Aiming For Escape Velocity: Macro Energy Investing Outlook
Summary
- Some allocation to energy can produce the uncorrelated alpha your portfolio might be missing.
- The commodity reflation trade has reinvigorated the oil markets. This broader market theme of reflation will dictate oil’s next move.
- We measure out a new cycle high which peaks in the $75-$80 range.
Foaming At The Mouth
Remember the movie Old Yeller? Surely most readers recall that bewildering feeling of sadness and sobering horror when Disney ended a seminal motion picture with All-American, Travis Coates offing the family pet. There is a powerful investing lesson embedded in the awkwardness of Old Yellers tragic demise. Yes, sometimes you must take the dogs out back and shoot them! Feels a bit like owning energy stocks, does it now?
But how do we do it? Do we put on a brave face like Travis and dispassionately dispose of these wretched thieves of our capital? Or are we scared to open the corn crib like young Arliss? Preferring to dream of better days ahead (and more secure dividends.)
Further, where, and why do energy stocks belong in our portfolio? What types of energy stocks should we own and for what reason? Most important, how do we manage risk within our allocations to these stocks. Some allocation to energy can produce the uncorrelated alpha your portfolio might be missing.
Energy remains an important part of our portfolio. The commodity reflation trade has reinvigorated the oil markets. This broader market theme of reflation will dictate oil’s next move. It is important to pay attention in the late innings of the ballgame. Will this just be another counter-trend bounce in the deflationary tail? Or have we turned the corner toward secular inflation and entered the nascent phase of a new commodity bull cycle?
Our macro framework is multi-duration. Our tail call favors an inversion in the deflation vs. inflation market structure. However, the transition period will not happen overnight. Deflationary impulses are still likely against this unknown time horizon. The fundamental difference is that we see the deflation trade as the new countertrend. Our process is to capture all cycles with dynamic management. We continue to emphasize the importance of identifying the macro picture as the key to success in this vibrant management model.
Please review our macro framework as a guide to how we position for trades, trends, and tails: https://seekingalpha.com/article/4404606-dollar-bubble-deflating and https://seekingalpha.com/article/4416538-margin-of-error-risk-managing-dollar-in-uncertain-environment
Consider this quote from Nomura Strategist Charlie McElligott, as a guidepost to where we are in the cycle.
What you see are duration sensitives like low risk, hedge fund crowding, mega caps over small caps are losing to the economically sensitive stuff like ISM manufacturing PMI factor, trending higher ISM manufacturing regimes. 10-year yield sensitive factor, WTI crude factor...leaders now against legacy deflation positions but actually (they) become laggards as the cycle evolves. So that's part of this chop, right? It's a thematic chop, you're through the easy money of reflation.- Charlie McElligott, Macro Voices 4/26/2021
Laissez les Bons Temps Rouler
Identifying the macro outlook is the first step. Now, let's drill down into the fundamentals.
The CRB index has broken out of its long-term downtrend but is at key resistance. Something we are paying attention to.
Oil, as subset of this commodity trend observation, has its fundamental drivers. From the long-term perspective, we see a positive setup in the fundamentals. In the medium run, the outlook is mixed. In the short term, we expect higher prices.
The Lazarus moment has come and gone. The patient just ripped the PICC line out, knocked the table over, and walked out of the hospital. A negative contract settlement was the bottom of all bottoms.
Part of me wants to gloat here. The eulogists, narrative peddlers, and ESG funds had already lowered the casket. It tends to work this way. The louder people yell, the quicker they develop laryngitis.
Suddenly your teenager is not so anymore. He is sixty-five now, only but a year later.
Political posturing and best intentions cannot rid the world of hydrocarbons. Regression to less dense forms of energy is a giant leap for mankind. We have taken many steps forward but never back. It is difficult to foresee how a global economy mired in debt can afford the switching cost between inexpensive, dense energy sources and expensive, less productive ones. And if we cannot? What prevents these affordable sources of energy from becoming scarcer and more expensive due to a long-run lack of investment in supply?
Supply and Demand
Demand expectations have strengthened. EIA now expects global consumption of petroleum fuels to average 97.7 million barrels in 2021. A 6% increase from 2020 and approaching a level on par with 2017-2019 consumption. This seems rather optimistic considering the continued lockdowns in important demand centers such as India.
EIA expects global inventories to tighten in 2021. With a contingency built in for the OPEC+ course of action.
OPEC+ is dancing on the head of a pin. The ability to remain resolute amongst tribal disputes jeopardizes the tenuous pact to withhold market supply. OPEC+ has 4 times the spare capacity compared to the period of exorbitantly high oil prices seen from 2008-2014. Despite a carefully crafted campaign to jawbone prices higher, the cartel and friends appear eager to raise production. The super cycle highs of the past seem implausible given the lack of supply urgency. It is possible that the investment cycle deficits will show up in global supply in the coming years but our base case points to a tight but sustainable medium-term supply dynamic.
While global supply does not appear to be in dire straits the puzzling part of the EIA’s forecast relates to their outlook for US production.
We forecast crude oil production will average 10.9 million b/d in the second quarter of 2021 and increase to almost 11.4 million b/d by the fourth quarter of 2021. We expect U.S. crude oil production will average 11.9 million b/d in 2022. EIA, STEO
This is an impossible forecast to reconcile given the current data points observed. Anyone familiar with the parabolic nature of US supply understands the necessity of maintaining a constant completion rate in high-decline wells. The red queen effect. With global supply tightening, a material miscalculation of US supply growth (shrinkage) will give cushion to any actions taken by OPEC+. I believe they understand this.
The following chart shows US domestic supply since 2014 when oil prices first dipped below $80. This image shows us where our domestic supply has come from relative to the different basins. Also, how much they mean well in each play produces in the first 12 months.
Source: Enervus, Author's Creation
Here we examine daily oil production per basin and the shape of the typical shale well. 
Source: Enervus, Author's Creation
Most of the oil recovery in each instance occurs in the first year. It stands to reason that completions will need to stay close to flat in order for the EIA numbers to work.
As shown below, we are not keeping pace with the historical completion count.
Source: Enervus, Author's Creation
Furthermore, the rig and permit count show that the negative rate of change acceleration that developed since the pandemic is far from resolved.
Source: Enervus, Author's Creation
Conclusion
We believe EIA's forecast for 11.4 MM b/d by 4th quarter 2021 is off by an order of magnitude. Our base case is for a rate closer to 9 MM b/d with much potential for downward revision.
This allows OPEC+ to cautiously add supply back to the market without tipping the balance in the other direction.
Demand appears healthy with a real prospect of returning to pre-pandemic levels in the near future.
Looking at the chart for crude, we measure out a new cycle high which peaks in the $75-$80 range. We could envision these levels lasting through summer 2021 but feel it is likely that we will pull back by the late 3rd or 4th quarter.
Source: Y Charts
Similarly, we see energy equities, as referenced by the XLE, making new cycle highs and modestly breaking through their long-term downtrend. The move on XLE measures out toward $70 p/s which represents roughly 25% upside from current levels. 
Source: E-trade Pro, Author's Creation
We hope to offer up more thoughts and ideas on energy in the weeks to come. Perhaps a stream of consciousness that trickles out like a tear welled up in the eye of a 12-year-old boy who just watched Old Yeller for the first time. Or a 35-year-old man trying to make a career out of the sound and fury that has become the oil patch.
I once hired an 87-year-old pumper and gauger who could operate a nodding donkey with spit and baling wire. So that is how we will bow tie it. We can talk about inflation, real yields, and energy stocks. We can talk about duration of an expected rally within the (once) bearish trend for energy stocks and how to manage a trade. We can talk about asymmetry in energy portfolios with long/short pair trades. Or why and when to put on a OXY put option back spread as a short-term hedge against your actively managed longs. We can talk about uranium as the best proxy for green energy. We can talk about escape velocity! How to get that red stain off the books!
This article was written by
Analyst’s Disclosure: I am/we are long OXY. 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.
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