Coronavirus Roundtable - Energy At The Center Of The Storms
Summary
- The energy market continues to be in the center of several storms.
- From geopolitics to USO's implosion to negative WTI prints to production and dividend cuts to a nat gas surge, a lot's going on.
- We ask a panel of authors focused on the sector how they see things playing out.
Markets have settled and recovered from the initial shock of the coronavirus spread and the response of governments around the US and the world to lock down the economy. But while the major US indices have approached, if not quite matched, the fabled v-shaped recovery, there are still plenty of questions left for investors.
The disconnect between the markets and the economy has become a cliche, which doesn't change its validity. The size of stimulus in the US has been unprecedented. As governments start to reopen, it's to be seen whether we will see a second wave of cases. And we don't yet know how quickly people will go back to spending, and what the engine of the economy will be in this uncertain period.
To suss out all these uncertainties, we're starting a second round of our coronavirus roundtable series. We'll be looking at some of the major sectors of the market that are in the market, overall market and macro outlooks, and niches that may deserve investors' attention.
We focus today on the energy sector. When we last touched upon it, the Russia/Saudi stare-off had just begun. Since then, we've seen oil contracts trade for negative amounts, oil majors cut dividends, and firms around the world pull back on drilling due to an oil supply gut. Meanwhile, nat gas stocks have surged. Where does that leave us? Our panel to discuss:
- The Fluidsdoc, author of The Daily Drilling Report
- Richard Berger, author of Engineered Income Investing
- The Value Portfolio, author of The Energy Forum
- Value Digger, author of Value Investor's Stock Club
- Andrew Hecht, author of Hecht Commodity Report
- Laura Starks, author of Econ-Based Energy Investing
- Joseph L. Shaefer, author of The Investor's Edge
- Kirk Spano, author of Margin of Safety Investing
- Elephant Analytics, author of Distressed Value Investing
- KCI Research Ltd., author of The Contrarian
- Laurentian Research, author of The Natural Resources Hub
Seeking Alpha questions are in header font. Author disclosures are available at the end of the article. Questions were sent out on May 5th and sent back in by May 7th.
The negative print on WTI May contracts rocked the markets. A few weeks out, what are the lasting impacts to consider?
The Fluidsdoc, author of The Daily Drilling Report: This was a transitory problem that was driven by concerns related to physical quantities of oil already in storage. The market discounted these fears rapidly, and crude moved higher once again almost immediately. I don't see a long-term impact from this event.
Richard Berger, author of Engineered Income Investing: WTI negative prices were a direct result of the shortage of storage space locally (and globally). Almost 1.2 Billion barrels is now in contango storage around the globe. Estimates are that 100% of all onshore and afloat storage will be filled by late May 2020. It will take on the order of 2 years for the oversupply to be abated even if producers co-ordinate to reduce their sales 2 million bopd below consumption. The virus economy coupled with the Saudi push to create a painful market glut for marginal producers was certainly the trigger to the current glut and crash, but the symptoms and trends creating an environment for ever more frequent busts have been in place since 2011, as I discussed in detail with my subscribers 2 weeks ago and shared publicly in my 4/27/20 article.
The Value Portfolio, author of The Energy Forum: Lower prices. The big oil companies didn't get burned from this the traders did. However, going forward you'll see traders less willing to take the risk in terms of holding contracts, which will keep prices depressed through the month. It'll take a few months, but it'll start to affect the bigger players.
Value Digger, author of Value Investor's Stock Club: This was overreaction, and as always, algos made things worse, which is usual in the oil markets. This is why we have seen a V-shaped recovery in oil prices over the last days.
Andrew Hecht, author of Hecht Commodity Report: Three takeaways. ETF/ETN products will need vast adjustments in the way they hedge. The downside risk on a short put option in commodities is far greater than a zero value for the underlying asset. And, never say never.
Laura Starks, author of Econ-Based Energy Investing: The negative price on the last trading day for the May WTI oil contract was a fireworks display putting an exclamation point on the storage shortage. While this illustration of illiquidity and high friction is unlikely to be repeated, the consequences of oil supply having outrun demand for some weeks that resulted in the inventory overbuild will be with us for a while.
Joseph L. Shaefer, author of The Investor's Edge: Zip. Nada. None. The May contract was about to expire in a few days, and some traders who could not afford to take delivery panicked and paid others to take the contracts off their hands. This was an excuse for media to panic and say oil was down 300%. No, it wasn't. A few contracts for immediate delivery sold there. Whatever happened to responsible financial journalism?
Kirk Spano, author of Margin of Safety Investing: I think people really need to digest what the negative price of oil reflected. The easiest way to understand it is that, for a couple days, you had to pay for your oil to be hauled away. The transportation was worth more than the oil. The completely misused U.S. Oil ETF (USO) played a "roll" in the plunge, but the negative price speaks to a larger trend: oil demand, which was already flattening out, is far further along in the process of declining than projections from just a few years ago. The price of oil is likely to stay lower for longer due to the oil glut and coronavirus-inspired changes in the workplace.
KCI Research Ltd., author of The Contrarian: The most direct lasting impact is that the structure of the energy market was changed, specifically the pace of the shut-in of liquids focused production was accelerated, which also benefitted dry gas production and natural gas liquids production. A second direct impact has been the structure of the United States Oil Fund was changed, with the fund historically holding a large percentage of its assets in front month contracts, yet this approach created a crowded trade that active speculators exploited, forcing a change in the contracts held by USO.
Laurentian Research, author of The Natural Resources Hub: The lasting impacts of the negative oil prices, which resulted from the expiry of May WTI futures contracts amidst Cushing storage space shortage, may be more psychological than fundamental. The whole world learned how bizarrely oversupplied the oil market has been because of it (although WTI quickly recovered from the abyss in the following days). In retrospect, that event appears to mean little for balancing the market. The heavy lifting still has to be done by a combination of demand recovery and production cuts.
How long until the oil supply glut clears, and how much of a demand recovery do investors need for it to make sense to invest in energy stocks?
The Fluidsdoc: The U.S. was using about ~20 mm bbls a day prior to the virus arriving. At its worst demand, dropped about 40%. The glut will be cured by U.S. production declining about 4-5-mm bbl over the next couple of quarters from shut-ins and lack of new drilling. In fact, I see us moving higher as shale production declines. Most production growth over the past few years and under-investment in deepwater projects will come home to roost.
Richard Berger: As I discussed above, a glut from current contango storage of 1.2 billion barrels will take years, not months to unwind. Exporting nations have agreed to cuts of production totaling 9.7 million bopd with curtailment to being May 1 to June 31 and then slowly ramp back up over the next 6 months to a targeted 6.3 mmbopd below current production. History shows this is very unlikely to be achieved, and it is insignificant even if it does. Contango storage build of excess production has been ramping almost 1 mmbopd, and demand is not expected to rise strongly at least into mid or late 2021. That translates to at best an average 5 million bopd under production to meet consumption demand for the next 18 to 24 months. 1.2 billion barrels in storage will constantly fill this demand. At that 5 million per day contango drawdown, this existing stored oil will take 240 days to draw down. This alone will abate pressure for any significant rise in crude prices for 8 months. Any sustained rise in price will also trigger economics to return currently shut in marginal economic production to sales. This will further extend the abatement of upside price pressure for many more months. It will add pressure to cartel curtailments to break ranks and (if history is to be the judge) lead to cheating and new price erosion with another collapse in oil prices 15 to 30 months from now. The picture is even worse if the virus economy is slow to rebound, as many think will be the case.
The Value Portfolio: You're looking at a year+, in a post vaccine world, for the glut to clear. But no demand recovery is required to invest. By then, the prices of oil companies will have long since recovered. The time to be greedy is when everyone is fearful.
Value Digger: This coronavirus-related oil crash is different from the previous ones. In previous cases, the oil crash was the result of increased supply. In this case, coronavirus has affected both the supply and the demand side. When it comes to the demand, there are still some unknowns because the economies re-open gradually. Assuming that we will have a coronavirus medicine or vaccine in the second half of 2020, we expect that oil prices could reach or exceed $40/bbl by year end.
Andrew Hecht: The glut will clear as output adjusts. Falling rig counts in the US will cause output to decline. OPEC, Russia, and other producers will continue to slow production as their customers purchase less. A return of demand is in the hands of scientists working on treatments that will allow a return to normalcy in the economy. I would only look to energy stocks that are tied to national security, i.e. the strongest like Exxon Mobil (NYSE:XOM), BP (BP), and Royal Dutch Shell (RDS.B).
Laura Starks: A multi-billion-dollar question. Energy is the spine of the world economy. I don't recall who said this about oil in particular, but oil = transport = trade = wealth. The transport and trade links have been broken by government-mandated shutdowns and require repair. It looks like the U.S. and world restart will be a collection of bumpy, uneven mini-restarts. We may not fully come back from April's 70 million barrels per day (MMBPD) to the prior 100 MMBPD of demand. However, it appears likely a good chunk of this demand will return in the next 2-3 quarters. Demand is back up in China (whatever one thinks of China's role) and is inching back in the U.S. as states slowly reopen. Pandemic-depressed earnings are already priced into energy stocks. Well-run companies remain well-run companies, so I'd argue most energy companies without big debt loads are probably attractively priced now, if one assumes a resurgence in the next few quarters.
Joseph L. Shaefer: I don't know and neither does anyone else, no matter how certain they try to sound. It depends upon the pace of economic recovery. Oil is essential for manufacturing, transportation, and the myriad by-products as mundane as petrolatum, the prime ingredient in Vaseline. I am guessing if people take the medical protocols seriously, the glut could correct in 4-6 months. When to buy? Anytime it is cheap - the stocks will forecast 4-6 months before the glut is over.
Kirk Spano: As I discussed in a recent article, the oil glut might not ever be gone. With millions of people working from home, not just for a year or two, while this pandemic plays out, but forever, the glut will dissipate very slowly at best. Oil storage capacity is about 95% full, and the Strategic Petroleum Reserve was recently refilled after the government had sold some oil off in recent years. Production hasn't even come down enough to put the market in balance yet. All oil storage, on land and sea, could be full in the next month or two. There is no sense in buying oil stocks anymore. Most of shale is going to reorganize through bankruptcy. The majors will limp along as zombies. Maybe Chevron (CVX) and Total (TOT) can keep their dividends. Shell already cut. Exxon will have to cut eventually. If an investor really wants to be in oil, buy a ranch with a few conventional wells on it or buy the bonds of a company you'd like to own shares in after it goes through bankruptcy.
KCI Research Ltd.: The supply glut is going to clear faster than many anticipate, as low prices are ultimately the cure for low prices, forcing a greater than expected supply response. As far as investing in energy stocks, since the broader equity market low on March 23rd, 2020, the SPDR S&P 500 (SPY) is higher by 25.7%, the Invesco QQQ Trust (QQQ) is higher by 30.2%, the Energy Select Sector SPDR Fund (XLE) is up by 46.6%, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) is higher by 55.3%, and Antero Resources (AR), a leading natural gas producer, which I touted as my favorite idea in the December 28th, 2019, Energy Roundtable, and again in the March 23rd, 2020, Energy Roundtable, is higher by 209.0%. Thus, looking at the return data since the market bottom on March 23rd, 2020, the time to invest in energy stocks is already at hand.
Laurentian Research: While it looks like the combined cuts by OPEC+ and projected voluntary reductions by other producers may play only a small role in limiting inventory builds in 2Q2020, they should have significant impacts on drawing down inventories and raising prices to the neighborhood of mid-$40s or higher by end-2020, i.e., a potential double from the current WTI price. If investors were to wait for a balanced oil market to start investing in energy stocks, they not only would have forgone the big, early gains but also would have to settle for smaller gains at higher risk. They should act when they see the first confirmed sign of worldwide demand recovery.
Earnings season question one: We're starting to see oil majors cut dividends or capex. What are you taking away from their reports so far?
The Fluidsdoc: The majors get a lot of credit for seeing the trends of the market, and planning accordingly. The reality seems to be that their crystal balls are no better than anyone else's, given all the asset write-down the past couple of years. I think opportunities for share price appreciation exist, given the depth of the decline, but high yield dividends were the reason to stay long through thick and thin. That thesis will have to be reviewed, and I expect the majors will be viewed as more of trade than an investment.
Richard Berger: The dividends and buybacks of the super-majors have been unsustainable for many years, relying on net borrowing to fill the free cash flow gap. Shell is but the first to cut dividends. I expect all, except perhaps Total to reduce dividends and buybacks within the next 18 to 24 months. Shell CEO announced its cut of the dividend and strong uncertainty if oil will ever return to prior demand levels and prices, confirming its declining trend since 2011. 4 of the 5 super-majors have delivered negative total net returns for the past 8 years since oil peaked in 2011. If you have not yet read my 4/27/20 article "Oil: Every Investor Needs To Consider These Factors", it is imperative that you do so. The next 24 months are going to be very painful for oil investors and the long-term prognosis is for consistently under-performing the markets.
The Value Portfolio: The companies seem to be realizing more and more that this could become a drawn-out collapse that they need to be fully prepared for. Proactive cash management is key here, and the companies seem to be finally realizing that.
Value Digger: They finally realize that they have to live within their means. Hopefully, they will not change this approach in 2021.
Andrew Hecht: Some will survive. Equity holders could be left out in any recovery. Government bailouts should leave equity holders out.
Laura Starks: I disagree that the biggest majors other than Shell are cutting dividends. BP, Chevron, and Exxon Mobil have not cut their dividends. Occidental (NYSE:OXY), which cut its dividend almost completely, is a special case due to its $40 billion debt burden from acquiring Anadarko. The oil majors' aircraft-carrier-like size conceals a nimbleness we did not see during the early days of the U.S. shale revolution, evidenced now in their quick, deep budget reductions. Since these companies answer to public (not private equity) investors and various countries' governments they take seriously their business model of returns to investors - especially pensioners and retirees - via dividends. Chevron has explicitly said it will protect its dividend; Exxon Mobil and BP didn't raise but didn't cut their dividends.
Joseph L. Shaefer: The responsible firms that cut their divvies, slash their capex, and stop wasting shareholder money doing stock buybacks will survive. A few with deeper pockets may not have to do all three, but all will have to do some of these. I would rather buy the responsible grownups rather than those pandering to the sanctity of a dividend or the bonuses for management that result from buybacks.
Kirk Spano: The end of the oil age is upon us. It really is that simple. Oil demand might have peaked right before coronavirus. Even if oil demand sets slightly higher marks in a few years, it won't last long as the car companies are telling us that the EV age begins mid-decade. Don't discount what William Clay Ford Jr, Chairman of Ford, just said, I paraphrase: "it doesn't make much sense to straddle the old and new car worlds anymore." Takeaway: Electric vehicles are coming, internal combustion engine is going. That's a massive hit to oil demand. Oil majors are going to have a lot of stranded assets. Their transitions to being new types of companies are unclear and sure to be expensive. Shell cut dividends and flat out said they're accelerating their long-term strategic plan away from fossil fuels. Chevron is heavily cutting capex, but should be able to limp around the track a few times before going through their own expensive transition someday. The CEO at Exxon is a grade A idiot, and I think is going to take that stock down to under $10 per share.
KCI Research Ltd.: Even though $WTIC oil prices traded in the $50-$60 range in 2019, oil directed drilling rigs, completion crews, and frac spreads were already down roughly 20% year over year at the end of 2019, so the adjustment was already in progress in North America. However, the oil majors, led by Exxon Mobil and Chevron, specifically with their respective targeted production growth in the Permian basin, had a plan to invest through the downturn, to grow production, and market share. Lower than expected prices, however, have forced a renewed fiscal discipline, and this is ultimately good for the balance sheets of the majors, and the overall supply/demand balance.
Laurentian Research: The oil majors finally responded to a market condition, born of over-investment during the previous oil bull market, that would have occurred much earlier if not the civil wars and efforts of oil standardization through sanctions. Their decision of dividend and capital budget cuts will help avoid balance sheet ruination, which is good for shareholders in the long run; it will also help lower production, which is good for balancing the oil market. Unfortunately, oilfield service companies will suffer a lot from their belt-tightening.
Earnings question two: Lots of shale producers are, not surprisingly, cutting drilling. Too little too late for either the companies themselves or for the broader sector?
The Fluidsdoc: The cheapest storage is in the ground. The well-capitalized major oil companies can shut-in these wells and wait for better returns. As discussed, I don't see them having long-term problems as oil prices recover. What I do consider suspect are the growth estimates many shale producers have for growing production. XOM, for example, was on track to ramp up to ~1 mm BOPD by 2025. Will that still happen? It's not looking likely at this point. The weak link will be the service and supply industry, after being brought to its knees currently will be very reluctant to commit capital to increasing capacity.
Richard Berger: Some highly leveraged shale producers will fail. Many will ride out the storm with shut-in and curtailed production and will rise again as cheap cost of development due to a glut of rigs, frac equipment, and related services makes it cheaper than ever for this oil segment even as crude prices do rebound. Keep in mind that shale oil has a very high initial production with very steep decline curve. This means that most shale wells have paid out within their first 12 to 24 months and only need to generate excess cash flow over lifting costs to service debt. The picture for many shale producers is painful but not fatal. Existential threat only is seen for those that are highly leveraged.
The Value Portfolio: There definitely are some companies for which it is too late for, however, it's not too late for the broader market.
Value Digger: Yes, this is too little too late. Many shale producers will not avoid bankruptcy because of their debt overhang. From day one, we have been saying that investors must avoid the highly leveraged energy companies, either oil-weighted or natural gas-weighted ones. But many investors believe in miracles, so they are destined to learn the hard way.
Andrew Hecht: Some will disappear as they can't service their debt. For the broader sector, the cure for low prices in commodities is LOW prices that at first balance the market, and then lead to shortages. China is on a buying spree at bargain-basement prices in the US Permian, and other parts of the world. It is mind boggling that governments are allowing the Chinese to make purchases in this environment.
Laura Starks: Shale producers and the sector are acting appropriately by reining in drilling. They, alas, have so much experience with oil price volatility that it only took days for them to stomp on the capex brakes in order to preserve cash. The most challenged sector right now is not producers but oilfield services. The lengthy drought which started last year could put many more out of business. It has already forced at least one combination and some bankruptcies.
Shale producers in the most trouble are those who came into these twin crises with too much debt. Occidental, Whiting Petroleum (WLL), and Chesapeake (CHK) are examples. I am also not a fan of any company with a sub-$1 stock price. The pandemic + price crash has acted as a clear sieve on these companies for investors. However, other producers with sufficient cash, production - even if they have to shut some in - and contractual ability to compress their capital programs will make it through.
Joseph L. Shaefer: Too little too late for a lot of them, yes. These firms have chosen the punchline from the old joke, "We're losing money but we are making up for it with volume." Those with deep pockets are now able to buy the ones on the ropes for dimes on the dollar. Those who overstepped will die. Those with financial discipline, and the broad sector, will thrive.
Kirk Spano: It's too little, way too late. The shale companies should never have ramped production back up after the 2015 slaughter. It was greed and hubris and stupidity all rolled into one for them to take shareholder money and burn it on unprofitable drilling while collecting their bonuses. The shale companies "high graded" and are left with more expensive oil to drill than before. They couldn't even make money on the cheaper oil in a higher oil price era. By my count, well over half of the listed oil shale companies are going to declare bankruptcy or suffer massive dilution.
Elephant Analytics: The drilling reduction is a necessary step, but the future of many shale producers is largely out of their control. North American oil production declines aren't anywhere near enough to counteract the massive demand destruction by themselves. The playbook for shale producers is to cut capex, manage liquidity and then hope that demand recovers faster than expected and that OPEC/Russia production cuts will bring inventory levels under control over time. The most heavily indebted shale producers are still likely to go bankrupt even if oil rebounds to $50 due to the challenges of refinancing their debt with declining production levels.
KCI Research Ltd.: No. Ironically, because of their ability to stop and start production quickly, with short turnaround times, the surviving shale oil players could be a major beneficiary of the current upheaval. The key words are "the surviving shale oil players", with the knowledge that U.S. shale oil production is not a world class asset, many U.S. shale oil companies will not survive, and they cannot compete on the global markets, while U.S. shale gas is a world class asset, particularly in the Marcellus, and these producers can compete on a global basis.
Laurentian Research: Oil producers usually don't react to fallen oil prices immediately, partly because they typically have a hedging program in effect and partly because they like everybody else cannot predict future oil prices. So, it is a bit unfair to expect them not to be 'too little too late'. After all, that's how oil industry cycles are created. The silver lining of the oil crash is that certain high-quality energy stocks have become dirt cheap for discerning investors.
We started our last roundtable with Saudi Arabia and Russia. There has since been a production cut agreement. Where do they go from here and how important is that at this stage?
The Fluidsdoc: These two are unlikely bed-fellows. Saudi exists only as a result of American military support, in exchange for their "friendship," and has traditionally (last 30 years or so) relied on exports of much their oil to the U.S. and Europe. Russia looks to check and diminish American influence globally, and maximize its own oil sales in the Eastern hemisphere. They found common ground in a desire to thwart high cost production, notably shale and deepwater. Their current collaborative attempts since the end of March 2020 have backfired so badly, that I don't see a bright future for OPEC+. As prices rise, I expect cheating on quotas, with Russia saying they are in compliance and actually selling all they can. Saudi will again be left to bear the brunt of the cuts. The impact of all of this as the market tightens though will be diluted and to an increasing extent, made unnecessary by the sharp declines in U.S. shale and aging conventional resources.
Richard Berger: The production cut agreement will fail badly if history is the judge. All prior production cut agreements by OPEC and affiliated producers have had huge cheating and ultimate collapse, spurring monster gluts. The pressures this time around make it a certainty the cuts will not achieve much initially and be even less useful to driving prices up as the economic situation evolves. I provide details in my recent article of 4/27/20.
The Value Portfolio: At this point, the countries need a much more significant production cut if possible, potentially with the rest of the world, to lower their glut. They're still betting on a sizable recovery, however, and they're careful to make sure they're not subsidizing the shale industry. But as storage fills, production could be cut again.
Value Digger: The production cut agreement was too little too late. We believe that the big American energy producers should join Saudi Arabia and Russia, but there are two problems with this. First, they are not controlled by the American government. Second, the big American energy companies such as Exxon Mobil did not participate in a production cut deal and wanted to let the market forces work because they are integrated companies and their downstream segment benefits from low oil prices. However, we believe that this is a short-sighted approach and the negative impact on upstream earnings will outweigh downstream gains. A new production cut agreement is very likely in the next weeks.
Andrew Hecht: Price will dictate the next move. The 9.7 mbpd cut was about one-third the level it needed to be. The cure for low prices is low prices.
Laura Starks: Government officials - the president, senators, the DOE, others - deserve credit for jawboning/negotiating Saudi Arabia and Russia into agreement, especially since unlike these other two global energy powers, there is no one in the U.S. with top-down authority to mandate production cuts. All three countries are in a grit-it-out position as we wait to see how much of the 30 MMBPD demand contraction experienced in April returns. Current estimates are that the demand-supply gap has closed by about half, with 2-3 MMBPD more of demand and 13 MMBPD of supply cuts between the U.S., Russia, and Saudi Arabia/OPEC. Let it be noted that the Texas Railroad Commission did not intervene to force/suggest Permian basin reductions, so all U.S. supply cuts arose individually from dozens of U.S. companies. U.S. supply will further be organically "cut" as reduced capex budgets mean production from fast-declining horizontal wells is not 100% replaced with new production.
Joseph L. Shaefer: When dealing with two colossal egos, the guesses are all over the place. Russia is already a dying nation serving as Europe's gas station and Saudi Arabia is unaware that the world around them has changed. Nations run by oligarchs, dictators, single parties, etc. cannot compete with entrepreneurs and innovators from capitalist nations. Where they go from here is likely downhill, though not without creating problems along the way.
Kirk Spano: It is very important to understand what the production cut is and isn't. It is not based on the most recent production. It is based on higher levels from 2018, including 11mbd by Saudi Arabia and Russia. The actual cut from 2019 levels is only about 6mbd and that is scheduled to be tapered to get back within 2mbd of 2018 production highs within a year. All Russia is doing is holding back on capex to replace declining and depleting wells. Russia can let their conventional wells run with minimal cost and they will. Saudi Arabia, with among the cheapest oil in the world, has no incentive to give up market share. Expect them to product 10-11mbd until the world doesn't need it. The cuts were something nice to say to placate America through the election. Simply put, welcome to a free market in oil where cheapest cost of production wins.
Elephant Analytics: It will be important for Saudi Arabia and Russia to follow through with their pledges and cut production in accordance with their targets. Average oil demand is expected to fall in the high-single digits to low-double digits millions of barrels per day (such as 8 to 12 million barrels per day) in 2020, which is close to total US oil production. Thus, even with minimal North American capex, the majority of the supply cuts would need to come from elsewhere.
KCI Research Ltd.: Obviously, Black Monday for the energy sector was March 9th, 2020, when Occidental Petroleum and many energy equities lost 50%, or more, of their market capitalization in a single trading session directly sparked by the Russia/Saudi oil production dispute. So, no doubt, this cast a pall over the market, which was amplified by the widespread outbreak of COVID-19, and conversely, their ability to come to an agreement on a production cut has provided a boost to the markets. Looking through the volatility, the market is actually forcing the production response with pricing, so while Saudi Arabia and Russia are immensely important to the global energy picture, their respective influence is being overshadowed by what the market is forcing, specifically in terms of production discipline.
Laurentian Research: Yes, OPEC+ agreed to cut 9.7 MMbo/d in May and June 2020, 7.7 MMbo/d from July to December 2020, and 5.8 MMbo/d from January 2021 to April 2022, which I believe the cartel members will comply to especially in the beginning. The fall in demand due to worldwide lockdown measures has so far outpaced supply by a lot, a situation perhaps to last for much of the 2Q. However, going into the summer, the anticipated widespread lifting of lockdown will likely drive demand considerably higher. Adding aggressive production cuts by OPEC+ and non-OPEC+ producers, it is probable we may well exit 2020 with a better-balanced market.
Natural gas exposed stocks have emerged from long-term bottoms with big rallies. What do you make of what's happened, and is there more to come? Why or why not?
The Fluidsdoc: I think this is a result of the declines in drilling and production curtailments now underway. This will reduce the supply overhang as it is doing with oil and create some runway for improvement in this sector. The long-term "clean fuel" thesis still holds for gas and LNG in my view, so these companies should rebound as the economy picks up.
Richard Berger: Natural gas is not suffering the contango storage capacity crisis that oil is and therefore not being punished as hard. In fact, that segment has been deeply depressed in prices for several years already and will probably see long term benefits from the current crisis in crude oil.
The Value Portfolio: Natural gas is primarily used for electricity, not transportation, and that means that demand has held up much better. I expect that to continue going forward. There's some risk from the natural gas that's subsidized by oil, but overall, these companies should be better off.
Value Digger: We had forecast it again and again, so the recent rise in natural gas prices has not surprised us. However, we point out that the rising tide will not lift all boats and will not save many heavily indebted natural gas-weighted companies from bankruptcy. Therefore, investors must be very picky. We also believe that natural gas price could reach or exceed $2.5/mmbtu this summer if the weather helps (i.e. heat waves). It did not help last winter. As you know, the weather plays a key role in the demand side both during the withdrawal season and the injection season.
Andrew Hecht: This was seasonal as NG rallied at the time of the year when it typically does. Beware of NG companies carrying heavy debt loads. I'd rather trade the commodity than those stocks. Production will be a function of demand, which is weak. I expect lower output to support the price of the commodity. We have already seen a shift from lower highs and lower lows to the opposite starting in early April.
Laura Starks: Natural gas producers are another beaten-down sector. Initially, there was the hope that as Permian oil production was turned down, so too would be the "forced" production of associated gas that comes out with oil. Additionally, electricity generation is a big market for natural gas and electricity demand is not suffering as much as the oil (transport) market. So less associated gas supply without the bid drop in gas demand relieves the pressure, so to speak, on natural gas supply and prices. Longer term, however, there are issues: a) there was already a gas flaring problem in the Permian - so less gas being flared does not change the volume of marketed gas; b) gas will continue to compete with low-priced coal in some electricity markets, c) the LNG export market has contracted by several BCF/D, and d) as soon as oil production returns, so too will the issue of larger volumes of associated gas.
Joseph L. Shaefer: Gas, on a BTU-equivalent basis, became cheaper than oil. If you can choose one steak and lobster dinner for $25 and another for $100, both at fine restaurants, which will you choose? Yes, I believe there is more to come. Nat gas is the cleanest fossil fuel and still cheap.
Kirk Spano: Natural gas has a new tailwind, but an emerging headwind. The tailwind is that there is less associated gas with oil production falling. That's good for the price of natural gas short term. However, more expensive natural gas has no long-term future at solar is extremely cheap during the daytime. Competition from alternative energy will continue to increase dramatically throughout the 2020s. Already, the past 4 years, alternative energy as a group has been 100% of all new net electricity generation and taken more of the coal retirements than natural gas by about 2 to 1. Natural gas producers that did not go belly up, with a few exceptions, will survive, but don't expect much from them as they have years of debt clean up to do on balance sheets. The natural gas pipeline companies are in a good place though. I think enterprising investors can look there.
Elephant Analytics: The rise in the natural gas strip makes sense due to the decrease in associated natural gas production with the oil price crash. Natural gas focused producers were already limiting 2020 capex due to sub-$2 natural gas early in the year. I do think there is a bit more room for improvement in natural gas strip prices (and thus natural gas exposed stocks). Natural gas prices are likely to have trouble staying above $3 for a lengthy period of time though, due to the surge in development activity that would result with strong natural gas prices.
KCI Research Ltd.: We are just at the beginning of the rally in natural gas stocks, from my perspective. Since the March 9th, 2020, Black Monday in energy equities, Southwestern Energy (SWN) shares are higher by 121%, Range Resources (RRC) share have gained 118%, EQT Corp. (EQT) shares have gained 113%, Antero Resources (AR) shares have gained 112%, CNX Resources (CNX) shares have gained 96%, and Cabot Oil & Gas (COG) shares have gained 22%. Over this time frame, dry natural gas prices have gained 11%, with the United States Natural Gas Fund (UNG) lower by 1%, the triple levered Velocity Shares 3x Natural Gas ETN (UGAZ) lower by 20%, SPY down by 3%, and XOP down by 1%, so clearly, natural gas equities are outperforming over the past roughly two months. Why will this continue? There are several reasons, led by the fact, that curtailed liquids production, which was already happening in 2019, as I illustrated earlier, has clearly been accelerated by the demand destruction of the COVID-19 outbreak, which is going to put a lid on associated gas production, and also natural gas liquids production, leading to higher prices across the futures curve, which will in turn boost the free cash flows to the downtrodden natural gas producers.
Laurentian Research: Those who want to chase the natural gas-exposed stocks should carefully consider the validity of the theory that the declining associated gas production will lead to a sustained natural gas shortage in the U.S.
Are there any safe havens in the energy sector that you are looking at?
The Fluidsdoc: There are certainly no safe havens at present. The industry is still in turmoil burdened by high debt loads, and questions about the viability of the industry. Do we still need an oil industry? I think these questions will be resolved, at least to some extent, as supplies begin to tighten in the second half of this year. If we do indeed have shortages or supply disruptions, many of the players currently being shunned by the market could come back into favor.
Richard Berger: Opportunities always exist if the right strategies are used. I continue to provide my subscribers frequent actionable trades generating 12% to 40% annualized yield rates along with deep downside market protection. 2 examples are provided to the public in my recent article of 4/27/20.
The Value Portfolio: Investors who want to participate in the sector but want to minimize risk should look at an investment like the Vanguard Energy ETF.
Value Digger: Yes of course. We focus on debt-free companies with stellar balance sheets, good management teams and high insider ownership that also are takeover targets.
Andrew Hecht: Only the companies that are critical to national security - XOM, BP, RDS.B.
Laura Starks: In the face of the gigantic demand shock, nothing is safe. However, sectors I like for various reasons: a) utilities depend on their regional economies and while we haven't seen the extent of the economic damage except on a national basis, utilities are in better shape than many businesses; b) well-run producers were huge bargains in March; c) refiners will see a tough second quarter and rebound, but they've already adapted by reducing throughputs, and they have cheaper feedstock oil costs, and d) some IOCs (international oil companies) hewing to their dividend payouts offer good yields.
Joseph L. Shaefer: Yes. Find the big royalty landowners that spend virtually nothing in the tough times; they neither drill for oil or gas, nor do they transport it. They "suffer" only in the sense that their cash flow declines when less oil and gas are being produced and transported, but they do not have the expense of shutting in wells, finding storage, etc. Their response to increased production is then exponential.
Kirk Spano: Natural gas pipeline companies and alternative energy are where the money flow is.
KCI Research Ltd.: Natural gas equities. This is what I wrote in the March 23rd Roundtable. "When something is as historically out of favor, and as loathed as the energy sector, that is the perfect starting point for future outperformance. Said another way, the energy sector is where REITs were 20 years ago, unloved and undervalued. The major surprise over the next decade, in my opinion, is going to be that the energy sector is the best performing subsector of the market, and natural gas equities, which have been among the most loathed equities in the entire U.S. stock market, are poised to be the leading performing stocks over the next decade. A specific area of opportunity is the Appalachia natural gas equities, specifically, the core Marcellus players, who have a basin advantage over most of their peers, with lower decline rates, more tier-1 drilling locations, and the most prolific production per well. These Marcellus producers have grown production at impressive CAGR the past decade, and they now dominate the list of the largest natural gas producers, EQT Corp. producers more natural gas than Exxon Mobil, the number two domestic producer, who I like as a large-cap play here as well for the reasons articulated above. Going down the top-10 current producer list, Cabot Oil & Gas is number four, just behind BP, Antero Resources is number five, and poised to grow into the second-largest dry natural gas producer, alongside already being the second-largest natural gas liquids producer. Chesapeake Energy is the current number six producer, and they have terrific natural gas assets, however, they have invested all their growth capex in oil the past 5 years, and that is going to be a problem with lower oil prices. Southwestern Energy, Range Resources, and CNX Resources round out the list of top-10 independent natural gas producers, who are core Marcellus producers, and these equities are poised to be among the best performing U.S. stocks over the next decade. Why? As natural gas prices rise, growth capital tails out, and lower breakeven costs shine through, the ability of these companies to generate attractive free cash flow yields is massively underappreciated right now." Now, look at the returns since the date of that publication, which was also the broader stock markets bottom. AR up 209%, RRC up 88%, EQT up 83%, CNX up 49%, SWN up 39%, and COG up 34%.
Laurentian Research: In my opinion, there actually do exist a few safe havens in the energy sector with regard to the fundamentals although their strong fundamentals may not help spare them from being sold off. In a few isolated natural gas markets, producers enjoy high prices protected by long-term take-or-pay contracts (e.g., Canacol Energy - OTCQX:CNNEF) or seasonality (e.g., Headwater Exploration - OTCPK:CDDRF). I must add that these companies may have other characteristics that drive investors away.
Any individual names that you like right now?
The Fluidsdoc: I am particularly looking at the big service suppliers, Halliburton (HAL), Schlumberger (SLB), and Baker Hughes (BKR), and put out favorable articles on them recently. The thesis is that they will be among the first to benefit as drilling and completion activity picks up in the second half. I am certainly not predicting a return to where we were at the first of 2020 (I've made the point previously the capacity simply won't exist and stand by that comment.), but will increase from present levels here and around the world.
Richard Berger: I see opportunity with the right strategies in all the super majors at this time for short-term trading, avoid them all for mid term (1 to 3 years) and expect many to become glorious cash cows for the longer term (5 to 20 years). Total and Royal Dutch Shell are my primary trades at the moment, with strong avoidance of XOM, BP, & E for now.
Value Digger: We like Deep Down Inc. (DPDW), an unknown and grossly undervalued company from the energy sector with zero debt, high insider ownership, good management and a pristine balance sheet.
Laura Starks: From the groups above: a) utilities - NextEra (NEE) is a long-time favorite, and the Florida economy is faster out of the lockdown than many, Eversource (ES) has held up surprisingly well; b) deep bargains were available in March on Chevron and Diamondback Energy (FANG) - Diamondback was a $100 stock that became an $18 stock and is now at $39/share; c) refiners Valero (VLO), HollyFrontier (HFC), and Marathon Petroleum (MPC) quickly turned down their run rates; and d) dividend investors may find Exxon Mobil with its 7.9% current dividend and BP with its 10.6% current dividend of interest. In particularly, in my EBEI Marketplace portfolio, I just upranked Exxon Mobil to "buy" on the basis of its dividend yield attractiveness.
Joseph L. Shaefer: Equinor (EQNR), 66% owned by blueblooded oil giants known as the Norwegian government, and a brilliant explorer/producer that is also on the forefront of renewables. Repsol (OTCQX:REPYY) an under-followed Spanish firm with superb connections in the current frontiers in offshore Africa and South America. At the right price Exxon, Chevron, Total, BP and Royal Dutch Shell.
Kirk Spano: Kinder Morgan (KMI) suffers from the "getting Kindered" syndrome, so is cheap. It's mostly natural gas pipes with some good oil and CO2 business. Its shares will get back into the $20s soon with the dividend slowly rising and shares getting bought back. Eventually, there will be a strategic transaction that's almost certainly why Richard Kinder has been buying millions of shares for years. Once that cash out is done, it'll be time to move on. Disclosure: after selling most of my KMI shares a few months ago, I have added back to the position at lower prices. Going forward, with one or two possible exceptions on pair trades, I plan to short oil stocks into the cold ground from where they came.
Elephant Analytics: I've been looking at bonds since there are a fair number of companies that are going to go bankrupt, with the bondholders likely ending up with most of the new equity to benefit from the potential oil price recovery. Chesapeake Energy's (CHK) bonds look quite interesting, although there is uncertainty about how it will attempt to pay down part of its first-lien debt (rights offering, asset sales).
KCI Research Ltd.: I have previously called Antero Resources (AR) a generational buying opportunity in a February 19th, 2020, article published on Seeking Alpha. At the time of the publication, shares were priced at $1.80, and they recently closed at $2.93, for a 63% gain, while SPY has declined roughly 15% since publication. Before rising like a phoenix, Antero shares declined precipitously at first, as many do not understand Antero's complex balance sheet, that has a number of hidden assets, including a roughly 29% stake in Antero Midstream (AM), a hedge book that was recently more than $1 billion in the money, and a very high net well interest (84% to RRC's 79.5%) that allows for a royalty sale to monetize production at much higher valuations than today's depressed multiples. Adding to the narrative, Antero and almost all of the core Marcellus producers are coming to the end of a roughly decade-long stretch of growth capital expenditures, so very few understand the free cash flows that these owners of world class assets are going to produce at normalized commodity prices, and maintenance level capital spending.
Laurentian Research: I see so many high-quality energy businesses that can be had for a song. For example, I like low-cost conventional oil producer GeoPark (GPRK) and Permian shale producer Earthstone Energy (ESTE).
***
Thanks to our panel, obviously a lot to cover in this part of the market. If their words here intrigued you, check out their work at the links above.
We'll continue this series next weekend. If you have any sectors or areas of the market you're especially interested in hearing about, let us know.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Fluidsdoc is long HAL, SLB, RDS.B, and OXY.
The Value Portfolio is long XOM, RDS.A, RDS.B, and OXY.
Value Digger is long DPDW.
Laura Starks is long BP, CVX, FANG, NEE, MPC, and VLO.
Joseph Shaefer is long EQNR and REPYY, and may open a position in XOM.
Kirk Spano is long KMI.
Elephant Analytics is long CHK's second-lien bonds.
KCI Research Litd. is long AR, EQT, COG, SWN, RRC, CNX, and XOM.
Laurentian Research is long GPRK and ESTE.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given that any particular security, portfolio, transaction or investment strategy is suitable for any specific person. The author is not advising you personally concerning the nature, potential, value or suitability of any particular security or other matter. You alone are solely responsible for determining whether any investment, security or strategy, or any product or service, is appropriate or suitable for you based on your investment objectives and personal and financial situation. The author is an employee of Seeking Alpha. Any views or opinions expressed herein may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank.
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Comments (33)
Scary. Some don’t know what they’re talking about.Eg. the guy who claims the cheapest oil storage is in the ground.
Let’s mythbust him: only maybe true if nobody else is pumping out of that formation. And often there is another adjacent lease competing with me.
Buyer: CVR Energy of Carl Icahn.Let's see what late-May to early June 2020 brings us...
Even gloom and doom Goldman has oil at $50 this year.
www.marketwatch.com/...
The Value Portfolio (XOM, RDS.A, RDS.B).
Laura Starks (BP, CVX, MPC, and VLO).
Joseph Shaefer (EQNR, REPYY, XOM).
KCI Research Ltd. (XOM).Plus other authors may also own refining stocks as known by their Marketplace subscribers but chose not to mention here.
