Energy Destruction and Portfolio Construction: 2015 Reflections
On June 27, 2014, the price of Nymex WTI Crude Oil (per barrel) reached a high level for the year of $107.50. It began a slow, steady decline that, over the next three months, brought the price down to the $90 per barrel range by the end of September. The story of this white paper begins in October, where the $90 price became an $80 price in less than two weeks, the $80 price became a $70 price in about four weeks, and the $70 price became a $58 price in just two weeks (1). All in, the price of crude oil per barrel has dropped 45% in just a few months, and the impact has been felt across the energy markets. Significant price deterioration has taken place in the value of oil producers, oil drillers, oil services companies who support the producers and drillers, oil and gas pipelines, and even a variety of other sectors that may seem (at first glance) to be unrelated to the actual price of oil as a commodity. Our aim in this paper is to evaluate the causes of this unprecedented price drop, analyze its impact on specific parts of the oil and gas industry, and determine what path(s) a long-term investor may want to consider given this sudden malaise. Differing views on all these subjects can be found across the analyst and pundit community, so our goal is to present our own view, rooted in historical analysis and our perspective about the future, not to merely mimic what the alleged “consensus” views are stating. While the macroeconomic causes and effects are of interest to us in this discussion, our fundamental objective is to determine a strategic, tactical, and prudent response to recent events as investors, not merely as commentators.
There are primarily two schools of thought when it comes to determining causation of this 40-45% drop in crude oil prices: One focused on Supply, the other focused on Demand. There is plausible explanation in both. The last seven years have seen unprecedented growth in oil production, largely driven by U.S. shale development. Much has been said about the energy renaissance in our own country which created this production boom (http://www.morganstanleyfa.com/public/facilityfiles/mssbaaaaaabflr/4a89497e-1b31-45c3-8cc0-fb7a4b6daba4.pdf). The 2009 production levels of 5.3 million barrels per day have now become 2014 levels of 9 million barrels per day (2), creating an incredible reduction in foreign export dependency, but also stimulating an entire domestic industry to support the infrastructure of this production. Perhaps most notably, the possibilities of this expanded production capacity include the ability to export oil (and gas), thereby creating significant economic opportunity for producers, shippers, and, of course, end users who have previously been captive to OPEC-member countries. The school of thought focused on supply as the cause of this oil price decline also points to the fact that Middle Eastern production has continued at escalated levels, where even volatile regions, like Libya and Iraq, have maintained production.
One problem the school of thought focused on supply as an explanation for this price drop has to deal with is the violence of the drop relative to the extremely long and transparent period of supply growth the market has experienced. If there are experts who were unaware of the production growth in oil supply over the last five to seven years it would be shocking. The new found supply capacity is high, and perhaps there is inadequate demand to absorb it (or fear of inadequate demand to absorb it). But when is the last time a global commodity dropped 45% in price based on supply realities that have been fully known for years? That explanation in isolation seems inadequate.
The demand side of this argument claims that a weakening economy in Europe, a slowing economy in China, and a mostly unspectacular demand throughout the emerging economies has muted the need for this boom of oil supply. Again, there appears to be some plausible validity to the idea that softening demand has impacted global oil prices (particularly in conjunction with the supply factors mentioned previously). However, has demand weakened to the tune of a 45% decline? China GDP growth remains annually in the 7% range. U.S. GDP growth has experienced the best three quarters of the last five years this year. Europe’s economic growth has been muted and perhaps faces a re-visit of recessionary conditions. But was that a surprise to global energy markets in the last quarter? That seems highly unlikely, and is not being manifested in other price metrics one may look at to gauge impact. If international economic conditions were the primary cause of a 45% decline in oil prices, why would this manifestation be so isolated to oil prices?
An alternative consideration is that both the supply realities and demand constraints have impacted oil prices, and perhaps could explain a decline of 20% or so, but that the extraordinary drop beyond that is a result of the volatile and unreliable and certainly geopolitical realities of global oil markets. In other words, few sectors are more subject to manipulation than the energy sector, and this has been a constant truism in global politics and economics for decades. Saudi Arabia alone controls approximately 30% of the world oil market through its vast reserves and production infrastructure (2). Unlike the United States, which features nearly 1,000 separate and independent private enterprise producers, Saudi production is entirely state-owned and state-controlled. The ability to control oil markets, oil prices, distribution, and other such aspects of the energy ecosystem is the foundation of their economy and center of power. Analysts might want to consider that traditional supply and demand evaluation, while valid to a point, cannot tell the entire story of a 45% drop in oil prices in just a matter of months (indeed, with the bulk of that having accelerated in just a matter of weeks).
Impact on Producers
There is no question that for many producers the decline in oil prices has stripped a significant portion of their profit margin. Thus far, very little production has come to a halt (an almost undetectable amount), but surely if prices stay below $60 for long, or worse, there is a high likelihood of many producers needing to shut down. It is important to remember that profits for an oil producer doing no production are $0. Unless the cost of production exceeds the profits, declining as they may be, the producers have incentive to continue production. Which producers will have the financial wherewithal and motivation to continue remains to be seen. The more meaningful areas of oil production in our own country are still profitable far below this present price environment (5).
Finding a bottom for the oil producers will not be easy, and should not be pursued without a serious regard for the risks. Many producers may end up being acquired by larger producers (an opportunity in and of itself). What we do know is that there is no monolithic answer as to how the producers will respond here in the states. Profits are vulnerable at the margin, but that impact depends on each producers cost of production, debt servicing cost, and the region in which they drill.
If producers slow activity, doesn’t it stand to reason that the names providing equipment and field services to the producers will suffer as well? The answer to this is also name-specific, as different service providers have different contracts, different capabilities, and different balance sheet resources. More importantly, service providers have differing business models which differentiate themselves from competitors (for example, what their presence may be in the natural gas space vs. the crude oil space). Historically, oil services names have seen high correlation with energy commodity prices in the short term, but a breakdown of the correlation as more time goes by (a by-product of their flexibility, economic response, and business management). The toll this price decline has taken on the oil services sector is likely to create more industry consolidation, and through such, more strength competitively for the leadership names.
Oil and Gas Pipelines
In the wake of recent energy destruction, one may want to give serious thought to the oil and gas pipeline space when thinking about portfolio construction. The sector has seen price declines in the range of 20% as of mid-December (in less than one month) (3). There appears to be a concern that the value of the commodity in the pipeline determines the value of the pipeline itself, even though the value is based on the toll being paid for the transportation, and for the cash distribution the pipeline company pays. Let’s evaluate both of these things.
The pipeline space is the quintessential toll road model. Readers familiar with paying a toll to drive on a certain highway (the 73 Freeway comes to mind here in Orange County, California) will note that the toll is not assessed on the value of the car using the road. A new Mercedes Benz does not pay a higher toll than an old Honda Accord. Pipelines appear to be experiencing price declines based on indiscriminate selling, a misunderstanding of their business models, or other technical factors (late year tax-loss selling, disinterest in buying and receiving K1 status late in the year, closed-end fund selling on the backs of excessive leverage, etc.). However, for income-oriented investors, as well as growth-oriented investors, few sectors in the energy market offer more upside opportunity than this space for the following reasons. There can be no better argument about the disconnect between the underlying commodity price and the value of the pipelines carrying the commodity than this “Index vs. Natural Gas” chart.
While timing all of this is certainly impossible, the real-life precedent we have for the disconnect between commodity prices and pipeline/toll road values is what took place with natural gas over the last five years. The pipelines did suffer dramatic price declines as natural gas prices literally declined 80% from their peak to trough. Yet, even as gas prices stayed quite low, pipeline prices increased well over 100% (closer to 150%) in the same time period. In fact, this price appreciation does not even reflect the extraordinary cash distribution yield (dividend) that has also been paid (in most cases exceeding 5% per year). There is no doubt that execution risk is important here. Not all companies in this space are created equal. Counter-parties are important. Who are the pipelines doing business with? How safe is the distribution? How likely is the distribution to grow? Which companies in this space even grew their dividends in 2008 and 2009? That period of time gave us incredible optics to the fee model vs. commodity model of doing business. When one does the homework in this space, exercises selectivity and discrimination (around the factors mentioned herein: Geographic superiority, balance sheet strength, counter-parties, debt spreads, etc.), and stands willing to learn from history, significant opportunity can come from investment in this space. Patience can be important, and risks persist, but this strikes me as the major area of market dislocation we presently see which can be exploited.
How low can oil prices go?
If the stock market exists to “make the biggest fools out of the biggest amount of people possible”, commodity markets exist to humiliate people and then some. A price prediction connected to a timeline is difficult to do. When connecting that prediction to an investment thesis, it’s very risky. Investors may want to consider being as price-agnostic as possible in developing an investment response to present conditions. However, because the answer carries macro-
economic implications and even timing implications around the recovery metrics of certain energy-related stocks, it is worth considering the following.
While tremendous economic incentive exists for the Saudis to marginalize Russia, the United States, and other OPEC countries, the reality is that one can only punish themselves for the sake of punishing others for so long. It stands to reason that when a sovereign nation requires a certain oil price for their own national budget, competitive engagement becomes a different world altogether. The “Lower oil prices” chart (4) shows the level at which many OPEC countries require oil prices to be for fiscal breakeven. My own forecast is not for lower oil prices, or for higher oil prices, but rather for persistently volatile oil prices for the foreseeable future. A significant amount of world oil comes from the most inherently volatile geographic region on the planet – the Middle East. History suggests these cycles play out over and over again, and a perpetually long period of sustainably low prices does not often happen, just as the opposite is true about high prices. Present levels may very well have built up significant price opportunity in the areas of the market most exposed to the underlying commodity price (though selecting a bottom in that price could be a dangerous proposition). For long term investors, the risk/reward proposition is likely to be much more attractive in a price-agnostic sector (such as the pipelines), or in other peripheral aspects of the energy markets, which leads me to the next subject.
Natural Gas, Natural Gas Liquids (NGLs), and a Strategy for the Future
Some of the most significant price deterioration of the last month has been seen in companies that seemingly are not involved in the crude oil discussion. Those that somehow benefit from the use of natural gas and natural gas liquids have been hit as the market has assumed that lower crude prices threatens their competitiveness. Indeed, if crude oil at sustainably lower prices meant the permanent erosion of demand or utility for NGLs, much of the present economic landscape would change. That thesis seems to me to be quite erroneous.
Prices for natural gas are significantly higher around the world than they are here in the United States (6). The ability for the United States to export liquefied natural gas around the globe contains price dynamics that are extremely attractive for producers, shippers, ports, vessels, and so forth. In fact, many of those businesses do not even need to see price appreciation because they work off contracted prices. Producers have the profit motive to gain this arbitrage. Some investors may fear that incredible stability and friendliness will break out of the world’s biggest natural gas supplier (Russia), but that geopolitical outlook would not strike me (or you) as particularly rational. Natural gas is a greener alternative than petroleum/crude oil, has significant price arbitrage opportunities on a global scale, and has already seen its price deterioration moment six to seven years ago. Crude oil represents just 10% of the world’s electricity production, while natural gas creates 50% more. Natural gas as the greener alternative to coal and nuclear is a very defensible position. Varying theories exist as to why parts of the natural gas world have suffered throughout this oil price drop, but investors ought to consider where some of that has been disconnected from fundamentals, and what type of long term play on the supply chain of natural gas (its present, and its future) make sense (i.e., pipelines, processors, refiners, ports, vessels, etc.).
The Entire Economy
One of the most controversial claims I would suggest in this paper is my skepticism of the almost consensus view that the present oil price decline is an automatic and obvious boom to the economy (due to the increased disposable spending money it provides consumers who are realizing savings at the tax pump, etc.). Some extraordinary intellects are promoting this idea, so humility requires me to proceed cautiously, but I am simply too afraid of the near unanimous nature of the outlook to fully buy into it. Indeed, consumer behavior may on the margin lead to more spending in certain sectors of the market because of this gas pump relief. However, for sustainable and marked change in consumer behavior, laws of economics generally suggest the consumer must believe the price change will be permanent. Confidence that gas prices will remain permanently at present levels (or lower) could prove to be elusive. To believe that oil prices will be structurally lower requires one to know the reason for the drop, and if my option #3 theory suggested earlier proves to be correct, there may not be the boom to the consumer or GDP growth some are predicting. Additionally, there is an “offset” theory that I find reasonable which should be considered. This theory says that what the economy gains through increased disposable spending via decreased fuel pump expenses, it gives back through the potential loss of energy-related jobs and activity. Normally this theory would not make sense as turnover in one particular part of the economy is normal within an economy built on creative destruction. However, the disproportionate nature of how useful the energy sector has been to the overall economy (especially the labor market) over the last five to seven years leads me to believe that this is valid. Additionally, if 14% of the high-yield bond market turns out to have exposure to vulnerable parts of the oil production and exploration market, broader credit market disruption could also prove deflationary. I do not see an outlook where an impaired energy sector proves to be good for the economy in the short term.
The more optimistic outlook would be one where oil prices find equilibrium, producers and other economic actors the energy sector recalibrate, and through time enhanced productivity pushes prices lower, all the while the birth of a United States energy-exporting industry takes hold. This would bring vitalization to many sectors of the energy market currently suffering. More importantly, it would create entirely new supply/demand characteristics which would benefit all sorts of market participants. The short-term outlook is impossible to forecast, and investors must act within their own risk profile. Price volatility is the new normal, and yet fundamental values win out in the end. Our thesis remains that fundamental values are to be found (if one is patient) in the pipeline sector, the natural gas derivatives sector, and parts of the oil business as well. Each likely has different risks and timelines associated therewith, but the black swan event of a 45% oil drop has enabled investors to re-visit these very risk/reward possibilities.
(1) Bloomberg, Nymex WTI Crude, December 14, 2014
(2) Citi Global Markets, 2015 Crude Oil Outlook, November 6, 2014
(3) Alerian Pipeline Infrastructure Index, Thomson One Reuters, December 13, 2014
(4) JP Morgan Asset Management, Weekly Market Recap, December 7, 2014
(5) Rystad Energy, Morgan Stanley & Co., Commodities Research, December 5, 2014
(6) Federal Energy Regulatory Commission, World LNG Prices, September 2014