Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: ConocoPhillips – November 2019 Analyst and Investor Meeting IR Presentation

Executive Summary: Though raw energy resource pricing is on the rebound, the outlook for the oil and gas industry remains stressed. Global demand for oil and related refined petroleum products remains subdued due to headwinds generated by the ongoing coronavirus (‘COVID-19’) pandemic. The OPEC+ oil cartel has responded by pledging to keep a significant amount of oil output off the market for an extended time. However, raw energy resource prices need to go much higher and be sustained at elevated levels before the space could become attractive from a longer-term perspective. In our view, the US upstream industry (specifically those in the shale patch) need WTI to move and stay north of $60 per barrel to be in a position to generate meaningful free cash flow while also investing enough to maintain their production bases. We think the dividends at the oil majors may be at risk, even Exxon’s, and we include two high-risk midstream stocks in the High Yield Dividend Newsletter portfolio to capture a relatively benign risk-reward scenario when it comes to their respective yields. We maintain a cautious view on the MLP business model, more generally, however. For now, we are keeping a close eye on the energy sector considering things are slowly moving in the right direction. However, given the collapse in raw energy resources pricing witnessed during the first half of 2020, the industry still has a long way to go before it is out of the woods, so to speak.

By Callum Turcan

Raw energy resources prices are moving higher with near-term Brent (BNO) and WTI (USO) futures now back over $50 per barrel as of this writing, which supports natural gas liquids prices (propane, butane, ethane) along with regional natural gas prices in certain markets and global liquified natural gas (‘LNG’) prices as well. The rebound is driven in part by expectations that the ongoing coronavirus (‘COVID-19’) pandemic will end sooner than initially expected due to the distribution of COVID-19 vaccines worldwide.

Assuming all goes as planned, the economic trajectory in major energy consuming nations should improve materially which supports the demand outlook for refined petroleum products and thus oil demand. Global oil demand appears to be improving according to forecasts provided by the International Energy Agency (‘IEA’), and in 2021, the IEA expects diesel and gasoline demand will recover to 97%-99% of pre-pandemic levels (meaning 2019 levels). Another key factor is that the OPEC+ oil cartel continues to hold vast amounts of production off the market, though we caution that global demand for refined product products (and thus crude oil) remains subdued according to data and forecasts provided by the US Energy Information Administration (‘EIA’).

Update on OPEC+ Strategy

Back in April 2020, OPEC+ reached an agreement to remove 9.7 million barrels of crude per day of production from the market starting May 2020, with the size of that reduction slated to slowly phase out through April 2022. Please note the group has already reduced the size of that agreed upon cut. The trajectory of production coming back online remains a subject of debate as the OPEC+ group has already modified the original agreement (made possible through extensive behind the scenes negotiations) to consider the negative impact the pandemic has had on energy demand in key regions (including major energy consuming nations in North America, Western Europe, and Asia).

As an aside, various entities (government-run and private) in non-OPEC+ nations have curtailed their production as a result of the low energy resource price environment, taking additional barrels off the market, too. ConocoPhillips (COP) provides an overview of the reasoning behind those decisions in this presentation here. We caution, however, that the recent recovery in crude oil prices could drive production curtailments to be eased with or without notice--and it’s quite possible that many of the output curtailments announced months ago have already started to ease to capture the near-term jump in spot rates.

Starting January 2021, the size of the OPEC+ group’s collective agreed-upon reduction moved down to 7.2 million barrels of crude per day. At the start of 2021, Saudi Arabia agreed to “voluntarily” remove another 1 million barrels of crude per day from the market in February and March of this year, highlighting its role as the world’s swing oil producer (the US remains the world’s other key swing oil producer, of sorts). In our view, Saudi Arabia pledged further supply reductions in a bid to ensure comity within the OPEC+ oil cartel, as several nations have grown wary of continuing along with the output cuts with an eye towards Russia and Kazakhstan (geopolitically speaking, Kazakhstan is close to Russia).

Additionally, the UAE reportedly clashed with Saudi Arabia during the second half of 2020 as the UAE aimed to take advantage of its past investments to boost production, and considering the UAE reportedly viewed its production quota as too onerous. Part of the dispute reportedly involved the UAE pushing for a change to the structure of the agreement to boost compliance from nations not in full compliance, with an eye towards OPEC-member Iraq along with non-OPEC members Russia and Kazakhstan (these nations are perennial over-producers when it comes to OPEC+ production curtailment agreements).

However, Saudi Arabia appears to have smoothed over the situation by agreeing to shoulder more of the burden itself (on top of the substantial output cuts Saudi Arabia already committed to). As a related aside, the Saudi Arabia-led blockade of Qatar (another Gulf State) appears to be easing up with Saudi Arabia, Bahrain, the UAE (all Gulf States) and Egypt (a close geopolitical ally of Saudi Arabia) recently reaching an accord with Qatar that would see geopolitical tensions ease a bit. That accord includes Saudi Arabia reopening its land borders and airspace to Qatar, though tensions remain over a litany of issues and it is not clear what Qatar is offering in return.

Pivoting now to North Africa, Libya’s (an OPEC member) embattled oil industry has come roaring back. Libya remains gripped by an ongoing civil war, though a recent truce between rival factions has enabled the country’s oil production to surge from roughly 0.1 million barrels per day in August 2020 to 1.25 million barrels per day in December 2020. It remains to be seen if Libya can maintain that production level going forward, given ongoing domestic tensions and the presence of foreign geopolitical actors in the country. Rising Libyan crude production levels and related exports have created another headwind for the OPEC+ group, though volatile output from the country has been the norm during the past decade, meaning this was a known dynamic that the oil cartel knew it would eventually need to deal with.

Private Companies and Investment Commentary

Shifting gears a bit, we would like to stress that the recovery in crude oil markets and raw energy resources pricing (more broadly) needs to be sustainable in order to materially improve the outlook for private companies operating in the oil & gas industry. By that, we mean Brent and WTI would need to stay above $50 per barrel going forward and continue to recover to levels seen before the pandemic hit (in the $60+ per barrel area). The Energy Select Sector SPDR ETF (XLE) and SPDR S&P Oil & Gas Exploration & Production ETF (XOP) have both moved meaningfully higher of late, though those ETFs remain well below levels seen at the start of 2020 and far below their all-time highs (reached in 2014).

Upstream firms are responsible for the extraction of raw energy resources from the ground and are highly levered to fluctuations in Brent and WTI pricing given the impact those benchmarks have not only on global oil prices, but on natural gas (in some markets), LNG, and natural gas liquids pricing as well. Natural gas pricing in the US, measured by Henry Hub (UNG), is not directly influenced by changes in Brent or WTI, though higher oil prices tend to boost associated gas production (by stimulating greater upstream investment with an eye towards “fracking” activities) which creates headwinds for domestic natural gas prices and domestic natural gas producers. In other regions, higher Brent and/or WTI pricing positively benefits natural gas prices as the contracts covering the sale of those raw energy resources are tied to those benchmarks.

As we have noted in the past, but will mention here again, most of the intrinsic value of equities (generally speaking) comes from the mid-cycle and perpetuity part of the value composition (specifically the forecasted future discounted free cash flows on a normalized basis long into the future), with 25% or less of most equity’s intrinsic value derived from the forecasted future discounted free cash flows generated in the Year 1-5 period. Please read Value Trap for more on the subject. With that in mind, a recovery in near-term crude oil futures does not mean that the intrinsic value of upstream equities and energy majors with large upstream divisions has improved considerably, though it does go a long way in assisting with potential refinancing efforts (many oil & gas companies are burdened with large net debt loads) and improving their forward-looking dividend coverage metrics (i.e. the Dividend Cushion ratio).

Looking at upstream companies with significant exposure to the US shale patch, we caution the “shale treadmill” paradigm continues to limit the ability for these firms to generate sizable free cash flows in the long haul. Initial production decline rates at “fracked” wells, meaning horizontal wells that are stimulated through hydraulic fracturing activities, range from ~40%-80% during the first year of production depending on the geology, the level of development the play has already experienced, what type of choke management system is used, and other considerations. This forces upstream firms to continuously invest enormous sums towards drilling and fracking new wells, causing these companies to continuous spend vast amounts on capital expenditures. As an aside, beyond shale formations, limestone, chalk, sandstone, and other geological formations are being developed via fracking extraction methods.

Even when raw energy resources pricing is recovering, it is difficult for the US upstream industry to capitalize on this dynamic given the need to ramp up investment to offset steep production declines. In our view, the US upstream industry (specifically those in the shale patch) need WTI to move and stay north of $60 per barrel to be in a position to generate meaningful free cash flow while also investing enough to maintain their production bases. We are still a way off from WTI moving over $60 per barrel, though we understand recent investor excitement towards the space, albeit off an incredibly low base. In April 2020, oil & gas firms represented just ~3% of the S&P 500 (SPY) index, down from ~15% a decade ago.

Midstream companies (AMLP), owners of energy infrastructure such as pipelines and storage facilities, and downstream companies (CRAK), owners of refineries and petrochemical plants, will benefit from global refined petroleum product demand stabilizing as global health authorities work to put an end to the COVID-19 pandemic. Though higher raw energy resources prices can create headwinds for the downstream industry, what mattes most is that demand recovers to levels witnessed before the pandemic hit. For the midstream industry, recovering global raw energy resources production levels support the outlook for operations in producing regions (such as gathering systems, long haul pipelines, and processing facilities) while recovering global refined petroleum product demand supports the outlook for operations catering to end markets (such as distribution networks, long haul pipelines, and import/export infrastructure including marine terminals).

Refiners operating at subdued utilization rates tend to experience severe weakness in their operating margin performance (before taking “crack spreads,” the difference between the value of inputs such as crude oil and the value of the refined petroleum products outputs, such as gasoline and diesel, into account) given the relatively high fixed costs associated with those operations. The same dynamic applies to petrochemical plant operators as well (petrochemical plants produce plastics, adhesives, detergents, resins, fibers, lubricants, gels, solvents, and other building blocks that are essential for modern development and related economic activities). We caution that global demand for gasoline and diesel will likely recover before demand for kerosene, used to make jet fuel, recovers given headwinds facing the commercial airliner market (JETS). In fact, demand for most petrochemical products appears to be recovering as we write as consumer spending levels remain strong in key regions worldwide, assisted by emergency fiscal stimulus measures, while the global industrial economy is rebounding strongly as well.

Concluding Thoughts

We are keeping a close eye on the energy sector considering things are slowly moving in the right direction. However, given the collapse in raw energy resources pricing witnessed during the first half of 2020, the industry still has a long way to go before it is out of the woods, so to speak. When the update our cash flow models for the oil & gas industry, we may fine tune our assumptions given recent improvements in the industry’s outlook, though we caution that oil prices in the mid-$50s range is not a panacea for the various problems facing the space (with an eye towards the large net debt loads seen across the industry).

For high yield considerations, we continue to point to Enterprise Products Partners L.P. (EPD) and Magellan Midstream Partners L.P. (MMP), and include both midstream entities in the High Yield Dividend Newsletter portfolio. We remain cautious on the dividend health of many of the oil majors, including the two strongest, Exxon Mobil (XOM), “Exxon Mobil’s Weak Forward-Looking Dividend Coverage is Very Concerning,” and Chevron (CVX), “Chevron’s Forward-Looking Dividend Coverage is Becoming Stressed.” The energy sector remains in shambles, but it is looking to bounce back. 

Downloads

Exxon Mobil's 16-page Stock Report >>

     Exxon Mobil's Dividend Report >>

Chevron's 16-page Stock Report >>

     Chevron's Dividend Report >>

Enterprise Product Partners' 16-page Stock Report >>

     Enterprise Product Partners' Dividend Report >>

Magellan Midstream Partners' 16-page Stock Report >>

     Magellan Midstream Partners' Dividend Report >>

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Oil and Gas Complex Industry - BKR, HAL, SLB, BP, CVX, COP, XOM, RDS, TOT, COG, EOG, OXY, PXD, ENB, ET, EPD, MMP, KMI, PSX

Tickerized for stocks in the XLE, XOP, XES, CRAK, OIH, and AMLP.

Also Related: BNO, USO, UNG, VDE, FRAK

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Callum Turcan does not own shares or units in any of the securities mentioned above. Enterprise Products Partners L.P. (EPD) and Magellan Midstream Partners L.P. (MMP) are both included in Valuentum’s simulated High Yield Dividend Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.