Following the Iran threats at the start of the year, WTI oil price has dropped from highs of $64/bbl down to lows of $50/bbl recently. Not only did the hype leading to the Iranian tensions cause a price fall, but the subsequent collapse in Chinese oil demand from travel/tourism/businesses/refining following Coronavirus contagion fears caused the spot oil price to fall further.
China accounts for 16% of world GDP and is the world's largest consumer of oil, so when its economy comes to a screeching halt, the price will get hit, no doubt. In a very short period of time, there is a severe glut of oil inventory in the system as it piles up, this is reflected in the physical shape of the curve. Most commodities are dictated not only by the spot price, but by the shape of the structure of the curve; a point not many general investors observe or care to monitor. It is all about demand and supply at any given point in time, and if we have a glut of, say, 30-40 million barrels, then the spot price and nearby prices will fall to reflect the nature of the curve. The wonders of physical commodity arbitrage; it's a thing of beauty! This is the reason why the shape has gone from backward-dated (bullish) to contango (bearish).
Now let's get back to spot price. U.S. shale has been one of the biggest contributors to oil output growth over the past few years as they revolutionized the industry -- taking the U.S. to a net exporter from a net importer. Most analysts have gotten used to it growing around 1 million barrels per day year over year, but for how long can this go on? In their defence, U.S. shale producers have defied gravity and economics as they raised funds to help them produce even more efficiently as prices fell over the past few years. Thanks to greedy capital markets, money was always available to them, allowing them to over-spend and over-produce.
Now it has come to a point where they are not only outspending their cash flow, cheap money is harder to come by as investors have given up on them and their promises; capital markets are now more or less closed to them. They only have one choice now, to be capital disciplined.
Judging by the recent Baker Hughes drilling data, it seems U.S. oil output could fall by more than 50% this year as greater capital discipline feeds through to the system. This time, the message coming from the bigger players seems serious and they are focused on producing efficiently and returning cash back to shareholders. Some estimates suggest U.S. oil output can grow by 400-500k bpd even. Permian basin is driving the austerity. Not only is the spot WTI trading at $50/bbl, even the backend future curve (pricing for future dates) is around $52/bbl, where typically companies need about $55/bbl WTI to make capital and investment decisions. We are at crunch time and we have already seen a number of companies embarking on defaults and the system is slowly getting tighter. Only the larger and less leveraged will survive.
Producers focused on gas will continue to suffer, as gas price has already broken through floor economics and we have had a very warm start to the winter. However, names in the liquids space, Diamondback Energy (FANG) has given production guidance of 10-15% and it pays a dividend at $45/bbl WTI. Pioneer Natural Resources (PXD) is one of the largest Permian producers. The stock is not particularly cheap but it does deserve a premium based on its pricing differential opportunity.
When investors think of energy, they look first at oil majors, which tend to be the worst beneficiaries of oil price strength; they lag on the way up and underperform on the way down as they continuously face cost and margin pressures. They may give a good dividend yield of 4%-6%, but what does that matter? When oil price is up 10%, these stocks are down 5%.
There are pockets of great value in the energy space -- cheap value, but also EBITDA margin growth in a flat oil price environment, as well.
On Tuesday, Fed chair Powell gave his testimony to the Congress stating that the economy is in a good place and he feels the current monetary policy is on an accommodative path to sustain the expansion. While raising the specter of coronavirus presenting risks to global growth, he reiterated that daily repo purchases would remain in place until April and Treasury bill buying through at least Q2 2020.
No one addressed the elephant in the room as to why we still need repo operations given it was meant to be a year-end "plumbing" issue and technical. Needless to say, the Fed said that this would make sure the reserves and balance sheet would reach a level that would be reasonable. In a nutshell, the gravy train is not stopping until April.
We don't need to intellectualize the Fed, as they really don't know what they are doing or the bigger problem that they will need to deal with later, but liquidity is key right now. Powell also expects inflation to move closer to their 2% target -- currently, core CPI ex food-energy is around 1.5%. The reflation trade that was hinted at during Q4 2019 is still on the agenda. But people are too scared to buy oil, copper, and commodities now given everyone thinks China will go negative in Q1 and cause a collapse in world GDP along with it.
The coronavirus is a real and present threat and it could have been the straw that broke the camel's back. But as we have seen the worst in terms of rate of change of new cases, with businesses slowly restarting, it seems we are past the worst in terms of pricing in demand destruction. Now back to fundamentals, rather than fear. The WTI oil price seems unsustainable under $50/bbl for now. We all know the majority of OPEC+ is keen (aka "need") to see Brent oil prices rise closer towards $60/bbl plus.
