We are cautiously optimistic on Energy and the market for 1H19 where we expect higher than normal correlation between SPX 500 & WTI.
Data continues to be negative on the demand side, though investors seem to be looking through numbers for the Fed to be accommodating. Supply is in OPEC “control” for the 1H19 as pipeline constraints limit US production growth in the Permian. Our preferred sub-sectors are Large & Mid-cap E&Ps and Majors. Oil Service and Small-cap E&P we are neutral on sub-sectors but see some names that appear interesting. Refiners are least preferred other than a trade for IMO 2020. We expect volatility to continue with energy moving from macro to micro driven data flow. Macro demand concerns weigh on energy sector preventing the full benefit of OPEC cuts to be reflected in the stocks. We expect sector rotation to materialize over the next few years as the industry shows capital discipline. We are still early in the new crude cycle with significant spare capacity.
First or Last: Understanding Energy’s Binary Movements
The Energy sector has been either the best or worst performing over recent years on the year as a whole, but also swinging between the two polar opposites throughout the year. Capturing this volatility is key to outperformance in our view. Portfolio selection as well as active trading is required to navigate the polar swings. The market reacting to the rebalancing of the oil market is the factor that is creating the binary moves. Demand has been relatively stable or slightly positive but the supply response on the upside (OPEC easing cuts, US Shale production growth rate increasing) or downside (OPEC cutting and/or US Shale production growth rate decreasing) has created funds flowing in or out of sector. While many just simply call this rangebound, we believe there are three underlying drivers that produce the rangebound effect. We will be exploring these drivers throughout 2019 to help maximize returns this volatility provides.
- S&P 500 Correlation. Global demand is driving both crude and S&P 500 risk on/off movements. Crude volatility has dropped back into its normal range relative to the VIX. We see this ultimately as a positive as generalists are only assuming relative volatility similar to crude’s beta to the S&P 500. Ultimately, we see the third driver breaking the correlation in the 2H19.
- OPEC Supply Balancing. Crude market currently sees OPEC (Saudi) willing to remove excess barrels to maintain price. As long as OPEC maintains compliance, crude effectively has a put. In 2018, the crude market learned where OPEC would reduce and add supply. OPEC has defined the range for Brent from ~$60 to $70/bbl as comfortable zone in our view. (WTI implied is $50-62/bbl in our view) Outside this range, we would expect OPEC to attempt to first jawbone the market back into the “Goldilocks” range. OPEC spare capacity is still too considerable for sustained upside in crude prices at this point in the cycle.
- US Shale Production Growth. The greatest downside risk to crude is the expected 2H19 production growth as new Permian pipelines start-up. 1H19 pipeline capacity has limited production. The crude market wants E&Ps to maintain capital discipline even as the price has recovered in 2019. Upside potential is possible if, unlike 2018, E&Ps were to keep capital expenditures within guidance.
Are Energy Stocks Investible?
Underlying all our analysis is the fundamental question: Are Energy Stocks Investible? The answer is not simple, which weighs on the sector. We define investible stocks as companies that have a defined business plan where performance will be based on operational execution not corporate restructuring. Investible stocks also must have sufficient trading volume to be able to enter and exit positions. (We all know how problematic liquidity is in the entire stock market). Additionally for E&Ps, the companies must have 10 years of visible “known” reserves. Our analysis defines the following stocks as investible (we know this list will stimulate discussion): Exxon (XOM) , Chevron (CVX), Conoco (COP), EOG, Schlumberger (SLB), Occidental (OXY), Phillips 66 (PSX), Baker Hughes (BHGE), Halliburton (HAL), Anadarko (APC), Concho (CXO), Diamonback (FANG), Cabot (COG), TechnipFMC (FTI), National Oilwell Varco (NOV), Helmerich & Payne (HP), Transocean (RIG), Patterson-UTI (PTEN), and Range Resources (RRC). We will be adding Canadian and International majors and E&Ps in the future. PSX is our only refining company as we see the refining environment becoming increasing challenging post IMO 2020. The most likely reason you don’t see an expected company is because of trading liquidity. Most energy companies we view are in transition to investible stocks. We see alpha generating opportunities in these transitioning companies but for the moment they are more a catalyst trade than investible.
Five Macro Themes That Will Drive Energy Stocks
US Shale has changed the current cycle from the last few cycles. Spare capacity exists not only in OPEC, but also in the US as higher prices (above $60 WTI) cause a production response 6-9 months in the future. OPEC continues to strive to move crude prices higher to meet domestic funding shortfalls which encourages US producers to increase production. The US has returned to being the world’s largest oil producer as such we are no longer just price takers. Demand has undergone a more radical change this cycle with the increasing Green focus moving away from hydrocarbons. Unlike prior cycles, higher prices will also increase the secular move away from hydrocarbons. Crude prices will be volatile, but in a relatively well understood range without additional supply/demand disruptions.
1. Parent/Child/Non-Tier 1 Acreage
Most of the “parent/child” issues we have seen are the result of two factors: over stimulation for showcase wells (parent) and assuming too great a density prior to testing. We saw multiple E&Ps write-off acreage especially in the Southern Delaware in 4Q18. We believe early signs of lower quality inventories are beginning to show. E&P slowing their growth rate will allow E&Ps to “extend” their tier 1 inventory. If your acreage isn’t tier 1, there is a steep drop-off in valuation which leads us to the second theme.
2. E&P Capital Efficiency Gains
The street seemed surprised at the “capital efficiency” gains a number of E&Ps have demonstrated in 2019 vs 2018. We believe some of these gains are more one-time in nature for three reasons that will become clearer in the 2H19.
- Slowing production growth rate mathematically lowers capital intensity initially. Everyone is now asking about corporate decline rates. We have examined this over the past few years and it is clear that simple math delivers initial “capital efficiency”. Over time the gain will be reduced if growth rate is maintained. The amount of time this takes depends on new inventory being drilled and starting point of an E&Ps corporate decline. Canadian Trusts that performed the best had corporate decline rates closer to 20% but production growth rates were single digits. It doesn’t appear to us that street estimates are including this impact in their numbers.
- Natural Learning Curve/ Service Cost Deflation isn’t Repeatable Efficiency Gains. The data shows most of the “lower well costs” are the result of service cost deflation and not the result of E&P design. Data in number of frac stages per day in Permian continue to increase from large E&Ps like Occidental (OXY) to small E&Ps like Earthstone (ESTE). We see the rate of change slowing in 2019 but room still exists for improvement. This improvement is just normal learning curve and service crews gaining experience. Outside the Permian, we expect 2019 frac stages per day to remain relatively flat with slight improvement of 5-10%.
- E&P capital efficiency needs to be benchmarked over a 3 or 5 year period. We see multiple examples of the market giving credit to E&Ps for a single year change in capital efficiency. E&Ps outspend in prior years or expect to spend in future to achieve production goals. This process is not unlike mining companies that move from higher to lower ore concentrations as they work through the mining plan. As US shale has reached maturity, we believe investors need to return to evaluating companies over 3 or 5 years capital cycles to accurately measure intensity.
3. E&P Capital Discipline
Capital Discipline theme has yet to convince investors to pay higher multiples in E&P given the high capital reinvestment nature of the business. Natural gas companies are the first to move in this direction but only COG has been able to maintain their EBITDA multiple. We believe it will take multiple years of E&Ps demonstrating capital discipline and generating repeatable FCF for EBITDA multiples to expand.
- Slowing growth reduces multiple when markets are oversupplied. Virtually all US E&Ps have moved to match “cash flow” with capital expenditures as investors demand a slow down in production growth to aid oil prices. SMID E&P are most exposed since without sufficient outspend they will need a higher commodity price to reach “critical production volume” or achieve meaningful cash flow. FCF isn’t high enough in energy given the capital intensity of a depletion business.
- Capital Expenditures are more than just Drilling & Completion (D&C). We see a fundamental lack of basic capital expenditures as E&Ps are using just D&C to determine FCF. Land acquisition to block up acreage is key to any shale E&P so it should not be excluded. Also, energy is a depletion business where the molecule X will be consumed and replaced in inventory with molecule Y. While shale rock increases the consistency over an area greater than conventional, it is oversimplification to consider all remaining inventory equal to what is currently being drilled. EOG attempted to address this issue on their call as to why they aren’t returning more cash but it seems the street didn’t quite understand.
4. Seasonality Back to Normal/Street Estimates Need to Reflect
The normal seasonal movement in capital activity by E&Ps has reappeared now that crude prices have become rangebound. Private E&Ps add rigs and completion crews in 2Q & 3Q only to release in 4Q. We don’t see this reflected in street estimates for service companies. Street estimates seem to be all in a single direction up and to the right. Generalist investors don’t like investing in sector where estimates have high chance of being adjusted lower. Beyond seasonal capex activity, demand also functions seasonally (different patterns) for crude, NGLs, and natural gas. Natural gas has returned to a winter trade. Refiners still reflect a summer gasoline trade. We see opportunity to generate alpha by avoiding unrealistic street estimates.
5. Consolidation
Everyone has written on the need for scale in both E&Ps and service. The challenge begins with convincing management they have another opportunity to lead a new company. We haven’t seen many management teams successfully recreate energy companies in the last few years. Given the investment climate, investors must provide the incentives for management to pursue an exit. Service companies don’t have this issue. We see the problem simply as oversupply of old equipment (especially in completion). Finally, E&Ps that have made acquisitions haven’t been rewarded. The performance post deals have been relatively low.
Natural Gas Is Waiting on LNG to Breakout
We continue to see natural gas supply as abundant with Henry Hub prices in $2.70-$3 range. New LNG facilities must be built to sustain above $3/mcf in our view. Permian natural gas will be moving later this year when Gulf Coast Express pipeline begins service. Cabot (COG) and Range (RRC) have the long-term 10+ years of tier 1 inventory in our view that other companies do not without further delineation. Street views of $2.25/mcf forever have at least vanished. We believe below $2.50/mcf marginal production will be cut in Haynesville and Marcellus.
Companies Mentioned in this Report
Anadarko (APC), Baker Hughes (BHGE), Cabot (COG), Chevron (CVX), Concho (CXO), Conoco (COP), Diamonback (FANG), EOG, Exxon (XOM) , Halliburton (HAL), Helmerich & Payne (HP), National Oilwell Varco (NOV), Occidental (OXY), Patterson-UTI (PTEN), Phillips 66 (PSX), Range Resources (RRC), Schlumberger (SLB), TechnipFMC (FTI), and Transocean (RIG).
DISCLOSURE APPENDIX
This publication is for Institutional Investor use only and not for distribution to the general public. The comments herein are based on the author’s opinion at a particular point in time and may change at any time without notice. Alden Securities does not guarantee the accuracy or completeness of the information contained herein. Alden Securities is a FINRA-registered broker-dealer. Alden Securities shares in the commissions for trades that are executed through Tourmaline Partners, LLC, a FINRA-registered broker-dealer. This report is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment or undertake any investment strategy. It does not constitute a general or personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors. Past performance is not a guarantee of future performance. All investments involve risk, including the loss of all of the original capital invested.