This morning OPEC+ failed to arrive at an agreement to cut an incremental 1.5MM Bbl/d from the market in what was an attempt at offsetting a currently unknown amount of demand destruction resulting from the coronavirus. This outcome was highly unexpected. Russia’s economy is ~80% oil dependent and a small incremental cut which would have resulted in a disproportionally higher oil price (ie. higher cashflows) seemed very logical and is why some consultants are saying politics were at play in the decision. For now, fear is taking over as the market remembers the 2014 oil sell off that resulted from the OPEC scorched earth policy.
Today is very different than then. In 2014/2015 US shale was just starting to take off and OPEC wrongly assumed that a brief oil sell off would kill shale. Today, I would say that US shale is already dying. Access to external capital ended 2 years ago and technical issues with well productivity has led to eroding capital efficiencies and increasing supply costs. At today’s oil price ($41WTI) US shale is dead man walking. We know that growth rates were already imploding at $50+ (1.8MM Bbl/d YOY growth rate in August 2018 down to 0.8MM Bbl/d YOY growth rate in December 2019) and one consultant has written that the Permian Basin will be at a negative year-over-year growth rate by July/August unless activity levels materially pickup (not possible sub $50/bbl).
So where do things stand? Clearly oil demand is being impacted as people fly less (Southwest Airlines CEO said that he was seeing a 9/11 type hit in the short-term), commute less to work, and China slowly emerges from its self-imposed economic shut down. Unless one believes in the coronavirus resulting in a global culling of the population it is impossible to view recent demand weakness as anything but temporary. The challenge is that no one (literally) can quantify it and the market hates uncertainty. Unless OPEC (minus the +) acts soon to restore confidence in their traditional role it is likely that ongoing coronavirus worries will soften the oil price further.
Herein lies the challenge. Stocks had already decoupled from the oil price having fallen ~43% from January 1, 2019 to this morning. Is the worst being priced in as many energy stocks are hitting all-time lows? We were at $64/bbl before the coronavirus outbreak…why is it not reasonable to believe that we could get back to that level once people stop hoarding toilet paper and the market is able to quantify the demand hit in Q1/Q2? If I am even directionally right, many Fund holdings are trading below 2x EV/CF at $60WTI and 25%+ free cash flow yields…never before seen valuation levels. Further, of 10 Fund holdings eight of them have on average 48% of their 2020 oil volumes hedged at an average price of $59WTI.
If you have 43 minutes to spare below is a clip from BNN today where I go through my thesis on why the coronavirus demand hit is short-term noise in the context of a very positive medium and long-term outlook for oil. Given that appearances are booked months in advance the universe has a sense of humour for me to be on when Brent has its single largest daily plunge (10.3%) since the Financial Crisis in December 2008. I also speak to company valuations to try to give a sense of just how brutalized energy stocks have been. This has been the most exhausting and frustrating trade in history. Yet again, a macro event that was unforeseen has pushed out our bullish call for oil by another few quarters. Even if 2020 is a write-off (which we don’t yet believe) the combination of normalized demand growth of 1MM+ Bbl/d, crashing US oil shale production rates (<400k bbl/d in 2021), plateauing/declining global offshore production, and limited OPEC spare capacity all promise better days ahead.
As always, reach out directly with any questions on macro, fund strategy, etc.
Partner, Senior Portfolio Manager
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