Energy Industry Update

 

Throughout the summer, the oil and gas industry has been in a steep decline. Both WTI and Brent have been down since the end of the spring semester, with Brent falling from a high of $74 in April to its current price of $60, and WTI falling from its high of $66 to its current price of $55. The reason behind the drop in oil prices is supply build-up; the US has been ramping up production steadily for all of 2019, which didn’t hurt prices until the US stockpiles began to grow dramatically. Signs of a global demand slowdown in the energy market heightened investor fears of the ever-encroaching plateau of oil and gas.

Political dealings have also played their part in exacerbating the drop in oil prices-- with the first political issue being the heavy tension between the United States and Iran that made headlines over the summer, resulting in higher than usual volatility in the oil market. As the conflict with Iran promised increased scarcity, oil prices continued to drop. This culminated with a sharp sell-out in the market upon the president seemingly forgetting about Iran and all parties just moving on. The second important political issue affecting oil prices would be the heightened fear of both the US and China entering a recession on account of the trade war. Uncertainty about the future of demand from such large players in the oil space has caused investors to be more sensitive to stockpile increases than they would have been given no trade war.

On an industry-specific note, Independent E&Ps are beginning to feel a crunch in the market. Historically, independent E&Ps were viewed as the startups of the energy industry; investors placed little emphasis on the financial health of the company and focused purely on whether or not production was increasing. However, more recent market movements have signaled a move away from that perspective on independents. Contrary to current market trends, whether or not the business had a positive free cash flow was generally ignored, and valuations like NAVs were king as they provided simple predictions for future production. Now as worries of demand slowing grow, the company with the lowest breakeven will be the company that earns the most, and as many Independent E&Ps have breakeven prices over $70 which is highly unsustainable in the current climate.

Interestingly enough, oil indicators seem to point to an upward trend in the near future. WTI has recovered from its price of $51 three weeks ago to its price of $55 now. The WTI futures market has shifted into backwardation, with the difference between the first month and fourth-month contract being positive. This backwardated market shows a tighter and more liquid market for WTI than there has been for the past year. Increased trade activity may be a sign of investors thinking more positively about the commodity. Another driver for future performance is the WTI and Brent differential. The differential has declined rather sharply over the summer from its price of $10 three months ago to its current price of $5. This lessened differential will slow down imports which can be seen in the US crude inventory. This decrease in imports is going to have a larger effect on US inventories once it is combined with the fact that the Permian basin pipeline capacity is set to drastically improve as we head into 2020. This will thus lead to a positive feedback loop, with fewer imports reducing the differential and the reduced differential reducing imports.

To take advantage of this future potential export increase, it would be wise to invest in the leaders in Permian production, such as XOM and CVX, as well as the companies that will be providing the increased pipeline capacity shortly such as TRP. However, it is important to note that while the signs may seem to be overly positive currently, if the differential was to tighten further or possibly reverse to a point before the shale revolution (potentially due in part to many Permian players going out of business in a lower-priced oil environment), then the exports will drop significantly.

By Silvio Pantoja - Energy Sector Director, Baruch IMG