after the brutal sell-off, are E&P stocks a buy?

The 10% selloff in energy in the past three weeks doesn't seem so bad in comparison to the 7.5% decline in oil prices, but of course the equities had been declining faster than oil in the last weeks of September.  The Marcellus gas producers have held up particularly well, but that may be partly because of the Chesapeake sale to Southwestern of their southern Marcellus assets, which went for a nice price.  Oil producers in the unconventional plays need a relatively high price to make money.  Marcellus gas producers don't, or they'd be out of business.

If the oil price was going to stay where it is there are a number of decent buys out there, but why can't it fall further?  Supply has to come off the market or demand has to increase.  The market must be balanced.  The US seems to be doing its part on the demand side if booming SUV and pickup truck sales are any indication, but the auto industry on the whole is moving towards more and more efficient vehicles, and that doesn't seem to be changing.  China, the source of the biggest demand growth, appears to be slowing. Demand in oil tends to be very inelastic in the short term, so it is hard to see demand increasing and balancing the market in the short term.

On the supply side, we are now getting into earnings seasons, and it will be interesting if we hear about capex cuts in North America.  Due to the fast decline rates in unconventional, the production would certainly fall fast if they pulled back on capex in a significant way, but recently production has been growing with flat capex spending due to increasing efficiency by the drillers.  Many of these companies are hitting on all cylinders now, and I doubt we see them pull back unless the price goes down further.  They might talk up their willingness to cut capex in the event of a big price drop, but I bet most are taking a wait-and-see attitude for the moment.

We also have the November 27 Opec meeting.  Opec has a lot of competing interests now.  Nearly all the Opec countries are heavily reliant on oil revenues for their budgets.  But a few countries, like Venezuela, Iran, Libya, and Iraq, may be at risk of political collapse with prolonged oil price declines.  The situation in Algeria, Nigeria, Angola or Ecuador I don't even know enough to casually speculate about.  Russia (they are not an OPEC member) might be vulnerable to a severe economic collapse in a very big price drop scenario as well, especially given the western sanctions.  But many of the gulf states, like the Saudis, Kuwait, Qatar, UAE might be able to weather a rather long period of low prices, and if it derails US unconventional, Canadian oil sands, and deepwater to any extent, then that will put them in a stronger position for the long term.  If it causes a political crisis in Iran, then so much the better for the Gulf Arabs.  If I was in their position I might want to give the non-opec oil producers a good sweat, just like any prudent would-be monopolist, before balancing the market.  It will be interesting to see how they act.

weekly prices and other stuff

After a series of horrendous weeks in energy, last week was the worst yet.  The S&P was only down .75% for the week after Friday’s rally, but E&P stocks were down 5-6% on average.  Bakken companies were nearly totally correlated: down between 7, and 8.1%.  Whiting Petroleum now trades at 11x next years estimates and a 3.7x EV/EBITDA, and this for a company growing at a steady 30% CAGR for many years.  These estimates will likely come down with the retreating oil price, but the current $90 trading level for WTI certainly does not justify the fall in price over the past few weeks.  The declines are only rational if we believe the price will continue to fall, which unfortunately I do.

I find myself conflicted.  

The E&P companies I now own shares of, EOG and WLL, have both had phenomenal execution, and now trade at very low multiples.  On the other hand I have no confidence at all in the oil price.    But for now I am still resolved to hold these through earnings season. 

As a bit of an aside- on Thursday I also bought American Airlines stock amid panic selling that some attributed to the Ebola case in Texas.  In general, airlines have an inverse correlation with oil because fuel cost is over 30% of operating costs in a very thin margin business.  But this is only part of the reason I’ve bought AAL.  Along with E&P stocks, airlines are also extremely high beta, so they can become correlated with energy in the context of a general risk-off situation.  Airlines have also been selling off since July, and they tend to be extremely seasonal.  You never want to own shares in July and August, and they usually do very well in October through December.  Part of this may be because wall street tends to go on vacation in August, and it is hard to enjoy a vacation when you are holding airline shares.  The other reason to own them is that they are trading at 5.5x next year’s earnings estimates.  They might get to put a huge tax asset back on the balance sheet later this year.  I just mention this in passing, as I mentioned my CF fertilizer position earlier (which has not changed), because it is a trade that is energy related.

Saudi price cuts- the sell off continues

Saudi's sent a strong signal to the market by cutting their prices today.  An OPEC supply cut could make prices rebound strongly, but their meeting isn't until November 15.

Both US Crude and Gasoline inventories declined in the EIA report from yesterday but this has failed to slow the collapse in prices.  This is being compounded by the general market selloff and the failure of ECB to come to the rescue with QE.


Besides the shocking declines in the E&P stocks I would also call attention to the drill ships.  Both low and high quality drill ship companies are selling off as badly as the E&Ps or worse.  Transocean is down by over a third since its July peak.
 

Always volatile low-quality drill ship company Transocean (of BP-Horizon fame) is now selling at 1/2 book value.

 Higher quality Ensco is also dropping like a rock.

Schlumberger, the premium oil-service name has held up quite well, off only about 10% so far.

The oil majors have also pulled back by 10-20% off the highs.

I'm considering selling EOG, which is off by about 7% since I bought it only in August.  This would leave me with only WLL left.

With an OPEC rescue off the table for a little while at least, and inventory declines doing nothing to arrest the strong downward trend in prices, one last hope could be a short term rebound in the dollar, which has been strengthening for months now.  Lack of QE in europe might lead to mean-reversion for the dollar, and a weakening dollar is always supportive of oil prices.  The dollar has strengthened from about $1.39 to the Euro in May to about $1.26 today, an incredibly big move.

Trading positions review

I wanted to go over all my positions today.  I decided to sell out of APA today, with the continued deterioration in oil prices.  I am now only holding WLL and EOG, of which WLL is by far the larger position.  On the one hand I hate to be selling during such a strong pull back, but on the other hand it just feels to me like there could be quite some ways to go on the down side.

Chesapeake Energy (closed out):

I really should never have touched Chesapeake.  This is a company that is still recovering from the overly adventurous management of CEO Aubrey McClendon.  I still intend to do a post on CHK at some point, since it is a fascinating company.  Overall the trade wasn’t as disastrous as it might have been, since they did spin out seventy seven energy, which is worth about $1.58 per share at current trading prices.  Including the spin-out I netted 5.5% on CHK.  Had I held it I would now be badly underwater, with shares currently trading at $22.99 as of today’s close.  So on the one hand, I never should have bought this, but on the other, at least I ended up in the black by a bit.

Apache (closed out):

Overall this was a decent trade, with a 22% return not including dividends.  I bought it fairly well, and time will tell whether it was sold well.  I would certainly look at buying it back if we get a pullback or I regain some confidence in oil prices.

EOG (open):

I should have held off for longer, but this is a stock that I have wanted to own for a long time.  I may reassess after earnings.  The current position is relatively small.  I consider EOG to be the best managed oil large-cap E&P.  The chart does look ugly though.

 Whiting (open):

Whiting is by far the bigger position of the two remaining, at about 3x the EOG position.  I should have taken some off the table, as it has now pulled back off the highs by about 15%.  I intend to hold this through earnings on October 22 and then reassess.   Overall I'm still pretty deep in the black with a 38% net gain compared to the average acquisition price.

A few comments on oil prices going forward

I think there are two separate reasons for domestic oil producers to be nervous about the price of oil going forward.  There are two commonly traded oil price benchmarks that are the most heavily traded on the futures exchages.  West Texas Intermediate (WTI) is priced in Cushing Oklahoma and traded on the NY Mercentile Exchange.  This was historically the most important benchmark, but due to wild fluctuations in WTI most of the major producers have switched to Brent, a North Sea grade which is traded on the ICE exchange in Europe.

The WTI-Brent spread (the price difference between the two grades) had usually been +/- $3/bbl or so until 2010.  Please ignore the "QE2" marker on here which really has little to do with the spread.  I just used this chart because it is otherwise very nice.  In 2010 it grew due to production growth in the Bakken and Permian Basin regions, both of which had pipelines that fed Cushing Oklahoma, where there were several refineries.  So much crude was going into Cushing, but there was no effective way to get it all out and down to the mega refineries on the Gulf Coast of Texas and Louisiana.  This oversupply caused depressed prices relative to seaborn grades like Brent.

So recently two things have been happening.  The spread  has been collapsing, and is now only $4, down from highs of as much as $25.  I think a big reason for this is that the logistical constraints that created the spread have been largely alleviated by new rail capacity, and to a lesser extent new pipelines.  The collapse of this spread has been good for producers and bad for refiners.

The second thing that has been happening is the collapse in the Brent price.  Brent has been in freefall over the past few months, despite major turmoil in the Mid-East, which has historically been good for a supply scare.  Demand has been surprising to the downside and supply, mostly from North America, has been surprising to the upside.  US crude production was 8.6mm bbl/d in August, and EIA is now projecting 9.5mm boed average for 2015.  The US really does have a shot at becoming the number one crude producer in the world in 2016 or 2017.  Meanwhile EIA and other forecasters have been downgrading world crude consumption growth to about 1% per year, which works out to about 1mm bbl/d.  So US projected supply growth will fulfill total projected world demand growth if non-US production stays flat.  Meanwhile there is a whole lot of oil out there that is very economic to produce at prices far lower than the current price.  Libya, Iran, and Iraq all have tremendous capacity to grow output if they were not constrained by political turmoil.   It never pays to underestimate the odds of political chaos disrupting production in ME or Africa, but production capacity does certainly have the potential to grow in that region, even in a period of falling prices.  On the opposite side of the ledger there is Russia, which is currently the largest producer.  Their production has been growing since bottoming in the mid 1990s but is now showing signs of flattening out due to underinvestment.  It could fall further if sanctions are widely expanded.  This is not a very likely scenario, but it remains a possibility.  Even the possibility of sanctions is a disincentive to investment.  The current, relatively mild sanction regime is also keeping the most competent service firms out of the area.

In order to slow production growth the market needs to send a signal to the fast growing American producers to slow down.  Price trends can last for very long periods, because capex cycles are so long.  Breakeven price with a 10% cost of capital is probably around $40-80/bbl depending on the region.  If we do get a fall in price, supply may be somewhat more elastic than in the past because tight-oil capex can be turned on and off remarkably quickly, as was demonstrated in shale gas in 2009.  Tight oil wells also decline more quickly, so declines in capex may be followed by production declines relatively quickly.

And that chart is ugly, ugly, ugly.

Then there is the other potential piece of bad news for US producers.  Although the brent/WTI spread has tightened recently, to their benefit, it is in some danger of blowing out again.  Supply constraints have been effectively alleviated by rail capacity.  But there is a major potential constraint ahead.  The US has now displaced substantially all light oil imports, and it is illegal to export crude oil from the USA.  Now there is still the possibility of "lightly refining" oil and exporting it, as they are currently doing with some condensate (extremely light oil that is in gaseous form in the reservoir).  But this issue may well cause a blow out of the Brent/WTI spread again.  Congress may come to the rescue by passing a waiver to this very outdated law, but one should never count on congress to do anything.

This chart shows how small US imports of light oil are.  For domestic production to displace more imports, it would have to be displacing heavy crudes.  This would require substantial discounting because the US refining system is set up to take large amounts of heavy crude from Canada, Mexico, and Venezuela.   Note that the above chart can give a misleading impression that the US depends on imports more heavily than it actually does.  We are now a net exporter of about 4 million barrels per day of refined products and other non-crude petroleum liquids like propane, so net imports of petroleum products are only about 4.6mm bbl/d (as of June according to EIA).  This is down from a peak of 13mm bbl/d in 2007.

Might OPEC come to the rescue and cut supply?  OPEC supply has been flat, and the Saudi's have been dutifully balancing the market, so a production cut in the short term may well happen.  OPEC really hasn't ever had terrific supply discipline.  The Saudis will balance the market by taking off or adding 1 or 2 million barrels a day, but I'm not sure OPEC can support the price of oil over a long period.  It is always risky to be too short oil during a decline, because it only takes an announcement by the Saudi's to send it back up.  Right now it is also important to note that about 3 mm bbl/d of OPEC capacity is "disrupted" by political turmoil.  If that were to come back online (a big if), it is hard to see Saudis cutting by that much to balance the market.

So far US land Rig Count is Stable - Prices only really started to drop three months ago.  But spot prices have plummeted for drill ships, particularly for deepwater.  Look at the prices of Transocean or Ensco over the past few months.  According to some reports the breakeven cost for deepwater oil is now higher than US shale, although this breakeven price might come in if we have a collapse for day-rates on the rigs, a major factor in deepwater drilling costs.  The sharpest capex cutbacks may come in Canadian oil sands, North Sea, US Gulf deepwater, deepwater Brazil, and deepwater West Africa.  These regions may already be higher cost than tight oil.

So overall, as you can probably tell, I'm a bit nervous on oil prices, and the E&P stocks tracked on this blog all have tremendous correlation with oil.  But I also hate to sell WLL and APA badly.  EIA US production numbers have been great, so I think earnings season could be a positive catalyst for some of these stocks.

weekly prices

It has been a rough two weeks for E&P stocks.  The market, though volatile, is basically flat over the past two weeks.  E&P stocks have been surprisingly uncorrelated with each other, but it has generally been bad.  If it hadn’t been for the big rally on last Friday, this price comparisons would look a lot worse.  There are several reasons to be concerned in the near term about prices, and I'm going to do a post about that in a few minutes.

rough couple weeks in the energy sector

It has been a brutal last few weeks for energy, and I’m not at all sure that it’s over.  Demand has been surprising on the downside, and supply on the upside.  EIA.gov now predicts that oil demand will increase only by about 1mmbbl/d year over year for 2014, while non-opec production will grow by 1.8mm bbl/d.  Amazingly the USA alone is growing production by 1.4mm bbl/d year over year, an almost unbelievable 14.5% growth rate vs 2013.  US production for 2014 will grow more than total world oil demand.

WTI price.

Right now it feels a lot like the beginning of the year, everyone thinks the price will decline.

Increasing the complexity to the situation in the USA, nearly all the new production is light oil, and the US refineries are the most complex in the world, ideal for handling heavy sour oils.  This is part of the reason that crude imports are still relatively high at 8.8 million barrels per day: heavy crudes are still imported, especially from Mexico.  So while the US imports large amounts of crude, some of the refined products that come from it are re exported.  We are also increasingly exporting propane and other natural gas liquids.

This is since three weeks ago.  It is pretty ugly considering that the S&P was basically flat over this period.

I certainly wish I had cashed out some of my WLL after that big run!  I am glad that I sold my CHK though.  I picked up a bit of EOG at 101.32 a few days ago, but I don’t feel particularly good about it.  So my holdings now are WLL, APA, and EOG.  WLL position is about 3x the size of each of the other two.  I would particularly look to add to EOG if it continued to fall.  EOG is the company that I’ve always wanted to own but always felt like I’d be chasing to buy it.