Rude awakening for those who ignored the energy markets' warning signs

Back in February (see post) numerous equity investors refused to believe that a crude oil recovery is likely to be unsustainable. Many viewed this as a buying opportunity - just as they did in 2011 when such "bottom fishing" strategy worked. "Look at the declines in oil rigs" many argued - US crude production is about to dive. Even some in the energy business were convinced that crude oil recovery is coming and we will be back at $70/bbl in no time. It was wishful thinking.

There is no question that North American production of crude oil is stalling. However for now it remains massively elevated relative to last year.

Source: EIA

More importantly, many fail to understand just how flexible US crude production has become - the time to bring capacity on/off-line has shrunk dramatically. Furthermore, a great deal of production in the US is now profitable at $60/bbl and even lower as rig efficiency rises. Many view this as unsustainable because new exploration is halted and existing wells are being reused. But there is enough staying power here to continue flooding the markets for some time to come.

Source: EIA

The ability to bring capacity back online quickly is the reason we saw US rig count unexpectedly increased last week. This creates a natural near-term cap on crude prices, above which production can rise quickly.

Source: Baker Hughes

To add to the market's woes, the Iran deal threatens to bring materially more crude into the market in 2016, while immediately releasing a great deal of stored crude the nation currently holds.

Source: WSJ

Moreover, the Saudis are ramping production to record levels, as the OPEC members are left to fend for themselves. The Saudis will attempt to recover some of the lost revenue with higher volumes.

Crude prices in the US fell below $50/bbl in response to some of these developments. So much for the "recovery".

Source: barchart

All of a sudden, as investors realize that crude oil price recovery could take years, energy firms, particularly those focused on exploration and production (upstream), don't look that attractive. The chart below shows the relative declines of the overall energy sector as well a the upstream companies' shares over the past year (down 29% and 51% respectively).

Source: Ycharts

And even those who were betting on the M&A activity providing support to share prices are having second thoughts, now that the Backer Hughes acquisition by Halliburton may face challenges.

Source: Bloomberg

To make matters worse, many energy firms continued to borrow as prices declined. With no recovery in sight, credit markets are becoming much less forgiving. In traded credit markets for example we see spreads widening out again - with oil services and equipment getting hit particularly hard.

Source: Credit Suisse

The US energy industry is undergoing its most challenging period in decades and for many firms the worst is yet to come.

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Energy market dislocation impacting the economy

We now see more evidence of the energy market dislocation impacting the economy. Here is the job cuts report from Challenger, Gray & Christmas showing a pickup in layoffs.

Source: Challenger, Gray & Christmas

Of course it's not just the energy sector that is being hit. As discussed before the impact on other areas in oil producing states is significant. Here is what's going on with construction jobs in Texas.

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Diverging developments in oil markets vs. energy shares

Posted by Walter

Let's take a look at the recent developments in the US energy markets and the seemingly contradictory reaction by equity investors.

First of all, while we continue to see significant declines in the US rig count (both oil and gas),  ...

Source: Banker Hughes

... American crude oil production remains at record levels and still rising. It's going to take time for this momentum to turn.

Source: EIA

Part of the reason is the increasing productivity of new rigs in the US.

Source: EIA

Moreover, outside the US some major oil producing nations such as Russia and Iraq - desperate for hard currency - will maximize production in the months to come. Global production will therefore continue to rise.

The second key development has been a relatively steep crude oil futures curve (contango).

Source: barchart

This is encouraging crude investors to store oil. The arb involves buying spot crude, simultaneously selling forward, and storing for delivery at a future date (Profit = Forward Price - Spot Price - Storage Cost - Financing Cost). If the arb persists, the trade can be rolled. That's why this past week we saw the largest spike in volume of crude in storage.

Source: Investing.com

Moreover, the absolute levels of crude in storage are now at the highest level in some 80 years.

Source; EIA

As a result, analysts expect Cushing, OK (the WTI crude delivery/storage hub) to run out of storage soon.

Source: @jenrossa

Crude in storage is on the rise outside the US as well. As an example, Iran just launched a huge floating oil storage unit in the Persian Gulf (built by Samsung). This facility stores 2.2 million barrels of crude.

Tehran Times

The most important development in 2014 of course was the historic shift in the crude oil production cost curve, capping crude prices at $75-$80/bbl for some years to come.

Business Insider: @themoneygame

Now, with these production fundamentals in place, rapidly growing amounts of crude in storage, and longer-term prices capped way below milti-year averages, why are energy firms' shares still relatively expensive? For example, over the past couple of years spot crude oil is down 45%, while the energy component of the S&P500 is up 2%.

And forward P/E ratios are more than double the historical averages - these are some of the most expensive large cap shares in the market.

Equity markets seem to be betting on a quick decline in production and sufficient recovery in crude prices to return the energy industry to stronger profitability in the nearterm. There is also the view that some energy firms will remain resilient due to their midstream operations - storage, transport, and refining. And we've all heard talk of consolidation and M&A activity in the space which may also support share prices (see story). A number of analysts have turned constructive on the sector.

Source: Goldman Sachs

Furthermore, from the technical perspective many portfolio managers have been heavily underweight the energy sector for months and some believe that the eventual rebalancing will drive up share prices.

These are all solid arguments. However given the current lofty valuations, if we don't see a major improvement in crude prices in the next few months, energy shares may take another leg down. One can see this nervousness in the credit markets as HY energy credits remain near historical wides to the rest of the market (chart below). For those who wish to jump in at these levels, be prepared for significant volatility and deleveraging in the energy sector.

Source: Credit Suisse

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The good, the bad and the ugly of falling energy prices

The recent correction in the price of crude oil should have an immediate positive impact on the US consumer as well as on a number of business sectors. However there also may be a significant economic downside to this adjustment. Here are some facts to consider.

1. The good:

The US consumer is not only about to benefit from materially lower gasoline prices (see chart), but also from cheaper heating oil.

Source: barchart

With wages suppressed, the savings could be quite impactful, particularly for families with incomes below $50K per year.

Merrill Lynch: - ... consumers will likely respond quickly to the saving in energy costs. Many families live “hand to mouth”, spending whatever income is available. The Survey of Consumer Finances found that 47% of families had no savings in 2013, up from 44% in the more healthy 2004 economy. Over time, energy costs have become a much bigger part of budgets for low income families. In 2012, families with income below $50,000 spent an average of 21.4% of their income on energy. This is almost double the share in 2001, and it is almost triple the share for families with income above $50,000.

Source: Merrill Lynch

Furthermore, with gasoline prices lower, it is unlikely that consumers will be buying significantly more of it than they have been. Historically when oil prices fell, gasoline consumption in dollar terms also fell. Dollars saved on fuel will be redirected elsewhere in the economy.

Source: Scotiabank

Moreover, suppressed oil prices will, at least in the near-term, keep inflation expectations lower. That means lower short-term rates for longer (see chart) and therefore lower home equity and adjustable rate mortgage monthly payments. It also means lower longer-term rates and cheaper fixed rate mortgages (see chart). We may even see some new refi activity.

Other benefits include cheaper transport (potentially lower travel costs) and shipping costs (lower UPS/Fedex surcharges), as well as cheaper PVC, nylon, polyester, foam, etc. - all of which should benefit the consumer.

2. The bad:

The US has become a major energy producer, with the sector partially responsible for improving economic growth and lower unemployment in recent years. As an example here is the GDP of Texas as a percentage of the US GDP. This trend is driven in part by the recent energy boom in the state.

Source: @M_McDonough

If oil prices remain under pressure, this boom could soon be in jeopardy. While large US energy companies are sitting on a great deal of cash, at some point they will begin to cut portions of the higher cost development and production. And private investment into energy and oil services firms, which has been brisk lately, is likely to moderate. For example, here is the private debt and equity capital flowing into various states last month.

Source: CAZ Investments

While, only a portion of the funds going to Texas is directly energy related, various other Texas firms funded by PE (including some real estate, manufacturing and financial companies) have been benefiting from the energy boom. Soon that flow of private capital may slow dramatically.

To put this into perspective, here are the jobs directly generated from Texas oil and gas extraction in recent years. And this does not include the thousands of jobs that support this industry. Such trend is unlikely to continue if oil prices remain at current levels or fall further.

In fact, while the overall industrial production growth in the US has been strong recently (see chart), a big portion of the gains are energy driven (see chart from Lee Adler). A slowdown in that sector will be quite visible across the US.

3. The ugly:

A significant number of middle market energy firms in the US - many funded via private capital (above) - are highly leveraged. The leveraged finance markets are becoming quite concerned about the situation - even for larger firms with traded debt. Here is the yield spread between the energy sector loans in the Credit Suisse Leveraged Loan Index and the index as a whole.

Source: Credit Suisse

Rumors have been circulating of a number of energy (and related services) firms getting ready to "restructure". There are also stories that some large funds are gearing up to scoop up distressed debt of levered energy firms. However, in spite of the ample liquidity out there, bets on companies with significant commodity exposure will be limited going forward - at least until stability returns to the oil markets. Defaults, layoffs, and cancelled projects in the energy space may be in store in the near-term. And that is sure to have a negative impact on the US labor markets and the economy as a whole.

Finally, this is terrible news for the development of alternative energy sources. At these prices, fossil fuels are becoming increasingly difficult to compete with.

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From our sponsor:

5 facts about energy sources

We've had a number of questions on energy sources in the United States - particularly with respect to the generation of electricity. Here are a few interesting facts about recent trends that hopefully help clarify some of the confusion surrounding this topic.

1. The amount of electricity generated in the US in 2013 is virtually the same as in 2005 (about 11.1 million megawatthours per day according to EIA). This is in spite of the economy and the population being significantly larger. Efficiency improvements have been impressive.

2. Coal remains the primary fuel for power generation, with natural gas not far behind.

Source: EIA

3. Renewable energy (outside of hydro) has had the largest growth rate, doubling since 2005. Evidence suggests that at least a portion of this increase has been due to tax incentives rather than market-based reasons. Hydro and nuclear have remained virtually unchanged over the past 7 years, while natural gas is gradually gaining on coal. Petroleum usage to generate power has declined the most due to its high cost as well as other issues. These trends are expected to continue.

Source: EIA

4. Within the renewable energy space the largest drivers of growth have been wind power and liquid biofuels (bioethanol and biodiesel). Growth in biofuels however has slowed in the last couple of years (in part due to higher corn prices).

Source: EIA

It is important to point out that unfortunately in spite of this growth and with all the tax incentives, renewables (outside of hydroelectric) remain a fraction - around 6% - of total electricity production in the US. By 2040 that number is expected to only increase to around 9% (16% including hydroelectric). It will be a couple of generations or more before renewable energy becomes a viable alternative to fossil fuels. Data suggests that for now, particularly on a global scale, the only energy source that can challenge hydrocarbons is nuclear.

5. And since we are on the topic of nuclear power as a real potential challenger to the more traditional fuel types, let's look at the safety issue. Isn't nuclear power dangerous? Here we have some data on safety by fuel type, showing the number of cases of death per one terawatt-hour of electricity by energy source. For example 4 people will die for every terawatt-hour of electricity generated via natural gas. One  terawatt-hour is enough energy to power a 200,000 person city for a full year - making natural gas one of the safer fuels. Now compare that to coal and to nuclear.

Based on global statistics (source: IBM)

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From our sponsor:

Equity markets are discounting the rally in crude oil

Energy shares have underperformed the broader market starting in April when crude oil prices touched the lows for the year. Stock valuations clearly responded to the downside. On the up-side however, in spite of the recent sharp rally in crude (see discussion), energy shares continue to lag.

Source: Ycharts

Equity markets are not convinced by the recent spike in oil prices and view it as temporary. The US government economists seem to agree. The recent projection of average cash prices for 2014 puts Brent forecast 9% below the current level while WTI is predicted to be almost 15% below where it currently trades.

Source: EIA

The general consensus seems to be that unless we have further unrest in the Middle East or an unlikely event of materially improving economic fundamentals globally, prices should decline. Of course the question remains: How long should oil prices stay elevated relative to forecasts before energy shares begin to outperform?

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From our sponsor:

Looking for returns in the alternative energy space

How does one make money on a portfolio of alternative energy companies? Here are a few possible ways such an investment could work:

1. You hit a motherload by having a portfolio company invent some technology that would successfully compete with traditional energy sources on price and availability. It's a nice dream to have, but so far significant advances toward this goal have been elusive. This would not be a good investment strategy/thesis because it can not be relied upon to generate consistent returns (unless of course you focus on socially responsible investments irrespective of the return expectations).

2. You could have your portfolio companies lobby politicians to provide attractive tax breaks for alternative energy, benefiting your portfolio.

The Motley Fool: Most politicians love renewable energy, because it gives them a good excuse to increase the taxes on non-renewable energy, and it lets them buy votes and campaign donations by giving taxpayers' money to the renewable energy industry.

Naturally, whenever a government is giving away money, you get a big queue of people who want a piece of the action, and some renewable energy companies have been much more successful in getting subsidies than in producing commercially profitable applications.

Consequently, there have been several subsidy-related scandals, such as the one that surrounds the politically connected solar cell manufacturer Solyndra, which obtained hundreds of millions of dollars in US federal government loans and loan guarantees shortly before filing for bankruptcy. Solyndra is now being investigated by the Federal Bureau of Investigation!

Well, maybe relying on tax incentives to generate returns isn't such a great idea.

3. You work with your portfolio companies to convince politicians to punish traditional energy firms for using traditional energy sources (by increasing their costs) in order to encourage alternative energy uses.

The Motley Fool: In 2008, [the UK] parliament passed the Climate Change Act to encourage the adoption of renewable energy by deliberately increasing the cost of non-renewable energy. I also see it as providing a strong incentive to invest overseas, as it will damage British industry, since our energy costs are going to increase at a much greater rate than those of our foreign competitors.

The government's own figures indicate that this act will cost industry some £400 billion and increase the average British household's energy costs by around £760 a year. That's a big burden to bear, and it looks as if green policies will continue to put pressure upon domestic and commercial budgets.

Hmmm, that doesn't seem too sustainable or profitable for that matter.

4. Your final alternative, and the one that is most likely to succeed, is to bet on peak oil. When crude goes above $150, these alternatives should do well.

The Motley Fool: One thing that's guaranteed to improve renewable energy's economics is an oil crisis, preferably one which sends prices soaring to well above $150 a barrel for a long period of time.

But wait, if you are betting on peak oil, why not just buy traditional energy companies that would do well in a significant oil price appreciation? You don't have to bet on smaller firms or rely on tax breaks. With traditional energy firms one may do well even without an oil crisis. Better yet, why not just go long oil futures. This way you have no business risk at all - the peak oil effect would go straight into income.

These four options just don't sound appealing, making the alternative energy asset class fairly unattractive as an investment. And the markets happen to agree. Over the past couple of years the overall energy sector globally has been flat to up slightly. The alternative energy space however is down some 65% over the same period.

MSCI World Energy Sector Index vs. MSCI Global Alternative Energy. Index (Bloomberg; click to enlarge)

Update: Here is an example of underperformance by an alternative energy firm (4/17/12):

First Solar stock (FSLR) is down 85% from the same time last year.

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Oil price will stall on fundamentals

Oil prices are not going back to the levels of last summer. The prices are capped. The latest numbers from Credit Suisse show why. The financial crisis has created permanent destruction of demand growth. The expectation now is 1% growth in demand per year. Two contributors to this are:

1. Faster gasification in Asia (as Asian nations begin to use liquefied natural gas)
2. Greater auto efficiency in the US. Sensitivity to high gas prices is extreme, given all the pain the US consumers have experienced. Fuel efficiency is here to stay.

From Credit Suisse


Given that the demand by 2015 is expected to be 90 million barrels per day (MBD), this new need for oil can be easily met by cheaper forms of production, in effect capping the price.

The graph below from Credit Suisse shows where oil price needs to be to achieve a 16% return on capital investing in new sources of supply, vs. the amount of new supply available from these sources. To get to 90 MBD can be done with the more traditional projects that are profitable even when oil is under $70 per barrel (and certainly under $100).