News or Noise Special Report: The Energy Market

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1 News or Noise Special Report: The Energy Market By David Fisher, Chief Investment Officer Asset Management It has been a year since energy prices peaked and subsequently fell nearly 60%. Prices were already sliding last fall when it became clear that members of the Organization of the Petroleum Exporting Countries (OPEC), led by Saudi Arabia, were going to keep production at extremely high levels, even though the world had an obvious oversupply. Prices bottomed in March of this year and since then have rebounded by about 30%. The focus of this special report is on key questions related to current energy markets: Why is OPEC choosing to fight this battle now? Is the U.S. energy revolution over before it really got going? Why have prices started to rebound? And why has there been such little distress in the energy sector? We will avoid the temptation to provide hard price forecasts in an area of the market notoriously difficult to project. Though industry experts often give an answer when asked publicly about the outlook for pricing, if you talk with them privately they almost always admit they have no particular ability to predict near-term prices. A huge global commodity market, highly sensitive to changes to both supply and demand, and many government bodies with control over portions of the industry result in highly unpredictable pricing. Yet understanding the long-term dynamics of the industry and the impact on global and domestic economies can provide valuable context for overall portfolio design. The Impact of Shale Oil and Gas The reality is that creative destruction is happening in real time in the energy industry. This can be a painful process to watch, but in the long term it is a positive to the economy and society broadly. The innovations impacting energy in recent years have been dramatic yet are not widely understood. About 15 years ago, a few energy companies began experimenting with the combination of new technologies. Those experiments first started to prove successful in natural gas wells. As the technologies were refined, they were more widely deployed in a variety of energy basins and in both gas and liquids such as crude oil. 1

2 The two key technologies that have combined to revolutionize energy production are horizontal drilling and hydraulic fracturing. Horizontal drilling is essentially drilling a well straight down as much as a mile, and then turning the bit 90 degrees and drilling horizontal to the surface for another mile or even farther. This technology was then combined with fracturing, which pushes highly pressurized water, sands and chemicals through the well and literally breaks apart the shale, which allows the gas or oil to flow freely. The technologies have also been combined with more advanced digital imagery and drilling guidance, which means that energy companies can drill these horizontal wells into layers of shale that may be only a few yards thick and, through fracturing, quickly extract large quantities of oil and gas. Over the last decade, use of this technology accelerated and became widely available. With crude prices averaging from $80 to $100 and even more over the past few years, it was highly rewarding to purchase new acreage and drill as many wells as possible. During this period, the capital was almost unlimited for energy companies, and the number of oil rigs (rigs are the equipment that drill new wells) operating in the U.S. surged from 300 to more than 1,500. But with this surge in production came the inevitable overreach and, eventually, the price declines. Before assuming that this is a typical energy cycle, it is useful to step back and look at data related to the shale energy period. The surge in energy production in the U.S. is without precedent. After a gradual decline from a peak rate just under 10 million barrels per day (MBPD) in the late 1960s, U.S. production bottomed in 2009 at about 5 MBPD. In just the last six years, production has approached its previous high and could surpass all-time record levels in the next year. The chart below shows these production trends going back to 1987 and also shows that despite the 60% drop in the number of oil rigs since last summer, production levels continue to rise. 2

3 It is likely that production could stabilize near current levels for a few quarters, but we don t expect a significant drop-off in production, and the figure could continue to slowly edge higher in the years ahead. How can this happen after the large drop-off in rigs? Several factors seem likely to keep production moving forward in the intermediate term. First, drilling efficiency has continued to improve. The time it takes to drill and complete a well has gone from months to weeks, which means that many rigs can now drill as many as 20 wells a year versus just the few per year five years ago. Second, every well is different, so drops in the number of rigs don t create a one-for-one reduction in production. The highest-production wells will continue to be drilled, and these account for the largest percentage of actual production. Marginal opportunities will be the first ones canceled, and these would have limited impact on production. Finally, the costs have declined by as much as 25 40% since the peak of the cycle, which means that some rebound in drilling rigs is likely after a period of stabilization near current levels. So we won t try to predict near-term pricing, but cost information can provide insight into what a logical price range for energy would be that would create equilibrium between supply and demand. From all the research we see, it appears that, globally, prices in the $50 $70 range will create this balance. At this range, a lot of energy sources will not be economical, but enough opportunities will continue to make sense that supply will gradually rise. Demand will go higher, which is already being seen in miles driven, as we discuss below. The lower prices will create more discipline in the industry but will also continue to encourage technical advances. The Geopolitics of Oil The changing landscape of global oil production has impact beyond economics, including U.S. geopolitical relationships, especially those in the Middle East. This has been evident throughout the drawn-out negotiations with Iran, which have spotlighted our willingness to go against Saudi Arabia, our longtime political ally in the region. As recently as 2007, the U.S. imported nearly two-thirds of our domestic crude oil requirements. Today that figure has dropped to approximately 40%. The impact of this reduction has fallen mostly on OPEC trading partners. Imports from Canada and Mexico have held relatively stable, which has caused OPEC-sourced crude oil imports to decline nearly 60% to just over 2 MBPD. This trend is likely to continue over the coming years, as the U.S. could conceivably see nearly 100% of our crude oil originating in North America. After several decades of geopolitical focus on the Middle East, the Obama White House, under then-secretary of State Hillary Clinton, made a strategic decision to pivot our geopolitical attention toward Asia. The rise of Chinese power in the region was a significant part of this decision, but it would not have been possible to execute on this plan without the change in trends on global energy production. The U.S. has now largely withdrawn from Iraq and Afghanistan and has avoided involvement in Syria and other hot spots in the region. The final major aspect of this pivot-to-asia plan is the resolution with Iran over its nuclear program. As of this writing, those talks appear to be moving into their final stages and are likely to be implemented over the coming months. To be clear, the U.S. decision to reduce our involvement in the region does not provide stability. On the contrary, the debate over the Iran resolution is being fueled by our allies in the region 3

4 specifically Israel and Saudi Arabia who recognize that our decreased presence will provide an opening for Iran to become a much more significant force in the region, increasing tensions with Saudi Arabia as an opposing power. The changes are likely to increase tensions over the coming decades, but the strategic decision by U.S. military and political policymakers is that our resources need to be diverted to the Asia-Pacific region in order to contain China. For much of the past 40 years, OPEC has been the single swing producer for crude oil. Specifically, Saudi Arabia has consistently had the ability to adjust production relatively quickly by as much as several million barrels per day. This allowed them to balance global supply and demand forces and thus largely dictate prices over periods of time. One of the biggest underappreciated changes that has happened in the past decade is that the U.S. has become an alternative swing producer. In fact, over the past decade, U.S. oil production has increased by more than 4 MPBD, which represents the majority of the global supply increase. The chart above shows clearly how the U.S. increase in production compares with production changes for OPEC countries since Given this backdrop, it is understandable that Saudi Arabia realized last year that something had to be done to slow the pace of production growth in the U.S. Last summer the Saudis decided to fight an all-out battle for market share at the temporary cost of reducing their profitability. We remain in the middle of this battle, and the long-term effects are still not clear. The removal of sanctions against Iran impacts this as well, given that they retain the ability to increase production by at least 1 MBPD in a short period of time. The market seems to have factored this in already, but it does add another component of uncertainty to near-term prices. The final issue that factors into energy geopolitics is the U.S. export ban. Since the OPEC crisis in the 1970s, energy exports have been forbidden. However, with the expanding production capacity, a push by energy producers to lift this ban has been gaining traction. Over the past year, increased exemptions to the rule have been allowed. It is very possible that Congress will 4

5 act in the next year to remove, at least partially, the rule. The ability to sell into global markets will increase incentive for domestic producers and help energy move more efficiently through the domestic infrastructure system. The key question remains whether Saudi Arabia will be successful at suppressing the production of oil in North America or if its actions will only serve to keep prices lower but not diminish U.S. ability to act as a swing producer. It is not clear how long the Saudis can afford to hold prices below $60 or $70 before their fiscal situation is materially impacted. Our general feeling is that they may have waited too long to try to defend market share. The pace of innovation in U.S. shale production may have crossed a point where we can adapt and survive in this lower-priced world. But it will take more time for this issue to sort itself out. U.S. Consumers and Lower Oil Prices The impact of the recent drop in oil prices has been mixed for the U.S. economy. As a broad statement, reduced costs for commodities such as energy act like a tax cut for consumers reducing consumer spending on oil without requiring a change in behavior. However, in this cycle the impact on jobs from the decade-long boom in energy production partially offsets the positive effects. In our opinion, the price drops are still a net positive. Some have expressed surprise that consumer retail spending has not increased by an amount similar to the savings on energy. But consumer behavior doesn t work so clearly. First, the pressure to de-lever personal balance sheets remains as fallout from the financial crisis, and part of the savings from the drop in oil prices has gone to savings and reduced debt balances. Secondly, consumers tend to take time to adjust their behavior. It takes time before the permanency of a change is recognized and spending is adjusted. Finally, we do think the drop in prices has been a factor in strong consumer confidence figures recently. One piece of evidence we have written about is the mileage-driven data. The chart below shows clearly the strong growth in this indicator. 5

6 As the price of crude dropped last year, our biggest concern was its impact on the still-fragile recovery in job creation. There has been an effect, with about one in four job layoffs occurring in the U.S. this year directly or indirectly tied to the energy industry. 1 Companies in the energy services space and the manufacturing companies that feed into that space are seeing revenue declines and are reducing staffing. However, only about a dozen states are materially linked to energy production trends, and many of these are relatively small states. Texas has been the key state to watch, in our opinion. It is therefore a positive sign that, after initial declines in employment across the state, data has stabilized in recent months. In fact, North Dakota (home to the boomtowns in the Bakken shale basin) is the only state that has seen material job losses since last summer. Investment Implications For investors, the drop in oil prices has created more nuanced results. Though a net positive for the economy, the drop has not produced clear-cut winners yet. With only modest followthrough for consumer spending, consumer stocks have not significantly benefited. The negatives are more visible: Energy companies and emerging markets heavily dependent on energy have seen significant declines. Additionally, the strength in the dollar over the past year has been tied to the energy price declines, and this has created headwinds for many multinational companies that are headquartered in the U.S. In our opinion, all of these trends remain in effect. In our portfolio construction, we have reduced exposure to natural resource companies and commodity-producing emerging markets. We continue to hold high-quality U.S. equities, including multinationals, but we are overweight to companies outside the U.S. that will have the benefit of weaker local currencies allowing them to be more competitive when selling against dollar-based competitors. Given the dramatic price declines and resulting changes in the industry, many predicted large-scale distress and investment opportunity for those willing to take risks buying into the declines. There has been distress in the service companies that feed into the drilling sector, but this is largely a capacity issue. With rig counts unlikely to return to last summer s value anytime soon, much of this distress will be permanent and will not lead to good buying opportunities. The more attractive opportunity would be in the actual resource companies and those that became highly leveraged during the boom cycle. Somewhat surprisingly, this has not happened. Two reasons seem to be keeping these companies from a more negative outcome. First, the overall strength of the markets has meant that this has been a relatively isolated event. The amount of capital looking for high returns, especially in the corporate bond market, means that investors were quickly willing to step in after the initial price declines. Surprisingly, more capital has been raised in the first half of 2015 for energy companies than during the same period last year. The second factor minimizing distress is a unique aspect of energy resource companies. The banking system values reserves twice per year in March and September and because energy companies had hedged production for 2015 (by selling production levels in advance when prices were higher), banks were able to avoid marking down loans to these companies. The potential for distress may still exist, though. With the upcoming revaluation in September, banks and lenders may be forced to mark down loans, given the reduced level of hedges into 2016 and the deterioration in cash that has likely occurred since March. If opportunities are going to arise, we would expect them to start appearing by the end of the year. 6

7 Longer term we do remain positive on energy companies that will be able to compete with prices in the $50 $70 range. Companies that have acquired high-quality reserve assets and maintained discipline in cash and debt management will continue to perform. As believers in the U.S. shale revolution, we remain optimistic that production growth will continue, even if it is not at the breakneck speed of recent years. Capital will be more disciplined in the sector, but this doesn t mean that winners won t exist. The reality is that creative destruction is happening in real time in the energy industry. This can be a painful process to watch, but in the long term it is a positive to the economy and society broadly. Concluding Thoughts Some recent data indicates that production levels are finally set to show declines as the full force of the sharp drop in rig counts hits. 2 But as we have outlined above, we do believe that the U.S. shale revolution will continue. The technological innovation in the industry has been unleashed and is unlikely to stall, even under slower growth and a more disciplined capital environment. This will have implications for economies and geopolitics worldwide, especially in U.S. relationships in the Middle East. The lower prices will, over time, provide positive benefits for U.S. consumers. Over the next three to five years, we would expect prices to settle in a range of $50 $70. On a quarter-by-quarter time frame, moves above or below this range are certainly possible due to geopolitical threats or changes in supply and demand factors. Finally, we do expect levels of distress to pick up later this year, but it doesn t appear that these challenges will spread outside of the energy space. Those that had business models based on $100 oil will not be able to survive, but the industry will evolve and in fact strengthen during this next phase of the energy revolution. 7

8 Sources 1. Challenger, Gray & Christmas, Inc., 2015 June Job Cut Report: 44,842 Cuts Contribute to Highest Midyear Total in 5 Years, 2. Dan Murtaugh, Shale Oil Output Heads for Record Drop After U.S. Drilling Swoon, Bloomberg, July 13, 2015, What Is News or Noise? Like most of you, we are inundated with information on our phones, in our inboxes and on the Internet. Clearly, the world doesn t need another investing blog to reprocess stale information or reformat the day s useless headlines. Thus, in our investment blog, News or Noise, we ve taken up the challenge of sorting through the infinite bits of background noise and seeking the few truly newsworthy nuggets of information. What are the stories today that are likely to be meaningful for investors in the future? A very small number of headlines are important, and of those, many are immediately processed by investors. Only a tiny fraction of all the new data is truly relevant and underappreciated. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by SignatureFD, LLC), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from SignatureFD, LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. SignatureFD, LLC is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the SignatureFD, LLC s current written disclosure statement discussing our advisory services and fees is available upon request. 8