After an atrocious year of energy investing in 2015, the opening weeks of the new year did not hold respite for scarred equities owners.
The one truism about investing in resources is that commodities often overshoot both to the upside and, as we’re seeing now, to the downside. For investors that have longer time horizons, some elements of a contrarian investment opportunity are taking shape.
Back to the futures
Early in my career, I had the good fortune of working for a top-ranked analyst. “As an analyst, you want to be a meteorologist and not just a windsock,” he’d say.
Investors always look for predictive tools to navigate markets. Many investors think the futures strip is a predictive tool for oil prices and, at the very least, an expression of collective market expectations. As such, we evaluate energy stocks against the futures strip. But what was it telling us in the depths of the 2008 to 2009 crisis, and what is it trying to tell us now in the opening weeks of 2016?
During the crisis, central banks were rescuing venerable institutions and employing extraordinary measures to keep the global economic machine afloat. Amidst the chaos, the futures curve was telling us that the return to US$70 per barrel oil was expected within five years (see Chart 1). Today, the futures strip is suggesting that US$50 per barrel isn’t happening until after 2024.
But does that mean we should get used to low oil prices? There’s a strong case to be made that the futures curve is merely a windsock.
Let’s consider what a protracted five-year period of oil prices at less than US$50 per barrel might look like. For starters, U.S. unconventional shale oil development simply doesn’t work at less than US$50 per barrel. There have been some meaningful benefits in terms of the deflationary oilfield services costs reducing the industry breakevens, but at these levels the business is broken. Access to capital is impaired and the debt markets are all but closed to the majority of the energy sector. In this environment, the debt-fueled renaissance in U.S. oil production is basically over, and the banks themselves are grappling with managing the energy exposure of their loan books. Companies are currently slashing capital spending—the oil directed rig count in the U.S. has plunged 68% since October 2014.
Many traditional oil companies are faced with a largely uneconomic suite of opportunities at less than US$50 per barrel, never mind US$30. Most U.S. producers are retrenching, spending within cash flow against a backdrop of debt and equity markets that are largely closed.
Globally, U.S. producers are now fighting a losing battle against decline rates. One noteworthy thing about tight oil reservoirs is that newer wells have seen production declines of 70% or more during their first year. Recent analysis of U.S. producing wells by CIBC suggests that the shale boom has had the effect of increasing the overall decline of the country’s oil production to almost 30% (see Chart 2).
In fact, the base decline rate of just the Big Four U.S. tight oil plays is actually closer to 40%. These declines are a formidable foe, particularly in the face of contracting cash flows in a capital-constrained business climate.
Further, outside of the U.S., the vast majority of non-OPEC producers that could not grow in an environment of US$100+ per barrel in recent years are almost certain to be are fraught with declines in the current environment.
Excessive pessimism and the black swan
There is a peculiar dichotomy in the current oil market. Pessimism reigns supreme and we’re bombarded daily with stories about a slowing China (the key growth market for oil consumption) and the prospects for a tsunami of barrels from an Iran no longer bound by sanctions. The U.S. has finally dropped its decades-long ban on oil exports to the Middle Eastern country, potentially in time to flood the oversupplied global market with its surplus barrels. Mild weather around the globe and fuel-subsidy cuts are also slowing demand in the Middle East, as countries grapple with yawning fiscal deficits.
Sentiment is actually so poor that the “lower for longer” mantra seems now to be accepted as fait accompli. To make this point, Chart 3 shows a recent spike in the CBOE Crude Oil ETF Volatility Index (OVX). It demonstrates the skittishness of markets about further downside in oil prices, despite their being at a 12-year low.
The curious thing about this apparent bearishness is that it neglects to recognize some aspects of the energy market that are virtual game changers lurking in the shadows. There’s no doubt the market is oversupplied, perhaps by about 1.5 million barrels per day, and this is having a profound impact on global inventories. However, December OPEC production was 32.2 million barrels per day, in excess of their own 30-million barrel quota. It’s clear that, even without this production, the market would be in a deficit position.
Regardless of Saudi Arabia’s motivation, one thing is clear—this is an engineered oil crisis. What seems lost on the markets is that there is scant excess capacity, perhaps the least cushion we have ever had, in a world that has never been more unstable.
There are no fewer than five OPEC members in dire financial predicaments from depressed oil prices. All of this is happening in a global industry mired in a capital expenditure recession that has significant implications for the incremental barrels of tomorrow. Undeniably, there is little room for the producer cohort to stumble.
We would posit an opposing view to investors at this point in the cycle: we need to consider the potential that the futures strip is not to be relied on for its prognostications. This may be an opportunity for patient capital, but only time will tell.
In this difficult market, investors should remain cautious of companies with unmanageable leverage ratios, as well as low-quality assets.
Investors should instead focus on stronger companies with access to capital and cost structures that are sustainable during the downturn. Stick to those that can use this environment as an opportunity to strengthen their businesses.
Should the government nix flow-through shares?
Canada’s tax code allows the use of flow-through shares on the assumptions that they spur new exploration and that they benefit investors. A new report from the School of Public Policy at the University of Calgary argues flow-through shares (FTS) achieve neither goal.
FTS are a special type of common share issued by oil and gas or mineral exploration companies that allow the corporation to pass on, or “flow through,” certain expenses that it has incurred to investors. They let corporations that have more expenses than income pass along their expenses for shareholders to deduct from their own income taxes.
Report author Vijay Jog examines rates of return earned by investors in FTS issued during the 2008-2012 period. For small companies that issued these shares, the annualized absolute return was a nearly 100% loss. For larger companies, the returns were not as bad— negative 14%—but still a loss. From the $2.5 billion raised from Canadians using flow-through shares, investors have lost $1.2 billion.
What’s more, FTS cost the government $300 million in foregone tax revenues. “Our overall conclusion is that FTS seem to do more harm than good and that the time has come to reconsider the wisdom of providing tax incentives such as FTS for investments in particular sectors of the economy.”
by D. Mason Granger, P.Eng., MBA, CFA, is a portfolio manager in Toronto.