Valuentum: Still Drowning in Crude Oil
Image: An adaptation of President of Valuentum Brian Nelson’s call on Kinder Morgan (June 2015), still applicable to energy master limited partnerships that remain beholden to the debt/equity markets, exposed to volatile energy resource pricing directly or indirectly through customer credit health, and investor bases tied to distribution payouts that remain funded in large part by external capital. To read more about Brian Nelson’s June 2015 call on Kinder Morgan, please click here.
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“The biggest problem in the energy sector, in our view, is a structural one. In regulated capitalism in the US, oil producers cannot collude, and therefore, cannot act uniformly to fix or prop up prices, setting industry supply appropriately. President Teddy Roosevelt busted the trusts a long time ago.” -- Valuentum Securities
Just how bad is the world drowning in crude oil?
Commercial inventories of crude oil in the US continue to reside at 80+ year highs, according to the EIA, and the coordinated actions by the Organization of Petroleum Exporting Countries (OPEC) to potentially freeze production (and at what levels) are difficult to predict. Cash-strapped independent shale plays in the US may have no choice but to continue to produce the black liquid under any price scenario in order to generate cash flow to satisfy creditor requirements, and export-dependent countries such as Canada (EWC) will need to keep pumping crude to hinder economic recession. How aggressive will Iran produce following the lifting of sanctions and will Russia (RSX) seek to capitalize on any coordinated supply drawdowns by adding more barrels to the mix are key questions. The near-term outlook for crude oil prices remains troubling at best.
Yet, knowing that crude oil prices are driven by the economic laws of supply and demand, many pundits continue to be optimistic about the timing of the recovery in the price of the black liquid. Let’s first start with OPEC. In early 2015, Secretary-General Abdullah al-Badri said that oil prices have bottomed and “warned of a risk of a future price spike to $200 a barrel.” Since making those comments, however, crude oil prices are now materially lower, breaking through $30 per barrel for the first time in more than a decade in early 2016, raising concerns that the price of a barrel may once again approach levels not seen since 1998, when a barrel could be had for just ~$12. This scenario would have been preposterous just a few years ago.
The logical thinker might say that with US commercial inventories at record highs, OPEC not exactly ceding market share gratuitously to US shale-based plays, and other producers waiting on the sidelines looking to fill any supply void to shore up their own finances in the wake of the crude-oil price rout, why couldn’t prices return to the low teens at some point during the depths of the cycle? After all, the incentive continues to be with overproduction, not rational action. OPEC member nations, for one, are dependent on production for economic health, and scaling back would only play into domestic producers’ hands, which may seek to replace such supply drawdowns. OPEC has been playing a different game today than in years’ past, focusing on share gains not price stability, and this has had profound implications across the health of the sector.
How about Continental Resources’ (CLR) CEO Harold Hamm? The well-respected industry leader said in January 2015 that oil prices “could rebound faster than many observers expect,” but like the OPEC Secretary-General, since making those comments, crude oil prices have only headed lower, and materially so. Widespread capital cuts by exploration and production firms, almost across the board, may help to stem non-OPEC supply growth, but we’re not sure any industry expert can predict OPEC’s future actions with a high degree of confidence, nor the production decisions of Iran or Russia in the coming years. The market had thought OPEC would scale back production to halt the decline in crude oil prices many months ago and at materially higher prices, but the cartel did not, despite pleas from weaker member nations for emergency meetings.
From our perspective, OPEC continues to play “hard ball,” even though it appears that it has softened its stance somewhat during much of 2016. We don’t think OPEC will pursue economic “suicide” by allowing the price of crude oil to fall below $20 per barrel, but we also think it won’t ease the pain until key players in the US fold, or at least global production is slowed to the point where its market share is retained at a higher price point. Hamm, himself, admitted that many exploration and production companies can’t afford to borrow money, and in August 2015, Bloomberg estimated that the oil industry needs a whopping half-trillion dollars ($500,000,000,000) to “endure (the) price slump” at $40 per barrel. The credit rating agencies are expecting default rates to surge at the weakest high-yield energy plays, and some have already succumbed to conditions.
The biggest problem in the energy sector, in our view, is a structural one. In regulated capitalism in the US, oil producers cannot collude, and therefore, cannot act uniformly to fix or prop up prices, setting industry supply appropriately. President Teddy Roosevelt busted the trusts a long time ago. As readers know from their economic textbooks, all it takes is one large, irrational player to disrupt the market price. OPEC is doing that right now, and other participants remain mostly at the whim of their decisions. The cartel has sacrificed so much to put the backs of many US producers against the wall during the past few years, and we don’t think it will relieve the pressure until its goals have been achieved. This ominous backdrop may never go away.
The incremental near-term demand profile for crude oil isn’t exactly encouraging either. Economic growth in China (FXI), while still robust, is slowing. Brazil may be entering its worst recession in over 100 years. Job losses related to the energy and metals and mining sectors are taking their toll as US banks seek to raise their loan loss reserves. Economic growth in Australia (EWA) and Canada continues to face pressure due to their export-dependent economies, and the currencies of many emerging markets are reeling from a strengthening US dollar. Some currencies such as the South Africa (EZA) Rand are even at currency-crisis lows. Economic growth in the US remains a key source of strength, but the onset of contractionary monetary policy could put a damper on the pace of expansion.
As we outlined in March 2015, we think it may be prudent for risk-averse investors to steer clear of the most leveraged US-based exploration and production companies. Equity holders in some over-leveraged entities could see their investments completely wiped clean in the event of sustained oil prices below the $40 mark. Management teams have only started to address the current realities of a “lower for longer” crude-oil price scenario, despite the well-known cyclical dynamics of the price of the black liquid. Scaling back spending to preserve liquidity will help, but what this means more than anything else, is that most of the energy sector is playing a game of survival. Marginal projects are being canceled, and energy services and drilling firms are also feeling the pain, almost across the board
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The largest and strongest diversified oil giants are holding up, but they aren’t immune to troubles either. ConocoPhillips (COP), for example, has had to cut its dividend, despite slashing capital spending, while integrated players including Chevron (CVX) and even Exxon Mobil (XOM) have had to take on more debt just to keep pumping. The upstream master limited partnership model (AMLP) has been obliterated due to the energy resource pricing collapse, and midstream pipeline equities have also faced tremendous pressure as risks to their customer base mount. Perhaps the biggest shock to the markets thus far was the dividend cut at Kinder Morgan (KMI) in late 2015, and the sophisticated financing (implicit dividend cut) at peer Energy Transfer Equity (ETE) to keep some of its dealings on track. We maintain our view that Energy Transfer Partners (ETP) is inextricably tied to the dealings of its parent, and we remain concerned about the health of distributions across the energy MLP complex, pointing to Plains All American (PAA) as yet another entity whose payout is vulnerable. The severe capital-market-dependence risk of the master limited partnership business model has been exposed during this downturn, and many have been turned off indefinitely.
What are we thinking now?
Part of our short-term thesis on energy has been that there would be some kind of “dead-cat” bounce in energy resource prices in 2016, and we also acknowledge the possibility that such a bounce could be prolonged, before the next leg down across the broader energy complex may occur. In this context, however, we haven't ruled out the possibility that energy shares may be a leading sector during certain periods in the near future, and as a result, we retain some exposure to the sector. The threat of rising defaults across the upstream complex and its negative implications across the entire energy sector means that diversified exposure through energy sector ETFs may be one the best ways to play any short-term rebound, in our view. We include the Energy Select SPDR ETF (XLE) in both newsletter portfolios as a diversified way to capture the potential for higher crude oil prices without being exposed to the capital-budget decisions of any one operator that may be forced to slash their dividend, as Kinder Morgan and ConocoPhillips did. Income investors have had to endure enough, and the probability of a multi-year downturn in energy resource pricing is meaningful. The worst may still be ahead.
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Image Sources: Simon Cunningham, Images Money, Trading View. No alteration has been performed on the pictures.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice. For more information about Valuentum and the products and services it offers, please contact us at [email protected].
