration and production (E&P) companies. Today we have a decent overweight in energy. And it all comes down to that fundamental supply/demand imbalance. Q. How has the ESG movement influenced the behavior of energy companies? A. With oil prices touching $120 a barrel in 2022, the natural expectation (and historical precedent) would be a wave of supply in response. Yet we just haven’t seen that. We think that is partly due to the way the world now views energy. We have seen pressure from governments, regulatory agencies, and ESG influences damping enthusiasm for oil and gas in favor of renewables. These pressures have suppressed the usual supply response to higher prices. In certain cases, the compensation systems for management teams have shifted to include ESG metrics or environmental goals. During previous energy upcycles, energy companies were reinvesting more than 100% of their cash flow into new investments. Now they are reinvesting less than half. Instead, companies have shifted to returning capital to shareholders via share repurchases and dividends. The market has rewarded such capital discipline. Even if a company had a profitable billion-dollar project today, the market would likely react negatively to such an announcement—and a falling share price would only reinforce for other management teams that “I’m not going to do that.” Q. Where do you think oil is going to be six months from now? A. With our broader energy investments, we do not try to predict the short-term price of oil. It is an extremely volatile commodity with prices often heavily influenced by investors and speculators trading around the paper price of oil as opposed to physical barrels. We have also seen material disruptions from government intervention, such as the U.S. releasing significant barrels from the Strategic Petroleum Reserve, which has impacted prices over the last year or so. Ultimately, there are too many variabilities influencing the price of oil on any given day. Our thesis rests much more on the supply/demand imbalance over the medium term. Q. How do you mitigate the risks when investing in energy companies in the current environment? A. We think the risks have been mitigated somewhat by companies using this period of high prices and underinvestment to significantly deleverage balance sheets. Most of our energy investments have very little debt and are repurchasing shares and paying attractive dividends. The dividend yield for U.S. E&Ps is now significantly higher than the broad market. Select producers have also done a tremendous job lowering their cost structure, with many now breaking even below $40 per barrel. That lower cost structure provides a meaningful cushion from a pullback in energy prices. The combination of low-cost producers with strong balance sheets and shareholder-friendly capital return policies is a marked departure from prior cycles in energy. While this mitigates the downside, exposure to the sector does partially hedge the portfolio from the threat of spiking energy prices (with the recent situation in Europe serving as a stark reminder of what can happen when people are worried about keeping the lights on). LEARN MORE ABOUT YACKTMAN'S 30-YEAR TRACK RECORD Past performance is not a guarantee of future results. Investing involves risk including possible loss of principal. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for a long term, especially during periods of downturns in the market. Investors should carefully consider the fund’s investment objectives, risks, charges and expenses before investing. For this and other information, please call 800.548.4539 or visit the Prospectus & Annual Reports page for a free prospectus. Read it carefully before investing or sending money. This represents the views and opinions of Yacktman Asset Management. It does not constitute investment advice or an offer or solicitation to purchase or sell any security and is subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader theme. Data is from what we believe to be reliable sources, but it cannot be guaranteed. Yacktman assumes no responsibility for the accuracy of the data provided by outside sources. AMG Funds are distributed by AMG Distributors, Inc., a member of FINRA/SIPC.