June 2022 – Commentary from Dan Pickering

Well, that deteriorated quickly.  June was a terrible month for energy stocks.  While the S&P500 was dismal at -8.4%, energy was worse with Diversified Energy dropping -17.4% (S&P 1500 Energy, S15ENRS).  Energy subsector performance was as follows – Upstream/E&P -22.7% (XOP), oilfield services -20.7% (OIH) and Midstream -14.0% (AMZ).  WTI was a relative shining star at only -7.8% (~$105.80/bbl) and natural gas fell to earth, closing at ~$5.40/mcf (-33.4% for the month). ⁽¹⁾

Friends and longtime readers, this was the hardest monthly writeup in quite a while.  I struggled mightily and almost went with just one paragraph saying, “this energy market volatility is to be expected after a big upside move, energy markets are going to stay plenty tight, take advantage of this gift the energy stock gods have given you with this pullback, put your head down and stay the course.”  Instead, you got several pages.  Not sure which will be most helpful.  So, you get both!

We’ve spent the past few months repeating the opening paragraph below.  For most of this year, it’s been an anthem.  During June and the first part of July, it felt like a life preserver.  Regardless, it still captures our viewpoint:

The Russia/Ukraine conflict has elevated the strategic significance of oil and gas for the foreseeable future. Geopolitically risky barrels will be marginalized while Trustworthy Barrels will be more valuable, benefitting reserves and production in Western/developed countries. Energy can no longer dwell at the bottom of the S&P500 weighting as investors will be compelled to own more in the face of a potential or ongoing energy crisis. There will be significant volatility – both upside and downside – but the trend is stronger/bullish.

When parsing through the events of June, it is like watching a familiar scary movie.  We’ve seen it several times, we know the twists and turns and we know the flaws in the plot.  But it’s still scary.  There is currently a witches brew of geopolitical unrest, rising interest rates, inflation and the specter of recession.  Reacting to these factors, previously high-flying commodities were tossed out.  Equities were sold in general.  Economically sensitive equities were sold harder.  Economically sensitive equities with strong YTD gains were sold even harder.  The S&P500 carded its worst first half in more than fifty years.

In the midst of the market’s angst, energy has taken meaningful hits (as this commentary goes to print, front month WTI during July has traded as low as $95/bbl and as high as $110/bbl, with the S&P1500 Energy benchmark falling an additional -7.4% at its July 6 intraday low, before bouncing +3.7% to the July 7^th close).  Amidst the volatility, the fighter remains in the ring.  Let’s look at the various pieces of the equation.

Energy Macro¹

• Supply is restrained and supportive of strong prices.  Most incremental oil supply datapoints during June were bullish. Libya experienced downtime and saw its production cut in half.  Ecuador had political unrest and saw its production cut in half. OPEC+ did its monthly Zoom call and confirmed an August 2022 supply bump of ~650kbbls/day (of which perhaps 1/3 will actually find its way to the market given the maxed out production levels for many OPEC+ players).  The White House readied Air Force One for a July visit to the Middle East, where the administration can rattle a tin cup and ask for higher production.
• Russia production is down only slightly from pre-invasion levels.  With European sanctions still months away from implementation (later 2022), Russian barrels continue to find their way into the market.  Our base case is for Russian supply to be gradually squeezed out of the market over the next several years as Western consumers find other sources of Trustworthy Barrels. The loudest words are those condemning Russia and advocating for Energy Security, but the economic reality is that few around the globe can handle the price impacts if Russian production is “cancelled” too quickly.
• Energy demand is the big fear factor.  We’ve been talking about the risks of (actual and/or forecasted) demand destruction for the past few months. Taken in isolation, high energy prices risk demand destruction amongst price-sensitive consumers at both the retail and industrial/commercial level.  Although anecdotal, we think this type of demand destruction has been occurring for several months.  With the strong US dollar, anything happening in the US is likely being felt more acutely around the globe.  However, in our opinion, there has been nothing close to the amount of demand erosion that would move the current oil market from tight to loose.  More like an adjustment from very tight to tight.
• Oil at $90 is a reasonable response to rising recession fears.  We have no beef with a nine handle on near term crude.  The economy is slowing, Russia production hasn’t fallen much, China covid remains a wildcard.  Fear is in the air and “risk off” applies even to commodities where the fundamental picture is strong.
• Speed and severity are breathtaking.  If the absolute price of oil is OK, then what’s the big deal?  Rapid selloffs are scary as hell, particularly when accompanied by ugly headlines (inflation! recession!)  And of course, when things start falling and keep falling, the question is when and where does it stop?  And even scarier, will others pile on and make things worse?  Oil fell from ~$122 to ~$108 in 12 trading sessions from June 8^th to July 1st.  Down $14/bbl or -11%…painful, eyebrow raising, but not unprecedented and not panic.  But wallop it another $9/bbl in one session on July 5^th (close to a record move) and now you’re down 19% from the high, the bottom seems to be falling out and even the bulls start to gulp.  All this with oil still at a fabulous price of almost $100/bbl.  But the nagging question remains – when and where does it stop?  when and where does it stop? when and where does it stop? when and where does it stop?
• So…where does it stop?  Acknowledging that price prediction is a fool’s game, this fool will press on with the thought experiment. To assess downside, one must first decide the extent of the economic downturn that is upon us (another fool’s game most likely). Having slept at a Holiday Inn Express last night, we feel comfortable saying this downturn will be 1) worse than nothing (there is going to be a recession/slowdown, Europe cannot escape unscathed from high energy prices and the Russia/Ukraine conflict) and 2) much better than what was seen during covid (2020) or the Global Financial Crisis (2008-2009).  Thus, 2023 oil demand should be somewhere between -0.5% and +1.5%, with slight net global supply additions (+OPEC/+US/-Russia) and inventory remaining below average.  Similar supply/demand conditions in 2021 saw WTI trading at $75-$85/bbl, leading us to believe this is a fundamentally defensible range IF reality and/or sentiment continue to deteriorate.  FYI, 2023 NYMEX futures are currently ~$82/bbl.  If a true financial crisis emerges (which is far from our base case), all bets are off and oil goes to cash cost (sub$50’s).
• So…when does it stop?  Our gut says that this current knife fight won’t last much longer.  Either 1) oil takes another leg down (to the $75-$85/bbl range discussed above), gets cheap and brings out incremental demand and financial buyers or 2) energy data provides comfort.  While investors are likely to churn for many, many months around the macro questions of inflation, recession, global interest rates, hard landing, soft landing, etc., oil markets move quicker.  The next 4-8 weeks should provide enough oil market datapoints to resolve the current price uncertainty.  These include global inventory data (published monthly), Chinese covid-influenced demand (ongoing), Weekly US gasoline consumption (demand implications from lower pump prices), European demand erosion/resiliency/substitution (ongoing) and Russian supplies reaching global markets (ongoing).
• What do we believe?  Following the onset of the Russia/Ukraine conflict earlier this year, our base case moved to $80/bbl WTI through 2026 on the structural underpinnings of Energy Security.  No change to that thesis or price prediction.  Wouldn’t expect any given year to average less than $70/bbl or more than $100/bbl.  Now is a good time to repeat: price prediction is a fool’s game.
• With no underlying supply response, any looser conditions are only transitory.  The 2014-2020 downcycle lasted a long time because supply grew quickly and swamped demand.  The market then took many years to find equilibrium via underinvestment and natural reservoir declines.  If a recession drives the oil market to sloppy conditions and softer price, the recovery period will be relatively speedy given demand’s tendency to bounce quickly following soft economic conditions.
• Natural gas highlights how small changes can have big impacts.  When Russia invaded Ukraine, the global gas market went ballistic faster than Maverick and Penny Benjamin in Top Gun.  US natural gas was pulled along for the ride, rising from the $3’s/mcf to the $9’s/mcf.  Then in early June, an explosion at Freeport LNG in Texas took down 2bcf/day of export capacity. 2bcf/day doesn’t sound like a lot compared to ~100bcf/day of US gas production or to a 50+bcf/day global LNG market, but the ripple effects were dramatic.  The extra 2bcf/day that won’t be exported will take US gas inventories from tight to average. The extra 2bcf/day that won’t make its way to Europe tightened an already tight market.  US gas prices subsequently declined by more than 50%, while European gas (Netherlands Title Transfer Facility or TTF) has doubled.  Every molecule matters!  Lest we despair over the 40% correction, 2023 NYMEX at ~$5/mcf is still a healthy price.

Government Commentary

• In hindsight, June was “peak pain” for politicians and gasoline prices.  As Americans readied for summer vacation, the US national average for gasoline hit $5.02/gallon on June 14^th (source AAA).  This resulted in 1) a letter from President Biden to oil refiners (Exxon, Chevron, BP, Shell, Marathon Petroleum, Valero Energy and Phillips 66), 2) a closed-door session between Energy Secretary Granholm and refining executives, 3) a call for Congress to suspend the Federal gas tax (which hasn’t yet happened), 4) a discussion of the suspension of state gasoline taxes, 5) a revival of windfall profits tax discussions and 6) whispers of crude and/or product export bans.
• Political attention directly correlated to gasoline prices.  Regardless of the veracity of the arguments, political risk arises from political scrutiny.  If gasoline had continued its upward push during July, who knows what actions could have been unleashed.  Fortunately for all involved, recently lower oil prices will translate to lower gasoline prices and allow politicians to quickly claim victory in front of midterm elections and move on to other topics.  Lest we get complacent, despite the current heavy tape, the gasoline gouging narrative has at least a 50/50 shot of resurfacing, particularly if Russian supply disruptions were to accelerate.
• Gasoline station facts.  In the midst of rhetoric, we’d like to provide some facts regarding the “price gouging” refiner narrative.  According to the National Association of Convenience Store Owners, there are 145,000 gas stations in the United States. Fewer than 8,000 of them are owned by companies that refine crude oil (<6%), while 87,000 of them are controlled by one-station owners (~60%).  Competition is alive and well in the US gasoline market.

Industry Actions¹

• No change to E&P capital discipline. Oilfield service inflation is pushing 2022 capital spending budgets toward the higher end of initial guidance, but there have been almost no upward spending revisions focused on increased organic production growth.  The playbook of returning capital to shareholders continues, e.g., Diamondback Energy boosting its commitment to 75% of free cash flow from 50%.  We note this type of program doesn’t preclude higher capital spending (the free cash flow commitment is after capex), but the implicit commitment to discipline is noteworthy.  Recent oil price volatility, combined with economic and political uncertainty is likely to reinforce the framework of capital return vs. higher reinvestment.
• Share repurchase activity and/or Q2 commentary will be important.  With energy stocks down 20-40%+ in the past six weeks, investors will be paying close attention to share repurchase activity and guidance.  Companies that fail to express confidence in their share price at perceived “value” levels will almost certainly underperform the peer group.  It’s put-up-or-shut-up time in energy land.
• Continental Resources take-private offer contains multiple messages.  In mid-June, billionaire Harold Hamm made a take-private offer for the 17% of Continental Resources (CLR) he didn’t already own.  By our math, the $75/share offer was ~4.5x EV/EBITDA at $70/bbl or ~2.5x EV/EBITDA at the prevailing June 14^th commodity price strip.  Why make this move?  It is a given Mr. Hamm felt the stock was too cheap relative to his assumption of forward conditions.  Perhaps he is an oil bull and wants to capture the incremental future cash flows the market is unwilling to value.  Perhaps he felt the benefit of a public currency (for consolidation, executive compensation, etc.) was outweighed by public company costs and annoyances.  Perhaps the capital-return shackles of being a public company were too constraining and a new playbook was more attractive.  As a private entity, Continental could join the have-your-cake-and-eat-it-too crowd of large private companies that have accelerated drilling over the past year – enjoying both volume growth and strong commodity prices.  Whatever the reason, the message was clear, Mr. Hamm felt the public markets were undervaluing the business. He’s probably right.

For The Love of God, Talk About Stocks Already¹

• Just like it does over and over again, the market is once again forcing investors to “make a call” with incomplete information.  From the June 7^th high to July 6^th close, the S&P1500 Energy Index fell 26%, while the E&P and oilfield service sectors both fell 33% (XOP, OIH).  A much more significant correction than the -17% downtick in oil in the same time period.  Think back to energy stock discussions in 2008-2009 and 2020.  Now replace the words “covid” or “global financial crisis” with the word “recession”.  Things were much harder during covid.  But it is the same question.  How soft for how long?
• What are stocks discounting at current levels?  When commodities are turfing (if we can actually call a correction to $95/bbl “turfing”), we fall back to E&P Net Asset Value (NAV).  We take a company’s asset base and blow down the reserves using a flat price assumption.  We tweak the commodity price assumption until the cumulative discounted cash flows approximate the company’s current enterprise value.  We then compare that implied commodity price against our own assumptions, NYMEX futures curves and consensus expectations.  Today’s stock prices discount something under $60/bbl and $3/mcf long-term. This is cheap compared to the ~$76.50 monthly average NYMEX price through 2026 (particularly with the lowest point on the curve being ~$66.30/bbl at December 2026).
• Cheap does not inherently mean trough.  “Cheap” stocks can get even cheaper.  It happens all the time.  IF oil makes another meaningful move lower, stocks will almost certainly follow.  Legendary investor Stanley Druckenmiller says: “I never use valuation to time the market. I use liquidity considerations and technical analysis for timing. Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction.”  Fortunately for our thesis, in addition to being cheap, the benchmark S&P1500 Energy held its 200-day moving average, as did the E&P heavy XOP and front-month WTI.  Oilfield services…not so much.
• Our macro-economy/commodity view forces us to see the current energy stock pullback as overdone.  With a base case scenario that incorporates an economic pullback, but no crisis, we are hard-pressed to believe that oil will average less than the $60/bbl implied in stock prices.  Either commodity markets are too bullish or energy stocks are too bearish…or perhaps commodities are too cautious and energy stocks are way too cautious.  Either way, we like the stocks here, particularly given the balance sheet repair that has occurred across the industry over the past several years.

June and early July have been the first real conviction test of the current upcycle.  The sharp-down move in commodities has been spooky, even though absolute prices are quite healthy.  An economic slowdown does not change the story of tight oil/gas supply/demand with an Energy Security underpinning.  Therefore, we grit our teeth, cinch our belt, high-grade our portfolio and stay the course.  Energy’s risk/reward remains compelling.

Please remember the PEP organization is standing by to help – whether it be investment exposure, capital needs, energy market intelligence or help with a specific problem. As always, we appreciate your interest and welcome your questions.

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