Monthly Commentary from Dan Pickering
June was another solid month for the stock market, the oil market, the gas market and energy stocks. The S&P500 gained +2.2%, while Diversified Energy advanced +4.8% (S&P1500 Energy, S15ENRS), oilfield services beat the S&P500but was the subsector laggard at +2.8% (OIH). Midstream notched +5.2% (AMZ) and Upstream/E&P rallied +8.6% (XOP). Front month WTI crude oil easily broke $70/bbl, gaining +10.8% and finishing the month at ~$73.50/bbl. Meanwhile, front month Henry Hub was the star of June, gaining +22.2% and finishing at ~$3.65/mcf.
Inflationary dialogue and COVIDrecovery were the primary oil macro stories during June, although OPEC’s discord in early July has the spotlight back on the cartel. Disputes between the UAE and the rest of OPEC+ led to a postponement and then a July 5th adjournment of the monthly meeting. There was no outcome and no specific timeline for the next formal meeting. A 400kbopd increase per month through year end 2021 (totaling 2mmbopd returned by early 2022) was on the table. This was baked into consensus and the meeting failure now technically means no additional production will return to
the market for at least the next few months. On the surface, this is bullish for oil price as supply/demand will be tighter than previously expected. Oil prices rallied over $1/bbl on July 5thto $76+/bbl for WTI.
Beneath the surface, danger lurks. Rather than being giddy, oil market observers should be concerned and increasingly vigilant. OPEC has been THE stabilizing force in oil markets over the past nine months. If disagreements translate to a UAE breakaway with significantly higher production or OPEC+ cheating, oil markets could rapidly unravel. With 5+mmbopd offline and overhanging the market, all participants want a soft landing, not a free-for-all. The interactions between Saudi and UAE could wind up being merely brinksmanship, with a resolution within days or weeks. The entire kerfuffle could be a crafty mirage designed to keep non-OPEC players off balance, discouraging them from increasing production via the threat of potential oil price volatility. Or true OPEC rifts could be reaching a boiling point, which has longer-lasting implications for oil markets. For now, the headline is “bullish” for price and the range of potential outcomes has widened. Fundamentally, we didn’t previously think $100/bbl was in play. But this OPEC dynamic isn’t about fundamentals and triple digit oil now has to be considered possible. Previously, with a disciplined OPEC, oil market downside felt like $55/bbl WTI. It now has to be lower in the event of an undisciplined OPEC. We remain constructive on the view that OPEC has too much to lose by allowing the cartel to go off the rails, but complacency is absolutely the wrong approach.
Natural gas was the beneficiary of the record heat wave that swept parts of the U.S. during June. As we discussed in April, gas now has better supply/demand dynamics than in many years. While weather is never a variable that should be part of an investment thesis, inventories don’t care how they reach a certain level…and inventories got more supportive over the past month. $4/mcf seems more likely than $2.50/mcf for the next while. Although this might seem like a no-brainer statement with near-term pricing at$3.65/mcf, $4/mcf levels seemed like fantasy only a few quarters ago. Sometimes dreams do come true.
Industry consolidation continued. In Canada, a three-way dance ensued with Brookfield Infrastructure Partners (hostile) and Pembina (friendly) courting Inter Pipeline. Southwestern Energy (SWN) and private Haynesville producer Indigo also announced a merger. In the Permian, two rumored deals have attracted attention. The first is Chevron possibly divesting $1B+ of conventional properties. We put this in the camp of portfolio rationalization (many are trimming their vertical Permian exposure) and is relatively small for a $200B+ market cap company. The more interesting rumor (and in our view, the most important transaction we’ll see in the U.S. in 2H 2021) is the potential divestiture by Shell of $8-$10B of core shale production/acreage.
The Shell transaction, if it is truly in play, contains many “tells” for the market. Shell’s ESG pressures are well documented, but a short-cycle asset seems exactly what a producer would keep if they were worried about peak demand and impending irrelevance of hydrocarbons. However, U.S. shale is capital consumptive and the Permian is likely the only place in the world right now where a $8-$10B divestiture might find multiple bidders. Thus, in theory, it checks a number of boxes for the supermajor. The really interesting dynamic is on the buy side of the equation:
– How many buyers will show up and how competitive will the bidding be? European majors are out due to ESG pressures. Private equity is mostly out because the deal size is too big for any but the large diversified PE firms, and they have categorically stated they are not investing in traditional energy. From a financial buyer perspective, perhaps some of the Canadian pensions could participate (they are still doing energy investments), maybe in conjunction with an industry partner. On the industry front, names that are potential buyers include Chevron (big in the Permian, missed on Anadarko), Occidental (checkerboard acreage, the logical bidder, but debt and shareholder heartburn from the APC merger), Conoco (sizeable in the Permian, recent Concho acquisition), Devon (recently acquisitive in the Permian), EOG (longshot given they typically eschew corporate M&A), PXD (longshot but sizeable enough), and Apache (historically a buyer from Shell).
– How would a deal be financed? Assuming a 50/50 debt/equity split, any buyer except Chevron and (perhaps) Conoco would likely need to issue new equity. Would Shell accept equity? Would the buyer have to go to the market?
– How would an equity financing be received? If new shares have to be issued, would the new stock be priced down dramatically? We think valuation will be a critical variable in the equation (see below). If the market “likes the deal”, equity is probably available without a massive haircut.
– What about valuation? If a competitive situation develops and Shell winds up with multiple bidders and a strong price, all hell could break loose amongst energy equity investors. With PTSD from the past decade of shale growth and poor shareholder returns, investors will revolt if a bidder pays an expensive price (anything in the $25k+/acre range for the undrilled acreage). This will only confirm that the energy sector is a bunch of drunken sailors and the first hint of good oil prices brings them back to the saloon for more booze. We shudder to think about this outcome. An inexpensive price could convey the opposite. That companies have learned something from the past decade and are prudently approaching ongoing capital allocation.
– What if no transaction happens? This would be neutral/bullish as it would be the same as an inexpensive transaction, confirming capital discipline by the industry.
In the energy transition arena, it seems that every day brings more announcements from companies doing joint ventures or new projects. In addition to this private sector momentum, governments around the world (including the U.S.) continue to allocate capital, subsidies, incentives and budget to decarbonization. We expect hundreds of different approaches and technologies will be explored and eventually whittled down to the 10-20 verticals which become the real pathway to net zero. The Wild West will play out in front of our eyes, with those currently involved in any type of energy subsector deciding whether they are cowboys, gunslingers, gamblers, ranchers, provisioners, barkeeps, rustlers, bankers, or simply observers. At PEP, we certainly plan to be more than observers.
As always, we welcome your questions and appreciate your interest.