We will never let the great U.S. Oil & Gas Industry down. I have instructed the Secretary of Energy and Secretary of the Treasury to formulate a plan which will make funds available so that these very important companies and jobs will be secured long into the future! - Donald Trump
I've been following the oil situation very carefully in the past few weeks. In an article I wrote last week, I talked about the unusual contrast between plummeting U.S. oil prices and the energy sector's superior performance since the March 23rd lows. I argued that, despite the current low demand for oil, and the short-term pain in the energy sector, now may be the time to get into these equities while they're at rock bottom prices. Oil equities and ETFs could rally, even if the price of oil remains low. I said I would not be surprised if we see a bailout package for oil and gas, or if the Fed would start buying oil equities.
Well, it looks like we may be seeing the beginning of federal action. On Tuesday, April 21, President Trump tweeted that he was directing the Secretary of Energy and Secretary of the Treasury to create a plan which would make funds available to the U.S. oil & gas industry. On Friday the 24th, Treasury Secretary Steven Mnuchin confirmed he was considering several options for providing aid to the industry. These measures include a lending program for struggling companies and possibly even taking a stake in some of these companies. President Trump is also recommending that the federal government purchase oil for future use, similar to steps China is seeking to build an inventory of cheap oil to sell off in the future.
The news that a bailout arrangement was in the works and subsequent agreement to reduce output, combined with reports of renewed tensions between the U.S. and Iran, helped cause a spike in oil prices after the Monday lows. It remains to be seen whether these meager gains will be sustainable, or if they will subside back to single digits (or worse).
In the short term, many oil and gas companies would not be able to weather this storm without the government or Fed backstopping them. Even with states and crude oil importers taking steps to reopen their economies, and with an eventual rebound expected to be the largest in history, U.S shale producers require a $50 to $55 a barrel of crude oil to break even. A rebound is unlikely to reach those numbers in the short term, even if everything goes exactly according to plan. A survey conducted by the Kansas City Fed asked those in the industry what percentage of firms would remain solvent if WTI oil prices stayed at about $30 per barrel. The firms predicted only about 61% of firms would remain insolvent at these prices.
So, in comes the government and Fed to save the day. While there will be some pushback, I think it is more likely than not some kind of deal will be worked out. While we don't know what form this aid will take now, I think Trump has made clear, his entire presidency, that maintaining the U.S.'s strength in the energy sector is his priority. They will probably work something out, and it may prop many of the failing and over-leveraged companies up - at least for a little while longer. Their junk bonds will continue to be purchased. If the more significant companies threaten to go under, the government may step in to take a stake of the company.
While these rallies may occur, I expensed them to be short-lived. Outside forces cannot extend the lives of these companies forever. Demand will likely grow slowly as states and countries gradually transition back to normal, with the possibility of a second wave of the virus also looming. Further, societal changes, that were in motion anyway, may also slow the increased demand. People are now doing many of their tasks from home, including shopping and working. The airports may become safe again, but the recent financial hardships may mean fewer people travelling unnecessarily or going on vacation. At the same time, supply has grown to a point where we are running out of places to put the excess crude oil.
As long as the supply remains overwhelming and demand grows slowly, any rallies in crude oil will likely be short lived for some time to come.
With this said, buying XLE and other cheaper-than-normal oil and gas stocks may still make sense in the short term, if this government intervention happens. I've been highlighting some ideas to take advantage of the weekly risk signals in The Lead-Lag Report that I think have big potential. And even if the prices are artificial, there may be significant appreciation in the short term across the board. Once we get a precise plan, I will analyze it to see if it is likely to have its intended effect, and whether or not it provides the government (i.e. the taxpayers) an out, so we don't end up with Japanese-style zombie companies. But, for now, redistributing your assets to provide more exposure to the energy sector may very well be the best short-term move you can make.
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