“If something cannot go on forever, it will stop” – Herbert Stein’s Law
Guest post by Isuru Seneviratne, Founder & Portfolio Manager, Radiant Value Management. Isuru has specialized in energy sector analysis and investing since 2004. Visit www.radiantval.com for more information on the author and firm.
Oil prices have been under pressure ever since Saudi Arabia stopped regulating the market in the fall of 2014. The consensus view has become that the oversupply will persist for many years. However, the underlying cause of oversupply was overinvestment, which is quickly reversing. Here we analyze the supply dynamics of oil, which provides a third of global primary energy consumed.
The key to bargain hunting in today’s energy markets is identifying the businesses that remain profitable even at low commodity prices, while retaining upside to long-term trends in the energy markets. Well capitalized companies with exceptional low-cost assets will not only survive this downturn, but will emerge stronger on the end of the tunnel. Even in today’s market where outside capital is limited and expensive, a rare subset of companies will be able to self-finance growth. On the other hand, banks lend to oil companies based on the value of their reserves, which are reevaluated biannually. As indebted producers will see the rug pulled out from under them in fall 2015, we expect many companies to continue hurting.
Boom and Bust: Investments and Production
Elevated commodity prices and the emergence of newly accessible sources led to record inflows of capital into the energy and resources (E&R) industry. A Deloitte global study of 39,273 publicly listed companies in nonfinancial industries found that E&R raised more than $1.5tn between 2009 and 2013, the biggest issuer of net new capital. Oil and gas (O&G) sector accounted for $850bn of this capital. These companies invested in exploration, drilling and field maintenance, at a peak rate of $900bn in 2013. Part of this investment increased annual crude oil production during that period by 5.5 million barrels per day (mnb/d), compared to 94 mnb/d 2014 global supply, laying the foundations of today’s glut.
U.S. fields alone accounted for nearly 60% (3.3 mnb/d) of that production increase, and surged a further 1.5 mnb/d during 2014 due to the shale oil boom. North American independent O&G producers delivered resource capture in geopolitically stable jurisdictions and promised consistent high production growth. Smitten investors kept piling on capital even after commodity prices declined. According to Moody’s, in the first half of 2015, 57 energy producing companies raised $21bn in new equity, and 58 more issued $73bn in new debt. However, there has been a sharp downturn in outside capital, with Dealogic showing equity offerings of $333mn in August, a tenth the average monthly rate in the first half of 2015.
UBS tallies U.S. energy industry outstanding loans at $1.2tn, with a third held by exploration and production companies. As this debt is coming due, operating cash flows are plummeting. For the top 44 U.S. onshore producers that lead production growth, debt repayments amounted to 83% of operating cash flow during the year ending June 30, 2015. As the energy bond market collapsed, refinancing has become increasingly expensive. Even when banks are accommodating, regulators are pressing for exposure reduction.
In today’s low-priced, cost-focused, and highly competitive market environment capital is the biggest lever of adjustment. North American producers have been forced to reduce capital outflows by 40% this year. It has taken longer than expected for shale momentum to slow down, but U.S. production has declined 0.5 mnb/d from the April peak of 9.6 mnb/d.
Despite the price slump, production pre-sold at much higher prices helped companies keep pumping. U.S. producers typically hedge 50% of their projected annual oil output, but most are heading into 2016 with merely 15-18% of expected production covered. As revenues drop with hedges rolling off, producers forced to live within the resulting low cash flows will struggle. Another factor aggravating oversupply has been the stellar efficiency gains of shale. Despite the number of active rigs being cut in half year-over-year since March-April 2015, production has remained buoyant. Desperate for business as utilization fell, oilfield service providers have been furnishing their services at low or no cash margins. Many will be unable to maintain their equipment in good order, and some will go bankrupt. Therefore, when service providers have to retool as activity returns, such cost reductions are at risk of reversal.
All eyes are on U.S. production and productivity: with the shortest span between investment decisions to production, onshore shale has become the new ‘swing production.’ Thus, shale oil is presumed to be the marginal barrel of production.
Global Declines and the Marginal Barrel
Non-OPEC, non-shale ‘rest-of-the-world’ (ROW) fields produce ~50 mnb/d (54% of global total). As reservoir pressures drop, production from all petroleum wells naturally declines. ROW oil producers need to replace on average between 5% and 8% of output each year just to keep production flat. Due to sanctions on much needed capital equipment and technology, the decline may be greater for Russian production (10.8 mnb/d, or 12% of global total). On average, we expect ROW production to decline 2.5-4 mnb/d each year. While shale production (presently ~4.5 mnb/d, 5% of global total) will fill some of this shortfall, at $60 a barrel there is simply not enough to fulfill this future demand. Thus, in the long run, North American shale is not the marginal barrel.
With long permit-mobilize-develop cycles (sometimes up to 10 years), ROW projects already underway have been adding barrels into today’s oversupplied market. However, the number of ROW drilling rigs has fallen 20% since last summer, and this accelerating downtrend is not easily reversible. Rystad Energy survey shows 2015 oil company budgets are down by $180bn, or 21%, year-over-year. Spending for 2016 could be down a further 15%. Goldman Sachs has identified more than $750bn capital projects, corresponding to 10.5 mnb/d peak production, as uneconomic below $60 a barrel. While a significant production shortfall may not be apparent before next year, deep cuts to capital spending are setting the industry up for a strong up-cycle thereafter. The longer commodity prices stay low, the higher the risk will be to the upside.
Geopolitical Risk and the Lack of Spare Capacity
There is no geopolitical risk premium on oil at a time when many producing regions are destabilizing. While physical extraction of oil is cheap in OPEC countries, Exhibit 1 above maps the per-barrel threshold needed to balance the budgets of petro-states. At lower oil prices, these countries have to severely cut fiscal spending or burn through reserves. However, Middle East-North African countries struggle to reduce social spending post Arab Spring. Furthermore, under the 30-year-old Defense Minister and son of the new king, Saudi Arabia is flexing its muscles as regional rival Iran reemerges in the global stage. When sanctions are removed, Iranian production will add 0.5-1 mnb/d from mid-2015 levels to 3.5-4 mnb/d during 2016, contrary to market fears. Major investments are necessary to maintain this level of production, let alone to expand beyond. Iraqi infrastructure has been dilapidating, needing up to half a trillion dollars of investment, compared to zero at present.
When OPEC last experimented with flooding the market for share in 1986, the world had over 10 mnb/d of spare capacity (20-25% of consumption), compared to a historically low 1.1 mnb/d (1% of global consumption) today. Any natural or geopolitical disruption to supply would severely strain the market. Another key difference between the supply shock of the 1980s and today is the unprecedented capital flexibility of shale, which will balance the market much sooner.
Disclaimer: This material does not constitute an offer or solicitation to purchase an interest in any vehicle advised by Radiant Value Management, LLC (the “Adviser”). Such an offer will only be made via a confidential offering memorandum or other applicable offering circular. Alternative investments are speculative and are subject to a risk of loss, including a risk of loss of principal. There is no secondary market for interests in any vehicle sponsored by the Adviser and none is expected to develop. No assurance can be given that any alternative investment product will achieve its objective or that an investor will receive a return of all or part of its investment.
This material contains certain forward-looking statements and projections regarding the performance of certain projects and markets. These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described. These forward-looking statements will not be updated in future.
1 Deloitte University Press – Following the capital trail in oil and gas, 10 April 2015
2 Wall Street Journal – Oil Patch Braces for Financial Reckoning, 16 September 2015
3 Wall Street Journal – Energy Lending Caught in a Squeeze, 23 September 2015
4 Rystad Energy – The oil and gas industry is cutting investments by 180 BUSD in 2015, Canada oil sands and LNG is most
30 July 2015 http://www.rystadenergy.com/AboutUs/NewsCenter/PressReleases/capex-reductions
5 BloombergBusiness – Iran’s Oil Investments Shrink to ‘Almost Nothing’ on Crude Slump, 25 August 2015
6 Bloomberg TV – Oil Guru Who Called 2014 Slump Sees a Return to $100 Crude, 20 July 2015