Valuentum Exclusive Analysis for the Discerning Investor

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Image Shown: WTI is down almost 61% over the past year as raw energy resources prices were decimated by the news that OPEC and non-OPEC members couldn’t reach another production curtailment deal in early-March 2020.

By Callum Turcan

Raw energy resources pricing has crashed through the floor, so to speak, with WTI (USO) (US oil pricing benchmark), Brent (BNO) (international oil pricing benchmark), Henry Hub (UNG) (US natural gas pricing benchmark), and the LNG Japan/Korea Marker (pricing benchmark for liquefied natural gas [‘LNG’] deliveries to East Asian markets) are all trading at or near multi-decade lows as of this writing. The pricing for natural gas liquids (‘NGLs’), like ethane, propane, and butane, have also come crashing down (seen through Mont Belvieu pricing tanking, which is for deliveries to the NGLs hub in Texas). That’s pushed energy exporting countries and their finances to the brink, with reports coming out that Russia (ERUS) and Saudi Arabia (KSA) are prepared to utilize their vast but finite foreign wealth funds to cover enormous budget deficits that would make weaker developing markets crumble.

We’ve covered the ongoing Saudi Arabia-Russia oil price war in the very recent past, sparked by the collapse of the OPEC+ production curtailment agreement (which expires at the end of March 2020), and the ramifications for the energy sector in detail (here, here, and in great detail here). The collapse of that agreement is largely responsible for where the energy sector stands today (keeping rising US raw energy resources output in mind, courtesy of the shale patch), especially as it relates to the oil & gas industry. In this piece, we’ll provide an update on where things stand.

Geopolitical Side of Things

Saudi Arabia has foreign reserves of about ~$500 billion while Russia is sitting on roughly ~$570 billion in foreign reserves, according to Reuters. Reportedly, Russia is in a better position than Saudi Arabia financially speaking in part due to the Ruble being free floating whereas Saudi Arabia’s Riyal is pegged to the US dollar, in part due to Russia’s ability to utilize natural gas, coal briquettes, LNG, and wheat exports to generate hard currency export revenues, and partially due to Russia’s economy being more diversified. Please note that natural gas and LNG export prices are still heavily influenced by subdued raw energy-resource pricing benchmarks, as is coal, but those contracts (particularly between Russian state-run energy firms and buyers in Eastern and Central Europe) can at times be more lucrative than those benchmarks would suggest. Both nations can also turn to petrochemical and refined petroleum products exports, but wholesale prices have come down substantially (even if consumers in the US and elsewhere have yet to see those price reductions in full when filing up at the pump).

With all of this in mind, both countries will suffer immensely due to the subdued nature of raw energy resources prices and both will have to engage in quite the balancing act to maintain economic growth without blowing an enormous whole in their national finances. Saudi Arabia just announced a $32 billion emergency stimulus program to offset the negative impact of the ongoing novel coronavirus (‘COVID-19’) pandemic. Russia may consider such a program, but for now, part of its “stimulus” package is simply allowing its state-run and privately-run energy firms to drill more (considering Russia is no longer holding back the taps and plans to aggressively ramp up its energy production, just as Saudi Arabia is). It’s possible Russia will launch a more formal stimulus program but given that the nation has been under Western sanctions since 2014 due to its annexation of Crimea, arguably the Russian populace has become hardened to such economic hardships of late.

Russian President Putin continues to move forward with constitutional changes that would allow him to maintain his grip on power until 2036 by resetting presidential term limits. In Saudi Arabia, Crown Prince Mohammed bin Salman bin Abdulaziz Al Saud (abbreviated as ‘MbS’ in media circles) has solidified his grip on power in Saudi Arabia, supported by his father and the King of Saudi Arabia, Salman bin Abdulaziz Al Saud. Many see Crown Prince MbS as the de facto ruler of Saudi Arabia. With both President Putin and Crown Prince MbS having a steady grip on their respective nations’ internal affairs (save for the financial and economic situation, of course), the biggest threat to their ambitions comes down to the state of their respective nations’ economies.

Things have gotten so bad that private oil producers in Texas are calling upon the Texas Railroad Commission to curtail output in the state, home to the prolific Permian Basin in West Texas and the Eagle Ford shale play in South-Southwest Texas. Such a move hasn’t been made since the 1970s and would be antithetical to a more traditional understanding that the US is a market-oriented economy. Part of this comes down to the belief that the rift between Saudi Arabia and Russia won’t end anytime soon. We view this news as a sign of immense desperation within the oil & gas industry. Furthermore, the domestic oil & gas industry is seeking a “bailout” from the US federal government, one that could come in various forms.

The Trump Administration has responded by encouraging the US Department of Energy (‘DoE’) to purchase crude to fill up the Strategic Petroleum Reserve (‘SPR’), a reversal from the previous plan to sell off some of those barrels to raise funds for energy infrastructure improvements (as part of the Bipartisan Budget Act of 2015, which calls for selling off up to $2.0 billion worth of crude oil from the SPR from fiscal 2017 to fiscal 2020 to raise funds to carry out the SPR modernization program). With that in mind, please note this only adds an incremental amount of demand and won’t change the weakening global supply-demand dynamic by much given the demand destruction posed by the ongoing COVID-19 pandemic.

Private Sector Side of Things

Now let’s pivot to how this is impacting various private enterprises. Fears are growing that integrated energy giants like Exxon Mobil Corporation (XOM) and Chevron Corporation (CVX) might have to cut their payouts, while for the smaller independent upstream companies, many are growing very worried about their ability to maintain operations without filing for Chapter 11, seen through the deterioration of SPDR S&P Oil & Gas Exploration & Production ETF (XOP) which is down almost 65% year-to-date of as this writing (and down 76% over the past two years).

In the event of a Chapter 11 filing, many of the smaller firms like Whiting Petroleum Corporation (WLL), Chesapeake Energy Corporation (CHK), and Continental Resources Inc (CLR) would see equity holders completely wiped out given their enormous debt loads and lack of positive free cash flows. Continental Resources’ Executive Chairman and founder, Harold Hamm, has been pushing for federal support for the shale patch (it’s gotten that bad), and has filed a complaint with the US Department of Commerce alleging Saudi Arabia is “illegally” dumping its crude in the US. 

Due to various high-yielding securities funds holding a lot of the debt of these smaller independent upstream firms, seen through iShares iBoxx $ High Yield Corporate Bond ETF (HYG) having almost 8% of its portfolio by market value weighted towards energy (as of March 19, and that figure likely used to be higher before the sell-off in the energy sector’s high-yielding debt), that has decimated their performance. HYG is down 18% over the past year as of this writing while iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) is down 7% during the same period (keeping in mind LQD is also exposed to a meaningful amount of the energy sector’s debt at ~8.5% of its portfolio as of March 19; however, that is weighted towards the financially stronger players in the sector relatively speaking).

Another example can be found at SPDR Bloomberg Barclays High Yield Bond ETF (JNK), which is down over 18% during the past year as of this writing and that fund’s portfolio is ~8% weighted towards the energy sector as of March 19. In comparison, the iShares iBoxx $ High Yield ex Oil & Gas Corporate Bond ETF (HYXE) which doesn’t invest in high-yielding debt securities within the oil & gas space, is down just under 14% over the past year. While still a sharp drop, a ~400 basis point (+/- 100 basis point) difference in capital depreciation highlights the levels of stress weaker independent upstream firms are facing as it relates to capital markets. Were the HYG and JNK ETFs to be even more exposed to the energy sector (meaning a larger percentage portfolio weighting towards those “junk-rated” debt instruments), that difference would likely have been much more pronounced.

Concluding Thoughts

Upstream capital expenditures are coming down aggressively in the US shale patch and elsewhere, and just as importantly, even the bigger firms are throwing in the towel and scaling back their ambitions. Exxon Mobil has recently pledged to make material cuts to its capital expenditure budget, while Chevron is considering such a move, as are others. It will take a lot more than that to stabilize raw energy resources pricing given the demand destruction caused by the ongoing COVID-19 pandemic, with many households in major demand regions (namely the US and Europe) now “cocooning” in their homes to wait out the crisis. That’s on top of an expected surge in oil supplies from OPEC and non-OPEC nations, with an eye towards Saudi Arabia, the UAE, and Russia. We caution our members to not catch a falling knife here.

Oil & Gas (Majors Industry) – BP CVX COP XOM RDS.A RDS.B TOT

Independent Oil & Gas Industry – APA COG CLR DVN EOG MRO OXY PXD

Industrial Minerals - ARLP, CCJ, CNX, HCR, NRP

Refining Industry – HES HFC MPC PSX VLO

Oil & Gas Pipeline Industry – ENB ET EPD KMI MMP

Related: USO, BNO, UNG, ARMCO, XLE, XOP, VDE, AMLP, AMZA, HYG, JNK, LQD, CHK, WLL, KRE, KBE

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Callum Turcan does not own shares in any of the securities mentioned above. Kinder Morgan Inc (KMI) is included in Valuentum’s simulated Dividend Growth Newsletter portfolio. BP plc (BP), Enterprise Products Partners L.P. (EPD), and Magellan Midstream Partners L.P. (MMP) are all 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.