Will the most soul-sucking, emotionally draining, gut-wrenching, never-ending, stress-inducing oil trade in history be worth it in the end?
After nearly four years of immense volatility and frustration caused by a constant bombardment of new worries, ranging from demand destruction due to mass electric car adoption, improved U.S. shale well efficiencies, a resulting “new normal” break-even oil price of US$40 per barrel, a dynamic OPEC production policy, and trade disputes, that is the question that energy investors around the world find themselves asking.
The oil price action over the past few years has been wild. After trading at US$100 per barrel for three years between 2011 to mid-2014, it cracked in late 2014 following a historic move by Saudi Arabia to shun their role as the global swing producer. Falling to a low of US$26.05 per barell in February 2016, the price of oil has now rallied by 165 per cent (146 per cent in CAD terms) from the lows to US$70 per barrel.
At this current price, many Canadian oil stocks are trading at less than half of their historical multiples and at free cash-flow yields of 10-20 per cent.
What will it take for energy stocks to start performing better and reclaim part or all their lost historical multiples?
The energy sector needs buyers, and for this to happen two beliefs must become adopted as consensus.
First, oil must be in a higher trading level for the next several years due to robust demand growth, curtailed U.S. supply growth, exhausted OPEC spare capacity and falling non-U.S./OPEC supply growth. Second, oil companies will not squander their financial prosperity through aggressively increasing their capital expenditure programs and erode the many efficiency gains made during the downturn, but will instead focus on profitability and ultimately return on capital (i.e. dividends and buybacks).
We have for almost two years written about why oil is in a multi-year bull market, and why we believe oil could trade above US$100 per barrel in the next year to two. Slowly consensus has been catching up to us, and headlines like these were becoming – up until one month ago – increasingly common, signaling an important shift in sentiment. But it has shifted abruptly negative over the past two months.
U.S. president Donald Trump’s tweeting tirade flamed worries about a global trade war, and with it concerns about a global economic slowdown. Chinese oil consumption data from a few months ago seemed to back up these worries, while at the same time Turkey’s currency crisis became front-page news and ignited new worries about contagion within emerging economies.
In June, OPEC and Russia increased production by about 1 million barrels per day, bringing output closer to 100-per-cent compliance with its historic and effective production cut. While it is impossible with certainty to speak to the outcome of the trade discussions, we can with some confidence speak to why inventory drawdowns will accelerate in the coming months.
In recent weeks, despite very strong underlying product demand as exemplified by the highest U.S. refinery utilization for this time of year since 2001, U.S. crude oil inventories have been building primarily due to a drop off in exports. The reason for this has been reduced Chinese buying. U.S. production growth is also about to hit the wall as Permian incremental pipeline capacity now amounts to only 100,000 barrels per day with no relief until early 2020.
More holistically, the pace of OECD inventory drawdowns has been lessened somewhat by the factors mentioned above as well as the short-term impact of OPEC production growth as Venezuela and Iran being outweighed by Saudi, UAE, Iraq, and Russian growth. We continue to forecast that OECD inventories will reach their lowest level in history in late 2020.
It is very conservative in this estimation, assuming that demand growth rates will fall, the U.S. will grow production by 1MM Bbl/d in 2019, only a 1 million barrels per day Iranian export reduction and that Venezuelan oil production will only fall a further 200k bbl/d. The net result is the oil market remains undersupplied to the end of 2020. One theme that will become a dominant headline in 2019 will be the exhaustion of OPEC spare capacity. Given the 800,000 barrels per day increase in OPEC production over the past three months, much of the latent production capacity has been used up. The highest collective level for OPEC production over the past 2.5 years is 35.1 million barrels per day.
To put 1.1 million barrels per day of “real spare capacity” into a global context oil demand today is around 100 million barrels per day and demand is growing this year by about 1.7 million barrels per day . Therefore, total OPEC spare capacity likely amounts to only 1% of global production when one accounts for the countries that have “theoretical” but not “real” capability to regain their prior highs in the next year or so.
At the same time, it is highly plausible that Venezuelan production could fall a further 500,000 barrels per day by the end of 2019, production has been falling 40,000 barrels per day per month for the last 20 months, which would effectively eliminate 45 per cent of the “haves” spare capacity.
Investors need to see, through the action of executives and Boards, that there is a reason to be invested in energy stocks when every other sector on the planet feels like they are making new highs and making people rich overnight (ie. pot stocks). Buybacks are critical to regaining investor attention.
Given the widest dislocation in history between the current oil price and oil stocks we are extremely bullish on the outlook for outsized returns (eventually). In fact we had thought 2018 would be the “year to get rich” but this has been deferred by:
1) Trump stoking worries (via twitter) about global trade wars 2) NASDAQ stocks and pot stocks continuing to steal mind share away from the energy sector 3) Confusion about the OPEC+Russia production increase and what it meant for the supply outlook 4) Demand worries due to emerging market volatility
As we look to 2019 we see a world in which:
1) OPEC is largely out of spare capacity and therefore Iranian export reductions will likely exceed OPEC’s ability to add incremental barrels;
2) Venezuela continuing to decline by another 500,000 barrels per day;
3) The United States being growth constrained due to pipeline congestion until 2020;
4) Non-OPEC/US production growth hitting a wall due to the largest collapse in history in spending on long lead mega projects from 2014-2017;
5) The consequent continuation of inventory drawdowns to their lowest level in history while demand hits its highest level in history.
It is only a matter of time until the market realizes that the oil market is heading towards a multi-year chronic undersupply. At that point stocks that have lagged the commodity by over 50 per cent can easily double (or more).
Given this outlook our largest exposure is to long life, higher cost oil producers which naturally brings us to the WCS exposed Canadian heavy oil stocks.
We have meaningful positions in MEG Energy Corp. (MEG-T), Athabasca Oil Corp. (ATH-T), and Baytex Energy Corp. (BTE-T).
Despite near-term headwinds with WCS differentials blowing out to US$30 per barrel recently (down to $23.7 now) and a highly unexpected decision by the Canadian Federal Court of Appeals that invalidated the 2016 approval of the Transmountain Pipeline project we believe that each of these names offers us over 100-per-cent-plus upside potential over the next year.
Sentiment towards WCS exposed names (and Canada for that matter) is very poor, as Canada has struggled to get a pipeline across the finish line and rail companies have been slow to increase adequate capacity. As a result, takeaway options are maxed out and with production increases from 2 oil sand projects this year the WCS differential has widened to a multi-year high.
The time to buy is when sentiment is at its worst (and when stocks are discounting $25-plus per barrel long-term differentials, which is 50 per cent above rail economics) and we see several potential catalysts which should narrow the WCS differential in the next year.
To summarize, the oil macro backdrop is overwhelmingly bullish. Demand continues to grow while supply is curtailed by the U.S. running out of near-term pipeline takeaway capacity in its dominant growth engine, OPEC has exhausted most of its spare capacity, and Iranian export reductions are finally occurring with September exports down by 800,000 barrels per day in three months, and could easily dwarf remaining OPEC spare capacity.
Valuations within the energy sector have simply become too insanely cheap to ignore for much longer. We are witnessing companies announce buybacks for more than 10 per cent of their shares outstanding, using excess cash flow. At a time in the not-too-distant future, we will look back on today as what was likely the investment opportunity of a lifetime even though in the moment it sure doesn’t feel great.
Despite the heartache, the frustration, and the disappointment in the poor performance of energy stocks over the past several years we shall be rewarded with exceptional gains. At that point we will look back and say, “Yes, it was worth it.”
For an expanded version of this commentary, click here
Eric Nuttall is a Partner and Senior Portfolio Manager at Ninepoint Partners. Eric oversees the firm’s Energy investment strategies. Prior to Ninepoint’s formation, Eric was with Sprott Asset Management from 2003, more recently in the role of Senior Portfolio Manager of the Sprott Energy Fund (since March 2010), the Sprott Small Cap Equity Fund (since May 2014), and the Sprott Energy Opportunities Trust (since December 2016). Eric was named one of The Canadian TopGun Investment Minds Class of 2017.