It’s an exciting time to be an energy investor, and at Franklin Templeton we are finding a number of compelling, bottom-up opportunities across regions, energy subsectors and capital structures.
Our macroeconomic analysis suggests that a moderate crude oil supply deficit will become more evident as the year progresses as a result of declining net imports into the United States and refineries returning from scheduled seasonal maintenance; however, we expect the perceived supply elasticity of US production to cap any material price appreciation in the near term.
The OPEC Effect
Since its founding in 1960, OPEC has played an outsized role in the macroeconomic landscape for crude oil. However, rapid progress in the US shale extraction industry in the 2000s changed global industry dynamics by introducing an elastic source of supply that can respond in a relatively short period of time to price signals in the market. As a result, OPEC members find it more difficult to support higher prices without losing market share, as occurred in the early 1980s.
OPEC’s late-2014 decision, driven by Saudi Arabia, to increase production and avoid a repeat of the debacle in the ‘80s—which took 20 years to alleviate—sent crude oil into a bear market that bottomed in early 2016 when oil slumped below $30 a barrel.
The strategy had its intended effect, gutting the marginal North American producers and causing the US oil rig count to fall from nearly 2,000 at the peak of the cycle to 400 last year.1
However, the impact was not contained within the US market as spending outside the United States also contracted significantly. With OPEC member states also feeling the pain from lower prices, the cartel reversed course in November 2016 and agreed to the first coordinated supply cut in eight years.
Furthermore, OPEC persuaded 11 state producers outside of the cartel, including Russia, to voluntarily cut production. These actions, when viewed against a backdrop of relatively stable demand growth, have supported the price recovery to today’s levels.
Will OPEC Production Curtailments Continue?
The near-term issues pertaining to OPEC are the degree to which accordant producers comply with supply cuts, and uncertainty as to whether the agreement will be extended at the next cartel meeting on May 25.
On the first point, slowing imports into Asia—the main recipient of OPEC exports—along with a narrowing of Middle East oil-price discounts, suggests that OPEC supply has indeed contracted, though it’s difficult to confirm the exact magnitude of decline given imperfect reporting mechanisms.
On the second point, the industry is hopeful that current OPEC and non-OPEC production quotas will be extended at the upcoming meeting, and many believe Russia’s participation will be crucial to reaching an agreement on this front.
There appears to be a growing acknowledgment that the significant decline in investment during the oil bear market could lead to an eventual supply shortage, and indications are that OPEC’s current strategy of limiting production is intended, in part, to incentivize investment in longer-cycle projects that will deliver production into the next decade.
What Does This Mean for North America?
The other macro issues affecting the supply side of the oil equation are specific to North America.
The first is recent US Energy Department data indicating inventory builds from historically high levels, which led to a brief selloff in March and has continued to pressure prices in the second quarter. Traders and investors tend to focus heavily on US inventories due to the frequency and availability of the (weekly) data, while most international reports are released monthly with a long delay, and can be very limited outside of the Organisation for Economic Cooperation and Development (OECD) countries.
However, the high-frequency US information is of limited value when it comes to forming a longer-term view, in our opinion, given that it’s based on estimates and can be volatile from week to week. Reasons for continued US inventory builds over the past several months include refinery re-stocking in anticipation of rising prices, a seasonal decline in demand, greater-than-expected refinery maintenance and downtime in early 2017, timing differences between reduced OPEC exports and crude oil deliveries, and the transfer of more extensive floating storage to land-based options.
Rising US Production
US production has also been on the rise thus far in 2017 which, when combined with the other factors mentioned above, has likely contributed to increased oil stores. Turning to global inventories, several of the oil and gas exploration and production (E&P) firms we met with believed OPEC was aiming to move crude inventories back into the five-year range.
While six months of sporadic inventory data is insufficient to form a definitive trend, we have been encouraged by what appears to be a broad-based decline in total petroleum OECD inventories outside the United States since their peak in the middle of last year.
The second major issue in North America pertains to the elasticity of shale supply. We discuss this dynamic in more detail below, but the basic takeaway is that North American producers will likely be fighting to ramp up their production into a rising oil price.
Successful production growth at scale could close the expected supply deficit and cap any material oil price appreciation, in our view, although the ability of producers to achieve that outcome remains in question. On the other hand, challenges bringing on new supplies could widen the expected deficit and have positive implications for commodity prices, company cash flows and investment returns.
Energy Company Perspectives
At the corporate level, sentiment seems more positive than expected given lackluster recent share-price performance and commodity-price weakness, a dynamic that we would attribute to the potential improvement in macro visibility.
Overall, the E&Ps we have talked to appear to have about half of their planned 2017 production hedged at $50/barrel (on average) and seemed unfazed by the 2017 dip in oil prices, suggesting that operating plans and results may be less sensitive to oil prices this year. Perhaps a bigger concern is execution risk as the North American E&P and oilfield services companies attempt to manage accelerated business activity in a higher price environment.
Potential challenges cited in this regard included logistical supply chain issues, infrastructure, equipment re-commissioning, and resource quality as companies seek to expand production outside of better-delineated core acreage.
Although many companies have been reporting strong single-well results, repeatability and scalability remain questionable, particularly for smaller companies that have not managed larger drilling programs in the past. This is potentially a very important factor as some companies that appear priced for perfection could be at risk of disappointing investors.
Furthermore, though capacity utilization in the oilfield services industry remains low for some equipment, the quality of existing machinery and the ability of new crews to work efficiently may also constrain E&P companies’ ability to execute their resource development plans while also leading to cost increases.
Commodity Prices and Cost of Production
The relationship between commodity prices and the cost and scale of production has a somewhat circular dynamic. While price depends on production and cost levels, the magnitude of the production ramp-up in the North American shale industry also depends on the stability of oil prices.
While most E&P firms’ development programs have already been set for 2017, their management teams did suggest a drop in the oil price back into the US$40s could lead to a meaningful retrenchment in activity and production. Even a flat US$50 oil price would likely imply steady-state supply beyond planned drilling programs according to our conversations, implying production levels that would likely disappointment analyst estimates on a longer-term basis.
On the other hand, our analysis indicates the mid-$50 to $60 level would likely lead to US production growth on the order of 500,000 to 1.0 million barrels of oil per day, which appears to be the level required to satiate the International Energy Agency’s forecasted global demand growth and support a balanced market if OPEC maintains its current, constrained production levels. 2
In our view, the latter scenario seems to be what the market is beginning to discount in equity values. In any event, it appears that managing the cycle will be just as important for the service companies as the E&Ps, as costs are rising across the board and could pressure earnings and profit margins despite higher commodity prices, spending and resource development activity.
Investment Conclusions
Our general takeaway is that energy-sector opportunities in 2017 and 2018 are likely to be more idiosyncratic and company-specific, whereas in the recent past they’ve been driven more by the macro commodity price environment. As fundamental, bottom-up investors, this is an environment we welcome.
Although many companies in the industry have now shifted their focus from balance-sheet repair to drilling and production growth execution, it remains to be seen how easily production will ramp up, with major implications for the price of oil should producers materially over- or under-shoot guidance and expectations.
Focus on Production Targets
Our current focus in the E&P industry is on companies we think can meet production growth targets on budget while generating free cash flow in a recovering commodity-price environment.
We also look for companies with reserve and production growth optionality from underappreciated assets, which can come from the delineation of additional resource development opportunities. We remain very price sensitive, however, and demand a valuation margin of safety to cushion our investments from potential oil-price volatility or missed production targets in the near term.
Similar to E&P firms, the value of oilfield services firms tend to anticipate the cycle early on, and many related equities have recently been re-rated by industry analysts as firmer oil prices bolster expectations for increased drilling activity and profitability. While select opportunities in the oilfield services industry exist, from a valuation standpoint we appear closer to peak-cycle than trough-cycle for some companies, which could result in valuation compression if earnings recover.
Exploration Projects on the Horizon?
Turning to later-cycle opportunities in the sector, it is worthwhile to note that specialist offshore services firms indicated they were beginning to have more conversations with customers related to exploration and development projects in 2018 and beyond, suggesting that the capital-intensive deepwater market has perhaps bottomed and investment opportunities may be emerging in this particularly depressed industry segment.
Some large integrated oil and gas producers, meanwhile, have also been slower to re-rate and continue to offer selectively attractive value and healthy yield prospects, with most expected to be able to cover their capital spending and generous dividends at current spot prices within the next year.
Overall, we recognize the inherent cyclicality and complexity of the global oil market and, as ever, remain focused on fundamentals and valuations in our efforts to seek to identify the best long-term values for our clients.
