Monthly Commentary from Dan Pickering
Marching ahead (pun intended). After a very strong February, energy mostly scratched out additional gains in March. Diversified Energy added +2.7% (S&P1500 Energy, S15ENRS), while Midstream led the pack at +6.9% (AMZ), E&P added +1.0% (XOP) and Oilfield Services fell -4.8% (OIH). The S&P500 advanced +4.2%, front month WTI crude softened -3.8% (~$59.20/bbl) and front month Henry Hub natural gas dropped -6.0% (~$2.60/mcf).
The oil macro continues to be dominated by OPEC actions. The cartel, in particular Saudi Arabia, is managing the market artfully. In early March, OPEC++ extended their cuts for another month, while granting Russia and Kazakhstan a small increase – generally keeping everyone happy. Oil prices still softened during the month after the big February run-up, with European COVID-related shutdowns and bootleg Iranian barrels to China being the most cited reasons. As we mentioned last month, WTI in the low-mid $60’s felt a bit premature given all the factors at play (COVID recovery timing, OPEC barrels off the market, etc.), so a pullback here doesn’t feel inappropriate. OPEC’s early April announcement to begin returning barrels was inevitable and absorbed nicely by the market, with WTI holding above $58/bbl.
As we look through the remainder of the year, with demand picking up seasonally and COVID softness waning, the oil market will need substantially more OPEC barrels to avoid a massive inventory drawdown. We fully expect a gradual return of 3-5mmbbls/day at a pace which will support prices nicely in the $50’s but cap any runaway move to the upside. We wouldn’t be surprised by low $50’s (OPEC barrels coming back, COVID hiccup)…and would aggressively buy energy stocks during that type of pullback. We also wouldn’t be surprised by an inflation-fueled, OPEC-supported rally to the mid-$60’s…and wouldn’t be inclined to sell energy stocks during that type of rally. During 2021, if oil prices trade below $50/bbl WTI or above $65/bbl, something unexpected has happened. This feels like the appropriate time to say that oil price prediction is like navigating in the dark through an unfamiliar house. The odds of hitting an unexpected obstacle are high. Fortunately, right now, those forecasting obstacles feel equally likely to generate an upside surprise versus a downside surprise.
Tailwinds for the energy transition sector continue to build. The Biden administration is gung-ho for clean energy and the recently announced Infrastructure Bill will be supportive of lower-carbon initiatives (renewables, electric vehicles, R&D spending, etc.) Attempting to fund some of this spending via takeaways from the fossil fuel industry is disappointing but not surprising. We are advocates of “all of the above” around energy supply, but nuance and reality sometimes have no place in politics. Eliminating Intangible Drilling Cost (IDC) deductions for oil and gas companies has been attempted several times before and always failed. If successful this time, it will be a stark example of how far the pendulum has swung. We are watching closely, but don’t (yet) have any unique insights into exactly how the process will play out over the next year.
Turning to the oil and gas industry, consolidation continues. In the OFS sector, scale matters in a world of lower overall activity. Offshore drillers Noble Corp and Pacific Drilling are combining as they both exit restructuring processes. Franks International and Expro also announced a combination. In the upstream sector, Permian Basin deals continued in early April with Pioneer Resources (PXD) buying private equity-backed Double Point Energy for $6.5B in cash/stock/assumed debt. Reflecting the bounce back in oil prices and energy equities, the acreage values in this transaction were higher than deals seen over the past year (DVN/WPX, FANG/QEP/Guidon, COP/CXO). While slightly free cash accretive, the stock market reception was lukewarm – viewing the deal as neutral, with embedded optionality around oil prices.
Turning to equity markets, energy transition stocks and SPACs took a breather during March after being monsters over the past year. This was partly profit-taking and partly a slowdown in momentum as the market rotated toward “Value” and away from “Growth”. Solid-state battery maker QuantumScape had to downsize an equity offering, something unheard of as recently as early this year. Within traditional energy, the runup in stock prices generated a fair amount of capital markets activity. Several small cap companies did convertible offerings. Several companies did secondary offerings of shares held by private equity sponsors. There was even an oil & gas IPO (Vine Energy, VEI), the first in several years. None of these deals were particularly well received, generally underperforming their respective indices. While discouraging for the companies/investors involved, we think this is a positive sign for energy equities overall. By punishing issuers, the market is reinforcing the mantra of “live within cash flow, reduce debt, return capital to shareholders”, which has been the formula for recent positive stock performance on an absolute and relative basis.
As always, we welcome your questions and appreciate your interest.