Interview with energy expert offers insight into oil
January 30, 2019
As we have discussed over the past month and change, we have witnessed a distinct correlation in the day-to-day movement of the energy market and broader U.S. equities. Oil is often viewed as a proxy for expectations of future economic growth because as activity increases, demand for the input rises. So, what is going on in the closely followed energy markets on Wednesday?
WTI crude is up roughly 1% and now trades around the $54 handle as the market continues to digest the ramifications of the sanctions imposed by the United States on the Venezuelan state-owned oil firm PDVSA. On Monday night RBN Energy President and Principal Energy Markets Consultant Rusty Braziel gave an interview on the sanctions, natural gas, and where oil prices may head next.
As a quick highlight, Braziel said the impact of the sanctions would be "small" and "not a big deal" because the Permian Basin produces a far greater amount of oil compared to the amount the U.S. imports from Venezuela. It seems that the barrels taken offline by the sanctions could easily be replaced by the either the Permian, or perhaps even OPEC members looking to regain share amidst their recent output cut.
Looking ahead to where oil may go next, Braziel offered his thoughts based on the oil futures curve. Previously, Braziel has used the curve as a predictor of whether a spike higher (or lower) was real or temporary. To that point, Braziel spoke about how the volatile moves to both the upside and downside in late 2018 were not received with follow through in the oil futures curve. "In other words," Braziel said, "the market has recognized that it was never going to be $70. It was never going to be $40, $42. It's going to be bouncing back and forth between some number around $55 or $60."
So how can we invest in this back and forth range that Braziel provided? Most importantly, the energy stocks we own must be able to navigate and live within this environment. As we explain below, we believe each energy name we own can, and that is why we think they are good for at least a hold in the interim. But remember, the price of oil may be stuck in a range until we get an event that would improve (or worsen) expectations of future economic growth. The most closely discussed catalyst would be a resolution on trade with China, and high-level talks between the two nations resume today.
This past November, Anadarko Petroleum Corp. (APC) provided its 2019 capital allocation plan and reiterated their commitment to a disciplined investment strategy inside of discretionary cash flow at a $50 oil price environment. Meanwhile, free cash flow cash generated above the $50 commodity deck is prioritized for share repurchases, incremental reductions of debt, and potential dividend increase when appropriate. Management's ability to generate a significant amount of free cash flow and thei`r proclivity to prioritize shareholder returns with excess cash makes them one of the more shareholder conscious leadership teams in the industry,
With BP plc (BP), we have valued this integrated oil and gas company with a dividend yield slightly north of 6% for its visible production and free cash flow trajectory. We'll get a firmer update to management's strategy when they report earnings on February 5th, but management did reiterate how they are on track to deliver between $14 and $15 billion worth of pre-tax cash flow in 2021 at a Brent price of $55 per barrel environment during their December 2018 Investor Field Day. Not only does this long-term guidance on cash flow growth give us confidence in the dividend, but we think it also may lead to a step up in share repurchases in the future.
And regarding Schlumberger (SLB), an oil services company that is not directly tied to the price of oil, their fourth quarter earnings report validated how the company can live within its cash flows during this trough period of the investment cycle.
2018Q1 and year end energy sector summary
We generated a net return of +9 bps in Q1 2018, strongly outperforming the Oil Services Index (XOP US) which was down -9.27% and the Exploration & Production Index (XOP US) which was down -5.27% over the same time period.
2018 started strongly for Energy markets, on the back of solid oil prices and optimism that the global oil stocks were well underway to normalizing, due to the OPEC cuts. Investor participation started to grow as well, although most of the investments seemed to be driven by passive vehicles. However, the broader market turbulence also impacted Energy from February onward, and the trading environment reverted to being headline-driven, for the most part.
The escalating threat of a trade war initiated by tariffs imposed by the US on a variety of products, alongside the rising cost of borrowing due to the end of Quantitative Easing measures in the major global economies are two of the main issues that could negatively impact global growth – although the impact will vary widely across sectors and commodities.
While recognizing the uncertain trading environment that will likely continue for some time due to macro factors, I will try and highlight why we have very strong conviction in Energy investments representing a great source of returns going forward – and how we intend to approach them in the short and medium term.
I have written previously about the decoupling of Energy equity performance from commodity prices and fundamentals - oil prices have stabilized for some time, yet Energy remains a seriously under-owned sector.
The “fear” of investing in Energy is a reflection of the some of the concerns that I highlighted in my last letter. A quarter into 2018 and with better data available, I am happy to report that a number of the concerns that investors have about investing in Energy are proving to be unfounded.
Logistical issues are having a real impact on the growth of shale production, especially in the basins where most of the activity is taking place. Growth away from Excel modelling is proving to be significantly more challenging than previously anticipated by those predicting a flood of oil in the market and a price crash.
Permian service providers have struggled for many weeks to deliver sand from outside the basin, due to weather-related issues and a lack of rail transportation availability, leading to delays in completions and pushing out production growth. Additionally, pipeline takeaway capacity for Permian crude and gas will be limited until sometime in 2019, similar to the limitations facing DJ Basin producers until Q3 2018, and that will really impact realized pricing and production growth for those who cannot ship their product to the end markets.
The widening differentials between Midland (Permian) prices and WTI due to takeaway capacity constraints, which are expected to persist for 18-24 months is becoming greater.
Takeaway capacity constraints mean that regardless of oil prices, growth in certain basins in the US will be limited until new infrastructure is in place. Eventually it is no longer a question of price/profitability, as physical constraints dominate.
Of course there is growth in the Permian and elsewhere in US onshore, but what is also undeniable is that global crude and oil product stocks are declining and do not show signs of an oversupplied market. The typical seasonal build heading into refinery maintenance in the spring has been significantly more subdued this year, and the global output-cut deal between OPEC and Russia seems to be working well in reducing stock levels globally. If Iran sanction are imposed again in short order, as many expect, the global supply/demand balance will become much more challenging, putting a significant premium to US onshore barrels that can be produced with low political risk attached.
But demand will surely be destroyed by EVs that are and will be “flooding” the market, so the current situation is not sustainable.
EVs sold in India in 2017 equaled only 2,000 vehicles. Up from 1,050 electric vehicles in 2016. Total vehicle sales in India in 2016/17 equaled 21.86 million, including passenger vehicles, commercial vehicles, as well as two- and three-wheelers. EVs don’t even register as a category and are an entirely irrelevant segment of the market.
But the headline that gets repeated across news outlets, Twitter and other channels implies an entirely different reality. It suggests strong EV growth in the second-most populous country in the world. The article itself also fails to address the real issue – there will be no serious EV take-up in India until electricity is cheap and abundant across the country. Which is why India abandoned its official EV targets in 2018.
But how is the take-up of EVs in the rest of the world impacting fuel demand for transportation? The Tesla IPO was in 2010, coincidentally, but the demand for gasoline in the USA appears to be correlated to business cycles rather than EV substitution. As a matter of fact, gasoline demand is on a significant uptrend, while EVs sales globally are also growing.
Most recently, the EPA announced that it will review and relax efficiency targets for US auto manufacturers, reversing one of the most important elements of fuel-efficiency growth in the largest automotive market globally. While it is expected that this move may be challenged, the potential positive impact on future gasoline demand growth will likely be significant.
One of the key questions that we constantly think about is: assuming that generalist investors will eventually get comfortable with the facts about demand and supply in the Energy sector, what will bring them back to the sector, and what will they get involved in first?
As I have previously highlighted, capital discipline and return of capital are required to bring investors back to the Energy sector. By returning more capital in the short term, companies go a long way to addressing the investor concerns as more of the future value is delivered in the short term, reducing the component of value linked to long-term prices.
We are now at that stage in the cycle – after over four years of cost and capex cuts, with lower breakevens and solid reserves and production, the super majors are entering the capital return phase. With some of them offering north of 5% dividend yields and about to embark on years of share buybacks, given strong future cash generation, we believe that now is the time to own these shares. US onshore producers are also on the threshold of becoming cash breakeven while maintaining strong growth prospects, and they are likely to become major cash generators from 2019 onwards.
During period of investment restraint, the super majors (”Seven Sisters”) outperform both services and independent E&Ps. The super majors are BP, Chevron, ExxonMobil, Royal Dutch Shell, Total, and ENI.
That outperformance is initially driven by the capital return element, which in turn translates into multiple expansion as investors get comfortable with the sustainability of the return profile of the super majors.
In our view, that is the roadmap for this cycle as well – our E&P exposure has shifted more towards the majors with Shell (RDSA NA) and ENI (ENI IM) now a core part of our E&P exposure. We also own a number of US onshore names that have high-quality operations and are getting close to cash generation: Pioneer Resources (PXD US), Parsley Energy (PE US), Centennial Development (CDEV US) and Extraction Oil & Gas (XOG US). The list of names that we follow is much more extensive, of course, but we are prioritizing those players where we believe capital return is more imminent.
I feel that it is too early to shift towards higher beta or value names without short-term triggers at this stage, as investor participation in Energy is still lagging. This is also why we are short in servicers’ equities at this point (and long credit), because we expect continued margin pressure for them, while their liquidity buffers will ensure healthy debt service margins until the cycle shifts for them as well.
As we see the industry, it will be the organic cash generation from the Energy companies that will lead to the initial performance strength – not the belief in Energy by capital markets or investors – and that performance strength will bring investors into the sector. I am no longer alone in suggesting to companies when we meet that their best investment opportunity is in their own shares – many sell-side analysts are now increasingly suggesting the same, as the underperformance of the equities dwarfs potential investment returns into more barrels of oil and gas.
We expect that M&A will drive consolidation among service providers, and this is another theme that we have expressed in our portfolio, with our long/short credit positioning in offshore drillers. We see a lot of volatility as passive investors dip in and out of high-beta service names – as the fundamentals and past cycles show, that will likely be a losing proposition at this stage of the cycle. Earnings and cash generation will disappoint for most offshore service providers, especially drillers and seismic companies, in our estimation.
What we also like at this point in the cycle are idiosyncratic stories that benefit from the changing global Energy landscape. Our largest equity position and our favorite equity story in 2018 relates to American Shipping Company (AMSC NO). It is a prime example of a hidden gem that is completely ignored by the market but where we believe the fundamentals will take over and drive a significant rerating this year.
AMSC owns a fleet of 10 Jones Arc tankers that are leased to OSG, the largest operator of modern Jones Arc tankers in the US. The movement of crude and oil products (gasoline, diesel, jet fuel, etc.) within the country can be done only by Jones Arc tankers – vessels built in and operated by US entities. Approximately 25% of the Jones Arc fleet is over 30 years old and has been suffering from very low utilization due to safety concerns, with many of these units to be scrapped over the next 12 months. There is no capacity to build new tankers in the US until 2022-23, due to a lack of shipyard berths. The supply reduction has coincided with higher demand and has led to a strong recovery in Jones Arc modern tanker dayrates.
OSG has agreed an 18-month charter with a super major at just under $60,000/day and has had requests for three more tankers on the same terms – OSG has not accepted those additional charter requests yet, asit is hopeful of pushing the dayrates even higher. During a recent presentation, the CEO of OSG mentioned that they will control 10 out of 12 Jones Arc tankers available in the market between now and the end of 2019, giving the company very strong pricing power over that two-year time span.
The OSG shares responded very strongly to the latest earnings report and are up nearly 70% from the low of February 28, 2018. The American Shipping shares are up only 9% over the same time period.
Considering that OSG leases its modern tankers from American Shipping and AMSC benefits from a profit share above a certain dayrate, one would have expected a similar or even stronger move in AMSC shares. However, this arbitrage has been continuing for weeks now – mostly likely because AMSC is listed in Oslo and that investor universe seems to be unaware of the Jones Arc market developments.
We continue to earn an 11% in dividend yield on AMSC shares, and according to our analysis, the yield will rise by double-digits this year, if, as we expect, OSG is successful in signing long-term charters at $65-70,000/day.
AMSC is a share that we have owned for some time now, and whereas we expected an uplift last year in relation to the OSG refinancing, the trigger for the move this year is a hard one – OSG needs to exercise its lease renewal options in the next few months. We expect OSG to try and acquire AMSC as a way of maximizing value for its shareholders, with a take-out price nearly 100% higher than the current trading price of AMSC. If that doesn’t happen, the market should rerate AMSC shares based on its significantly higher dividend yield.
Additional idiosyncratic names that we own include Gulfmark Offshore (an ocean support vessel operator with a clean balance sheet and the largest exposure to the North Sea market, where dayrates are already 40-50% higher year-over-year) and Genel Energy (a UK-listed Kurdistan operator that trades at a significant discount to NAV while being very cash generative and benefiting from a number of upcoming material triggers over the next 6-9 months).
We are also finding value in some newly issued credit names – here, we tend to benefit from the market’s lack of interest in Energy. The bond issued by McDermott (MDR US) in connection with their acquisition of CBI was priced to yield 11.875% to maturity for a mid-single-B name, with an extremely strong franchise globally. We recently participated in Point Resources’ newly issued bond – secured by the assets of a private-equity-backed company that acquired the Exxon operating assets in the Norwegian Continental Shelf – and we are receiving a 9% yield to maturity on a 6.5-year deal, a significant premium to other E&P deals done in recent years.
Brent crude prices averaged $67.23 in Q1 2018, versus $54.61 in Q1 2017. The breakevens came down even further in that 12-month period. The fears about structural issues that may negatively impact the Energy market are unfounded, as we see it, and we find the value in a lot of companies to be extremely attractive. However, investor participation will not grow in a straight line, and I firmly believe that it will be led by the cash generation and capital returns to investors, and not by market sentiment. That is how the winners will succeed in attracting investors.
As Seth Klarman famously stated, “Value investing is, at its core, the marriage of a contrarian streak and a calculator”. The math in favor of Energy investing is getting so easy that even a calculator is no longer necessary in going long or short a lot of the names in question.
2017Q4 and year end energy sector summary
We have come through 2017 in what has been one of the worst years for Energy securities in recent memory, with the Oil Services index down nearly -20% and the Exploration & Production index down approximately -10% for the year. Unlike in other examples of difficult trading environments for Energy, the oil prices actually went up – by nearly 18%.
What worked for us last year were the truly hard catalysts in the portfolio – tender offers for bonds and M&A being most prominent. What did not work at all was making the right calls on a number of equity names that delivered better-than-expected results but got punished in the broader Energy sell-off for no obvious reason. As I will describe below, the fundamentals pointed towards an increase in equity exposure in our sector during 2017, but with Energy becoming the sole underweight/zero-weight sector of 2017, the price action did not reward that decision.
Given that the macro considerations, rather than individual names, were the drivers of performance last year, I will focus my discussion at those drivers in this instance.
So, what drove the pricing of public Energy securities to underperform the broader markets by nearly -40% during a year of strong oil prices, economic growth and forecasts for even better prospects going forward?
The two key words that we believe drove the market’s irrational behavior in 2017 are “shale” and “Tesla.” Those words represent the key elements of fear of the unknown that engulfed investors and led to mass selling of Energy exposure across the generalist universe throughout the year.
As you know, we are fundamental investors and always try to analyze and understand things we should be afraid of or excited about when we invest. As Benjamin Graham said:
The individual investor should act consistently as an investor and not as a speculator. This means that he should be able to justify every purchase he makes and each price he pays by impersonal, objective reasoning that satisfies him that he is getting more than his money's worth for his purchase.
What seems to have driven the generalists’ behavior during 2017 was the fear that shale was going to flood the market with oil, just as it happened in 2013-14 – many predicted that oil production volumes would surpass the peak of 2014. It was also the fear that Tesla (and other automobile manufacturers) were going to flood the market with electric vehicles at such a pace that demand for oil would disappear, making Energy companies worth a lot less than previously thought.
In our view, the reality is that both of those sets of fears are unfounded, and I would like to address them in some more detail below. I will also address what really happened during 2017 and why I believe we are set up to have an extremely strong year for Energy securities in 2018.
1. Shale “flooding” global oil markets
It is a fact that, during 2017, US shale production exceeded the previous peak achieved in 2014 (9.8m vs 9.5m barrels/day). It is also a fact that between 2014 and the end of 2017, global oil demand increased by well over 4.2 million barrels/day. So, purely based on US shale production, the world has “lost” approximately four million barrels/day in supply relative to demand.
It is true that the rest of global production has increased to fill some of that production gap, but the fear that US shale would flood the global oil markets appears to be entirely unfounded. And given global growth projections, 2018 may well be another stellar growth year for oil demand, with an estimated increase of between 1.6-1.8m boe/day. So the world will need all of the expected US growth (0.7-1.3m boe/day estimated in 2018) and then some.
The most obvious mistake in fearing uncontrolled growth in shale oil production was the difference between growth in a spreadsheet and that in the real world. There are no logistical issues on a spreadsheet – such as lack of frac crews and equipment, congestion in the West Texas roads, water availability/disposal issues, pipeline takeaway capacity, etc. In the real world, all of those considerations and many more mean that it is not feasible to grow beyond a certain pace, nor is it profitable or desirable from the asset owners’ perspective.
2. Electric vehicles “flooding” the automotive market and destroying oil demand in short order
Throughout most of 2017, news headlines spelt the death of internal combustion engines with increasing frequency, and this had a direct impact on investors’ appetite for Energy securities. But Tesla’s production issues in missing the Tesla 3 targets by over 90% exemplify the reality of EV growth and penetration, even assuming that the demand is already there.
The fact is that, globally, the fleet of two million EVs displaced an estimated 50,000 barrels/day of oil demand last year. Global oil demand grew by more than 1.3 million barrels/day, to reach nearly 97 million barrels/day during 2017.
The International Energy Agency (“IEA”) estimated that there will be between 9-20 million EVs by 2020 and 40-70 million by 2025. Therefore, at the top end of those projections, EVs will displace approximately 500,000 barrels/day by 2020 and 1.65 million barrels/day by 2025.
Assuming those projections are right, with global oil demand growing at 1.3-1.5 million barrels/day in recent history, EVs will not become a meaningful detractor of demand growth until the early part of the next decade and will only flatten global oil demand by 2025.
In order to support that EV adoption rate, Goldman Sachs estimates that we need $6.2 trillion in energy infrastructure investments to cater for the extra power required by the fleet of EVs. In addition, it will take time and investment to build the production lines that will manufacture the hybrid and electric vehicles of the future.
Whereas we are big believers in EVs and renewables, that future is not here yet, and there will be a lot of wood to chop before we do get there. In the meantime, we will still burn oil to drive, fly and ship goods around the world.
3. What ACTUALLY happened in the Energy sector in 2017
The most important development for the sector in 2017 was that E&P companies were fully able to cover their annual cash spend, including capex and dividends, with Brent averaging $54.75 for the year. At the beginning of the year, the guidance provided by the majors was for cash breakevens at $50-55/barrel, and they delivered that. The guidance for 2018 is for a further drop in the cash breakevens to $45-50.
The cash yield on the shares of some of the biggest Energy companies in the world (Shell, BP, Total, Statoil, etc.) exceeded 7-8% in 2017, leading most of them to remove the scrip dividends they paid out during the previous 2-3 years. That meant that the sustainable dividend yield on these shares was in the 5-7% range.
In addition, Shell announced a $20-25 billion share buyback over the next three years, on the back of very strong cashflows projected with oil at $50-55 per barrel. The company would, in effect, return approximately 50% of its market cap to its shareholder base over a period of three years, including dividends.
The return to cash generation in the Energy sector is something that we have always highlighted as a very important trigger for increasing equity exposure to the sector. After three years of cost cutting, capex reductions and project redesigns, the sector was able to cover its dividends in full during 2017. The fact that the generalists in the market did not seem to see it happening does not make it less important as an event – as you know, we do not believe in investing in Energy companies because of increasing asset values but rather when they return cash to investors.
And the theme of capital discipline was relevant across the globe, with US shale producers becoming very vocal about the need for capital discipline and focus on returns on capital. Boards of directors across the sector have started discussing changing management incentive schemes to reward return generation rather than growth, and that is being reflected in the budgets/behavior of management teams.
Whereas the US shale industry is significantly less mature than international E&P, its cash generation potential over the next 5-10 years is extremely robust, as companies mature their development concepts and focus on growing production rather than proving the resource. Pioneer Resources (PXD US), for example, is projecting annual cashflow at a 20% compound growth rate over the next 10 years, with production growing at 15%+ CAGR over the same period and free cashflow generation from 2020. That compares to the super majors’ growth of 1-3% per annum over the same time period.
4. How is the industry positioned for 2018 and beyond?
I highlighted above the cash breakeven achieved last year, with further efficiencies potentially driving better metrics during 2018. But whereas the guidance by the companies has been with oil in a $50-55/barrel range, Brent averaged $61.4 during Q4 2017 and has averaged $68.90 so far in 2018. We believe the profitability and cash generation of the sector will be magnified by the higher commodity prices, and the messaging from companies has been that the extra cash will be returned to shareholders or utilized to reduce debt. Strong beats during the Q4 reporting seasons could also have a positive impact on short-term trading and estimates for the rest of 2018.
What about the fear that US shale will flood the market? Considering the failure of that fear to materialize during 2017 and the front end of the oil price curve being very strong, the market appears to be beginning to understand the fallacy of that concern. It also helps that the oil curve is in backwardation (future prices are lower than spot) making it harder for producers to hedge future production and therefore alleviating the concern that shale producers will hedge away exposure, with production increasing uncontrollably.
The oil curve in backwardation provides an opportunity for generalist investors to invest in a carry trade, so that offers part of the explanation for the strength in the front end. Additionally, geopolitical tensions have had a positive impact on oil prices. Though it is less likely, I also hope that the disclosure from E&Ps and service companies of the logistical challenges to complete already-drilled wells has resonated with those who failed to appreciate the real-life complications of handling production growth.
Increasingly, while we remain focused on the fundamentals of the Energy companies, we think that the global markets are likely to experience a shortage of oil in 2019-2020. This view is driven by expectations of robust demand growth for the next few years (including the impact of EVs and renewables) and follows 3+ years of huge capex cuts globally.
The rates of both finds and developments have slowed down significantly in 2015-2017. This reduction in spending could have a direct impact on future production, leading to visible shortages beyond 2019 – depending on global demand growth rates.
In our view, the combination of capital discipline and focus on returns (reinforced by new management incentive plans) with higher commodity prices (far in excess of $50/barrel guidance for cash breakeven levels) will create an extremely healthy fundamental environment for Energy for a number of years to come. We firmly believe that the current evidence of strong cash returns and the promise of even stronger returns going forward will drive a major rotation back into Energy.
So, what we see in 2018 is a market that is significantly more rational, with higher investor participation and levels of scrutiny behind buying or selling – a very healthy development for a fundamental strategy like ours. We see many idiosyncratic stories out there, both on the long and short side, especially on the equity front. We expect M&A and share buybacks to become more prominent, and we have already seen two tender offers for bonds in our portfolio.
Despite our constructive view on the sector, however, the earnings/cashflow trajectories of various players along the value chain can be very different. That dispersion should continue to create both long and short opportunities throughout the year.