Seeking Alpha

Iran Escalation, Fed Or China Deal Could Drive Oil Higher Soon

|
Includes: APC, BP, CDEV, CVX, CXO, DVN, ECA, MRO, OXY, PE, PXD, RDS.A, XOM
by: Kirk Spano
Summary

Saudi oil export cuts and flattening shale growth are setting the stage for surprises to the upside in oil.

An escalation of Iran tensions, a China/U.S. trade deal or an aggressively accommodating Fed could all spark higher oil prices in a tightening market.

Oil companies operating out of free cash flow have the ability to increase shareholder yield through buybacks, dividends and debt reduction.

Five Permian oil stocks in particular have caught my attention on the absolute slaughter in oil shares.

Multiple catalysts are lining up to drive the price of oil higher in the short term. Not all of these catalysts need to manifest in order to drive oil higher, but certain could have more impact that others.

With oil stocks beaten to a pulp, it seems reasonable to think that there's too much blood in the streets to ignore any longer. Regardless of whether Millennials will buy oil stocks, we know that private equity is willing. Here are the five Permian plays that I think are the best buys right now.

Setting The Stage For Higher Oil Prices: Saudis Cutting Exports Again And Shale Growth Flattening

Saudi Arabia has announced another cut in oil exports. This time they are limiting oil exports to 7mbd. They are deliberately selling less oil than customers demand to force a reduction in inventory.

While this is not a viable long-term strategy, because shale growth would likely ramp back up after slowing lately, it's a quick solution to reducing inventories so long as demand doesn't drop off a cliff.

As noted above, U.S. shale plays have tightened up on their capex spending in response to shareholders, financial institutions and falling demand expectations. What was once projected to be another huge uptick in production for the year is now down to a rise to 12.4mbd for year end. That's largely on increased Texas Permian pipeline capacity.

Shale has recently been more responsive to shareholder demand for return of capital at the same time that lenders have tapped the brakes. The "drill, baby, drill" mentality has been thwarted a bit at the executive level.

With a substantial inventory of DUC (drilled but uncompleted) wells, it's understandable why rig counts have been drifting down this year. Rig counts have a lot of room to fall as drillers look for free cash flow.

U.S. Rig Count Although it only takes a couple quarters for shale to ramp back up, the high grading of acreage in recent years means that higher oil prices are necessary to profitably retrieve certain oil. This is an important part of the equation for companies looking to play both sides of the equation, increase production, while lowering costs.

Potential Catalyst 1: Iran Escalation

In geopolitics there are often unintended consequences. The trade war with China might be about to induce the United States to attack Iran in order to put more pressure on China to make a trade deal. Why could this be?

First off, let's not suppose this it's entirely speculative that the United States could attack Iran. In the two years since I first suggested America was on the path to conflict with Iran, President Trump has left the nuclear deal, engaged in a policy of "maximum pressure" on Iran, shifted military assets to the Persian Gulf and said he has already called off one attack on Iran.

While three years ago it might have been improbable that there could be some sort of military strike on Iran, it's clearly in the realm of possibility now. How possible? Divining President Trump is impossible, however, to dismiss the idea he could launch a strike is naive, in my opinion.

Here's an undercovered reason that the U.S. could attack Iran. China has continued to bring Iranian oil to its ports. According to Bloomberg, there are oil tankers with carrying capacity of at least 20 million barrels near the coast of China.

Reuters notes that between 142,000bd to 360,000bd of Iranian crude were delivered to China in July. The upper range of that would show a significant increase over June's 210,000bd which was the lowest in a decade. The Trump administration believes that about 70% of Iranian oil is going to China, despite the sanctions imposed by the United States.

Given the level of rhetoric toward Iran, what would it take for the Trump administration, influenced by Iran hawk John Bolton, to justify a strike on Iran's military, nuclear and petroleum infrastructure? Again, I don't know, however, I think we are moving toward more likely than not

With China now also promising to help Venezuela with refineries in return for oil, it doesn't seem far fetched that the United States would want to impede China's oil supply in order to pressure President Xi to cut a trade deal. These sorts of proxy wars have been going on since the end of World War II, and while I hope it doesn't happen, any prudent analysis has to include that it might.

I discussed the potential for the United States to strike Iran not only to deal with Iran, but to put pressure on China's oil supply to create leverage in negotiating a trade deal in my Friday webinar, now found on YouTube.

Potential Catalyst 2: A Trade Deal This Autumn Between The U.S. And China

I put this in the middle because I think it's the least likely of the three catalysts that could potentially drive oil prices higher. China and the United States are at clear loggerheads on trade. President Trump even stating that canceling the September trade meetings would be fine with him.

But, what if President Trump, looking to relieve economic pressure in time for his reelection campaign and President Xi sensing his best shot at a deal to come together? While the personalities are strong, a deal that allowed both to save face could in fact happen.

If a trade deal included energy commodities from the U.S. to China that would immediately tighten supply in the U.S. taking prices higher. That in turn would take many oil companies into much better financial territory.

With IMO2020 already looking like it will put some pressure on the American oil market, what would more demand for exported oil look like? Most likely it would drain inventory quickly now that domestic producers have committed to lower capex in coming months.

Potential Catalyst 3: The Fed Could Become Much More Aggressive

It's not like this Fed to flip-flop a bit. Last December Fed Chairman Powell suggested that rates would continue to go higher and were in fact a bit on autopilot. Of course, just weeks later, he was singing a different tune that the Fed was done raising rates.

In lowering the Fed Funds rate in July, Powell flat out said that did not indicate a series of rate cuts. Though, he did end QT (quantitative tightening) a month earlier than previously announced, injecting, by preventing to reduce, $50 billion into the economy and financial system each month.

So, what if the Fed lowers rates in September, as is completely priced in by the markets right now? Not only does the CME FedWatch Tool show a 100% likelihood of a September rate cut, but it's 18.8% predicting a .50% rate cut.

FedWatch

The FedWatch Tool also suggests a 79.6% chance the rates are lower still in October. And what if the Fed completely reverses course and uses another round of QE to inject more money into the system that it had taken out over the past nearly two years of QT?

If the economy shows signs of slowing in coming weeks, if summer vacation spending doesn't finish strong, if school shopping numbers come in bad or if there's more angst in Europe - German manufacturing declines, hard Brexit, Italian government collapse with financial impact... I don't think I can put it by the Fed to loosen aggressively by the fourth quarter.

The Fed loosening seems to be the most likely scenario to stimulate aggregate demand in general and with it stronger oil demand.

Buy These Permian Producers Now

While none of the catalysts listed above are sure things, when that many possible positive surprises line up, it's my experience that some end up happening. When positive catalysts meet lowered expectations, as the crushed oil stock prices reflect, that's a recipe for large potential gains.

With oil supplies tightening due to Saudi export cutbacks and flattening shale production and catalysts in place for higher oil prices, I think now is the time to buy the best Permian producers that also have M&A potential. I discussed these companies here:

Permian Pure Play Merger And Takeover Targets

The companies that are now operating out of free cash flow or getting very close are the most attractive.

Shale Capex FCF

My five favorites to buy now are on the chart above, four are in the green, or rather blue, for capex to cash flow:

Buy Pioneer Resources (NYSE:PXD) on its new stronger commitment to cut capex and return more money to shareholders. I could even see Pioneer being purchased outright now that they are a Permian pure play.

Buy Occidental Petroleum (OXY) on its quality, cash flow, Anadarko merger and potential to sell off non-core assets. Carl Icahn's activism virtually guarantees that Occidental will be selling off assets. It's entirely possible they become focused on the Permian, their CO2 business and just a couple other assets, which would make them a cash flow machine.

Buy Devon Energy (DVN) which is a top shale producer and is known to be seeking out an M&A deal. We don't know who exactly they are talking to, but in looking at acreage maps, production plans and balance sheets, it certainly looks like Marathon Oil (MRO) could be in play with them.

Devon Operations DVN

MRO Operations Buy Encana (ECA) on deep undervaluation and their plans to sell off non-core assets. I believe that Encana could surprise and sell-off more than expected and become a debt-free Montney pure play. They also have the types of assets that Royal Dutch Shell (RDS.A) (NYSE:RDS.B) has been talking about wanting to acquire. They also would fit nicely into Chevron (CVX), Exxon (XOM), BP (BP) or another diversified shale player, Devon perhaps?

I think we could even see a three-way merger with Encana, Devon and Marathon? Who knows, but I have to think all cards are on the table at this point. And that is the point. These companies need to turn a profit and return money to shareholders going forward. The oil age is beginning to end and there's little time to wait to maximize profits. Consolidation is one path for that and it generally includes executives getting nice exit compensation packages which I hear they like.

Encana ECA

The final Permian stock to buy now is pure play Parsley Energy (PE). They are about to turn cash flow positive and have desirable acreage. Chevron is right next door to them in several spots. That is a easy takeover to think could happen. Again with a multi-way merger, who is to say that Pioneer, Concho Resources (CXO), Parsley and perhaps Mark Papa's Centennial Resource Development (CDEV) don't get together to form a super Permian Resource company focused on oil, gas and water? Stranger things that don't make nearly as much sense have happened.

For the record, I rate Centennial Development a buy right now as well. Concho is merely a hold in my analysis, though that could change with better Permian takeaway later this year as pipelines open.

Armageddon In Retrospect

Somebody is sure to comment that I liked most of these companies are prices 30% to 50% higher. I absolutely did. I like them more now. Buying at this point means you get these cash flowing companies at a much better price than I did.

So, while the "armageddon pricing" reasons are likely to persist, the reality is that for at least some segment of the market, private equity perhaps, cash is cash and eventually most of these companies catch a higher bid, even if they never set new all-time highs ever again.

Disclosure: I am/we are long CDEV, ECA, PXD, OXY, PE, DVN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.