The fundamental conditions for the energy sector have generally improved over the past year. In particular, we believe that two factors—the price recovery of West Texas Intermediate (WTI) due to worldwide production cuts and an increase in sustainable efficiencies by oil producers—have led to improved fundamentals for energy stocks.
Oil -price recovery is supported by production cuts.
Compliance with planned production cuts by the Organization of the Petroleum Exporting Countries (OPEC) is exceeding 100%, aided by strong Saudi Arabian support and dramatic production drops in several countries, including Venezuela. The International Energy Agency (IEA) expects OPEC production to grow only 0.1 million barrels per day (MBD) annually through 2023.
Additionally, the potential for U.S. sanctions against Iran and Venezuela has increased. This would make it difficult for Venezuela to recover production and lead to tensions in the Middle East, both of which would likely increase prices.
In the United States, despite a 150% increase in the rig count since the beginning of 2016, WTI inventories actually declined in the first quarter of 2018 for the first time since 1996.
Substantial sustainable efficiencies have resulted in improved capital returns at much lower prices.
While some service-cost inflation is expected, it has yet to appear and will likely be very manageable. Increased capacity will keep it subdued, which benefits producers.
Drilling times continue to shrink as the oil industry has moved well along the learning curve. Improved completion formats, primarily meaningfully more proppant, have increased well productivity.
Merger and acquisition (M&A) activity also has the potential to create efficiencies.
Long-awaited public M&A—including a $9.5-billion stock transaction that would create one of the largest unconventional shale producers in the Permian basin—has just begun.
But smaller bolt-on and acreage-blocking trades—which allows companies to barter their way to more territory without frittering away cash—have been ongoing.
While cost savings in these types of transactions are modest, efficiency gains can result. First, companies gain the ability to do longer lateral drilling (reaching oil resources that are not located directly beneath the well itself). This has the potential to drive returns higher as a typical 10,000-foot lateral costs only 1.40 times more than it costs to drill a 5,000-foot lateral but can offer returns that are typically 1.75 to 2.00 times higher. Additionally, infrastructure savings also appear robust. So, we expect more of this activity, particularly in the Permian Basin.
A Focus on Returns
The industry is clearly more focused on returns. While some cash-flow outspending continues, buy-side demand for a more return-focused approach has taken hold. Furthermore, leverage ratios are in substantially greater shape than when WTI fell to $26 in 2016.
Stocks have decoupled from the price of WTI despite its move to the mid $60 range. In 2017, WTI was up 12.5% while energy stocks were down 5% to 18%, depending on the benchmark. That has continued through the first quarter of 2018, when energy stocks were down 7% to 11% despite a 5% increase in WTI combined with a healthier forward curve. Our view is that this cannot persist in perpetuity.
Where To From Here?
OPEC production cuts will not last forever, but the International Monetary Fund (IMF) estimates that the Saudi Arabian breakeven oil price is $70 per barrel, and higher prices are critical to the country achieving its social, economic, and financial reforms.
Furthermore, the tight labor market and infrastructure challenges (primarily in the Permian Basin), combined with the new-found focus on free cash flow, should keep U.S. production more in check than the market expects.
As a final note, gas is challenged, but producers with significant Natural Gas Liquids (NGLs) exposure look attractive given the price correlation of NGLs with WTI. We believe 2018 will be the most prolific year of natural gas production in history due to associated gas in the Permian Basin. This has kept a lid on gas pricing and forced the forward curve down.
David Mitchell, CFA
Partner & Portfolio Manager