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Monthly Commentary from Dan Pickering

Evidently the oilpatch loves “May flowers” as all energy indices meaningfully outpaced the S&P500 during the month. The broad market added +0.5%, while Diversified Energy increased +5.5% (S&P1500 Energy, S15ENRS), Midstream tacked on +6.4% (AMZ), E&P popped +11.1% (XOP) and Oilfield Services charged +16.6% (OIH). Front month WTI crude gained +4.3% (~$66.32/bbl) and front month Henry Hub natural gas increased +1.9% (~$2.99/mcf).

We’ve flogged our macro energy viewpoint every month for what seems like forever. Demand up (COVID recovery), supply constrained (OPEC discipline, US capital discipline, general ongoing underinvestment), inventory drawdowns (ongoing). This trend continued in May, to the benefit of the oil markets and the oil industry. Tension in Israel/Gaza and the ongoing possible rapprochement with Iran created relatively few ripples.

Away from the commodity markets, there were numerous events that captured our attention:

– Continued industry consolidation/rationalization: Deals during May included Conoco announcing the ongoing divestiture of its ownership position in Cenovus (received as part of the 2017 oil sands sale) and Diamondback Energy selling the Bakken assets it received as part of the recent QEP Resources transaction. Companies that emerged from bankruptcy wasted no time in scaling up – Oasis Petroleum (OAS) was the Diamondback Bakken buyer and Extraction Oil & Gas (XOG) merged with Bonanza Creek (BCEI). Private equity sellers traded into public companies with Blackstone-backed Alta going to EQT Corp (EQT) and EnCap-backed Sabalo selling to Laredo Petroleum (LPI).

– Private equity and equity-owners-via-restructuring changing up the playbook: During the last cycle, private equity owners often held the public stock they received from combinations. A number of these stocks went down dramatically, impairing the PE fund’s results. Changing things up this cycle, Apollo and Quantum, owners of Double Point Energy, brought a $1.6B secondary offering less than a week after closing their sale with Pioneer (PXD). We look for more of these exits – whether via secondary offerings, block trades or at-the-market transactions. We are hopeful new money will enter the sector, providing incremental capital to absorb these sales. Otherwise it is a zero sum game that pulls money away and depresses the stock prices of the other stocks in the sector. Because hope is not a strategy, we continue our #JustSayNo stance – passing on all equity offerings, regardless of the reason or use of proceeds, to avoid encouraging additional issuances. We don’t pretend that our abstinence is a needle-mover, but we are practicing what we preach.

– Not every deal is created equally or received well: The bar for consolidation has clearly moved higher as energy stocks have moved up and some optimism has returned to the energy sector. The announcement of a merger-of-equals between Cabot Oil & Gas (COG) and Cimarex (XEC) was met with a Bronx cheer. Questioning the strategic rationale for Cimarex and the valuation of the deal, there were multiple sellside analyst downgrades and investors punished both companies. Through the end of May, the two stocks have fallen ~5-8% since the deal announcement, compared to +3% for the E&P heavy XOP index. While the deal was accretive to free cash flow metrics, investors questioned the asset fit (Marcellus and Permian/MidCon) and governance issues (change-of-control payments for both management teams). Our takeaway is that Wall Street isn’t ready for consolidation for the sake of consolidation. Ironically, this is a sign of an improving energy tape – it proves people are paying attention and differentiating.

– Colonial Pipeline hack: Yet another wake-up call highlighting how inexorably linked our society is with hydrocarbons. Russians shut-down the primary refined products artery into the East Coast and gasoline lines form within days. The irony is thick – legislatures deny new pipelines, incentivize green energy and push for the phase out of fossil fuels, but are outraged by the lack of fuel. We expect this type of push-pull around oil and gas for the next several decades.

– It’s not business as usual for big oil companies: It was a very tough final week of May for the major oil companies. An activist won two seats on the Exxon board, Chevron shareholders voted for emissions reductions and Shell was ordered by a Dutch court to lower emissions 45% by 2030. The writing on the wall is appearing in bolder letters and bigger fonts. Inherently, the cost of doing business in the oilpatch is going up. Unfortunately, it probably isn’t going up ratably for all involved. We don’t expect Russian, Chinese and many other National Oil Companies to face similar pressures as quickly as European and US majors. While Exxon, Chevron and Shell may be “better” companies, they are probably going to lose market share, be less profitable and therefore be less interesting to investors. Will investors looking to own exposure to an improving energy cycle now move down the food chain to pure-play upstream producers like Pioneer, EOG Resources, Devon and others? Probably. And how long until activist investors also move down the food chain, coming after these players? Eventually. The entire domestic industry needs to hone its ESG/emissions/carbon game plan and messaging, attract the appropriate shareholder base (that won’t weaken the company) and gird for battle.

– IEA Net Zero report: The International Energy Agency laid out its pathway to net zero carbon emissions by 2050. The Executive Summary (first 29 pages) is worth reading for all those interested in the energy markets, regardless of your position on carbon and climate and fossil fuels. Some great charts, tables and data on what is required to achieve the 2015 Paris Agreement goal of holding global temperature increases to 1.5o Celsius. The report maps out what is necessary between now and 2030, which then enables further steps by 2050. Interesting snippets include:

– -Accomplished via a singular, unwavering focus from all governments –working together with one another, and with business, investors and citizens

— The pathway laid out is global in scope, but each country will need to design its own strategy

— Pledges by countries for net zero emissions by 2050 now encompass 70%of global CO2 emissions

— Annual clean energy investment rises from $1 Trillion to $4 Trillion by 2030 and is maintained at that level through 2050

— Half of the reductions in global CO2 by 2050 come from technologies that are currently in the demonstration or prototype phase

— Government R&D spending needs to rise 3.6x by 2030 ($25B to $90B)

— 14 million new jobs created by 2030 from net zero pathway, but 5 million jobs lost in the traditional energy sector

— The world economy grows 40% by 2030, with energy use -7% assuming energy efficiency is 4%/year (3x the average rate achieved over the past 20 years)

— EV global car sales move to 60% by 2030 (up from 5% today) with public charging +40x

— Solar grows 20x, wind grows 11x, electricity is 50% of energy consumption

— No new oil and gas fields approved for development beyond 2021

— Oil demand falls -75% to ~24mmbopd by 2050 (OPEC market share expands to ~50%)

— Coal demand falls 90% by 2050; natural gas demand falls 55% by 2050

— Governments must work together in an effective and mutually beneficial manner to implement coherent measures that cross borders

Reading the IEA Net Zero report cemented our belief that 1) spending on global decarbonization will be massive, 2) the outcome is far from obvious and 3) the timing is wildly optimistic. Without question, it is worthwhile for an energy investor or analyst to expand their worldview of “energy” and learn more about all the new energy transition and green/renewable subsectors and technologies that will grow meaningfully over the next few decades. However, it also feels foolhardy to abandon fossil fuel investments on the impending doom of Net Zero and the risk of zero terminal value for oil and gas reserves. As the market realizes the challenges of decarbonization and the long time frames involved, both capital flows and valuations for traditional energy are likely to improve.

As always, we welcome your questions and appreciate your interest.