Saturday, 14 December 2019 | 13:55
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Things Are Just Too Stable For Oil Producers; This Industry Needs Massive Consolidation

Monday, 22 July 2019 | 16:00

The announcement of the Baker Hughes rig count used to be a must-watch data point every Friday at 1 PM. Technically that data is now supplied by the entity known as “Baker Hughes a GE Company” and today it seems that data has lost as much relevance as GE has in the S&P 500. For the record, this week’s count of U.S oil rigs in operation (the most widely-quoted data point) fell by 4 to 954. That’s down 79 rigs from the year-ago figure and it is clear that the “sweet spot” that West Texas Intermediate crude oil futures seem to have found between $50 and $60 per barrel is tamping down demand for drilling equipment.

Yet, a look at the EIA’s data shows that U.S oil production ran at a 12 million barrels per day (mmbpd) pace last week, up a full 1 million barrels per day over the corresponding week in 2018. Production has fallen a smidgen lately—the EIA figure was 12.3 mmbpd two weeks ago—but the fact that the U.S. continues to produce at near-record levels on fewer rigs shows a basic truth in the oil game.

It is much, much easier to produce oil than it used to be. This is also true of natural gas, which has kept prices of that hydrocarbon in a near-depression for most of this year, but I will keep the focus of this column on black oil. The combination of horizontal drilling techniques with hydraulic fracturing, which has existed since the 1940s but seems to have been perfected in the past 10 years, has taken much of the cost of failure out of investing in an oil well. To use energy industry parlance, it has been de-risked.

While that may be good for the U.S.—I happen to be a big believer in energy independence as a political construct—it has not been good for oil stocks. The problem is that things are too just too darn predictable now.

I started following the commodities markets as a teenager in the 1980s, and in the past 30 years I have witnessed many events of global geopolitical turmoil that spiked oil prices. I am not a political analyst, but I do not think the Middle East is any more stable in 2019 than it was in 1987, but the U.S. energy industry is so far advanced that it may not matter.

That’s always been the long-term bull case for energy stocks. Political tensions in the Middle East will inevitably spill into actual warfare and that will drive the price of oil. It causes traders to be just as afraid of a supply shock as a demand shock, which is not the case in any other securities market with which I am familiar.

But that has changed. The U.S imported an average of 4 million net barrels of oil over the past four weeks, a staggering 36.1% decline in America’s oil trade deficit from the corresponding period a year ago. The Baker Hughes data goes back to July 1987, yet the current rig count continues to lag well below the 32-year average (954 vs. 1128) that is comprehended in the Baker Hughes historical data.

So, the “upside risk” to oil prices has been diminished. If the U.S needs more oil, it could be easily produced domestically. There’s just no reason for $100/barrel oil anymore.

That, obviously, impacts equity valuations and has caused the energy select SPR, XLE, to badly lag almost every other equity benchmark in the U.S stock market over the past five years. In valuing a stock, an analyst is essentially compiling a range of potential data points. If the higher-end points are no longer feasible, there is less “upside risk” and the underlying material should evince less volatility. That is exactly what we are seeing in the oil market in 2019.

So, as I have noted in prior Forbes columns this is a terrific time to own oil bonds—which are driven by production volumes—but has been a terrible time to own oil stocks, which are driven by the market’s perception of future commodity pricing.

This industry hasn’t always been rational, but the only rational response to a new normal in oil pricing is massive industry consolidation. Producers need to be able to earn sufficient returns on deployed capital. Major integrateds like Exxon can—and are—producing economic value creation at current commodity prices with enough left over to buyback shares and increase dividends. I own Exxon shares and probably always will.

For any entity smaller than Exxon, Chevron, BP or Royal Dutch Shell, however, the diminished chance of an oil price spike diminishes the attractiveness of its stock. The massive underperformance of oil equities isn’t because of dissipation in demand. The key EIA figure that measures demand, products supplied, showed a 0.6% increase in the four-week period ended last Thursday versus the year-ago period. No, there’s just too much balance between global oil supply and demand to convince portfolio managers to overweight energy stocks.

Managements need to adjust to this new reality and go private or merge. We saw a billion-dollar transaction this week as Callon Petroleum agreed to merge with Carrizo Oil and Gas, but there should be much, much more consolidation among the independent E&Ps.

In times of consolidation an investor would always rather own the target than the buyer—Callon’s shares fell more than 30% this week after the announcement of the Carrizo acquisition—and I will have attractive acquisition candidates in my next energy-focused column for Forbes.
Source: Forbes

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