Revisiting The Oil Bull Thesis In A Tumultuous Market (Commodity:CL1:COM)


Bull and bear on oil barrels in crude oil 3D render

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“Far more money has been lost by investors trying to anticipate corrections than has been lost in all the corrections combined” – Peter Lynch

Oil is in demand and on sale. Oil prices and related equities are down from recent highs, in the face of strong demand, limited supply, and low valuations. Recession fears are overwhelming positive indications of a tight physical oil market and compelling investment opportunities.

Many investors and theorists observe market price movements and use them to filter and interpret fundamentals. For many, price drives narrative. We have an alternative approach—focusing on the actual underlying economic forces, “looking through” price movements and sentiment—and finding opportunity amid volatility and negative outlooks.

This is the latest in a series of selloffs since late 2020, such as the Omicron scare last winter and the Chinese real-estate liquidity crisis last summer. This time the drop was faster and deeper, potentially exacerbated by lower market liquidity, and with a less obvious catalyst. As we have previously discussed, volatility, uncertainty and negative sentiment can indicate compelling opportunity.

Oil Market Update: Strong Demand, Constrained Supply, Prolonged Recovery and Discounted Equities

Oil demand is strong despite a challenging global macroeconomic situation. The energy crisis in Europe and Asia is increasing demand for crude oil (and coal) for power generation. Continued economic development in emerging markets is increasing structural oil demand. Much of the world’s population resides in these areas, with line of sight to a decade or more of oil demand growth. And the recent decline in oil price and compression of refining margins are resulting in lower gasoline prices, further stimulating demand.

Oil supply is being limited by continued under-investment across the value chain, driven by negative sentiment and ESG considerations. Governments continue to disincentivize investment in oil and gas through increasingly onerous taxes and regulations. And virtue-signaling investment firms and asset allocators are still divesting from the industry. As a result, many producers are choosing to de-lever and to return capital to shareholders, reducing growth capital and perpetuating undersupply. These are structural issues that may require years of activity and much higher oil prices to resolve.

Another symptom of prolonged under-investment is seen in OPEC+ and non-OPEC oil producers’ unsustainably depleting reserves. OPEC+ has very little remaining spare production capacity, which is on display as it continually misses its monthly quotas. Brazil and other non-OPEC countries are continuing to miss production projections. And the US is rapidly depleting its Strategic Petroleum Reserve to suppress short term oil prices, while shale development has slowed due to ESG-driven divestment and shifting capital allocation.

Oil and gas equity valuations have rarely been as low as they are now. The equities are “pricing in” much lower commodity prices than seen in the futures markets, yet share prices still declined even more than the price of oil in the recent sell-off. Some E&P’s shares are now trading lower than they were last year (when oil was $30/bbl lower!) and far lower than the last cycle high in 2014. And the companies are better businesses, with the long down-cycle translating to better company-level capital efficiency and higher shareholder returns, displaying higher profitability despite lower share prices.

On the Recent Oil Sell-Off

This compelling backdrop made the recent precipitous oil price decline even more jarring. On July 5th, WTI oil declined more than 10%, closing below the psychologically important price of $100/bbl. Unlike the post-Omicron sell-off, there were no obvious catalysts for this latest move, beyond general recession fears. In fact, it came after a long weekend of largely positive news streams for oil: Saudi Aramco announced that it was increasing its market pricing and there were indications that US-Iran negotiations were faltering, keeping an estimated 1MM bbl/d of oil production off the market. Contemporary markets are increasingly dominated by large index and mutual funds, and market makers are largely automated, and so it is possible that this crash may have been triggered by technical or other algorithmic factors. For instance, Brent oil broke below its 100-day moving average, a potential sell indicator for algorithms behind some market participation. And open interest in oil futures is low, increasing potential price volatility:

spec positioning vs oil price

Crude Oil Net Spec Positions vs WTI Price (Bison Interests, CFTC, Investing.com)

Regular pullbacks are characteristic of a healthy bull market: they weed out speculators and reduce capital investment, improving long-term industry prospects. To put this recent move into perspective, there have been several days where oil prices were down more than 6% in the last two years and three days where oil prices were down more than 10%. Each of these were followed by sharply higher oil prices, as can be seen below:

daily oil change % vs oil price

Bison Interests

Oil Equities Remain Cheap with Strong Fundamentals

Down about 30% from their recent highs, oil and gas equities appear to be pricing in a recession, especially considering pervasive recession fears and active recession focus in financial and social media. Many companies’ share prices have retraced 2022 gains, and are trading near or below levels they were at when commodity prices were much lower. Yet sector profitability has improved, with companies generating substantial cash flow at $90+ WTI oil and $6+ natural gas.

E&P valuation discounts to fundamentals have widened further with the recent sell-off. Recent investment bank research estimates that share prices of larger capitalization oil and gas producers imply $60 oil and $3.50 natural gas, and that shares of more heavily discounted smaller cap producers imply $50 oil and $3.00 natural gas. In theory, this discount provides a “margin of safety” even if commodity prices fall, especially considering that many E&Ps are highly profitable at lower commodity prices.

E&P business models have rapidly improved with higher commodity prices and lessons learned from the 2014 oil price crash. Following massive overinvestment that led to hundreds of billions of dollars in losses in the previous cycle, companies are limiting investments in new projects and are instead paying off debt and returning capital to shareholders. The associated decrease in financing costs may unlock further cash flow, particularly for companies burdened by high interest debt incurred during the industry downturn.

Many oil and gas company equities have become cheaper as fundamental improvements have outpaced share price appreciation since the start of the bull market in 2020. There is enormous potential upside if oil and gas equity valuations were to mean revert to historical valuation multiples. And even if a re-rate never materializes, there are alternative paths to attractive returns for the sector, such as substantial free cash flow directed to debt paydown, share buybacks and dividends.

Warren Buffett’s recent, large purchases of oil and gas companies are another indication that the timing is right for oil and gas. Buffett has demonstrated his skills as a value investor and market timer over decades of investment success. Buffett aggressively purchased oil and gas positions in the first quarter of 2022, when share prices were higher. And he apparently is finding these investments even more compelling at current valuations, as he has continued to buy recently.

Potential “Commodity-Triggered” Recession

This pullback may prove to be another buying opportunity in hindsight, similar to our call in November 2021. If recession fears do actualize, commodities and associated equities may continue to outperform while the broader market languishes for several years, like in prior “commodity-triggered” recessions:

commodity prices in commodity drive recessions

Bloomberg

Growing Demand from Developing Countries Despite Downturn Narrative

Contrary to the prevailing narrative, the world needs more oil, not less. Oil and gas are essential to human life and are deeply intertwined in the complex value chains behind many of the items we use every day. Demand continues to grow every year, particularly in rapidly developing countries where people are trying to improve their standard of living via incremental oil consumption. This trend can be observed in this chart of the Human Development Index vs. energy consumption per capita:

human development index vs energy consumption

Bison Interests

Most world incremental oil demand is in developing countries, tracking improvements in standards of living. With a large portion of the world’s population in these countries, it is likely that the long-term trajectory of continued oil demand growth will continue. And the IMF projects the world economy will grow by 3.2% in 2022, despite a “gloomy and more uncertain” economic outlook in July 2022.

Falling Refining Margins Support Demand

Refined products demand has been resilient in the face of soaring prices. Demand destruction expected by many analysts and economists at this price level has been moderate, and could be overstated based on congestion and gas station purchase data. Fortunately for consumers, crack spreads—the difference between the cost of crude oil and the price of diesel and gasoline—are narrowing:

us refining capacity vs crack spread

Bison Interests

The decline in crack spreads is a result of the resumption of some exports of refined products from China and Russia, an increase in exports from Saudi Arabia, and additional domestic refinery utilization. These factors are making gasoline and diesel cheaper for consumers while increasing crude oil demand. While a further collapse in crack spreads could be a negative indicator for oil demand, these margins are still quite elevated compared to historical averages and are at levels where refinery operations are highly profitable. This reversion back to more normal crack spreads could lead to higher oil prices and lower refining company margins, implying margin expansion for E&Ps.

Upside from a Potential DXY Reversal

The dollar index (DXY)—which measures USD strength relative to a basket of other major currencies—has been appreciating over the last year. This appreciation was largely driven by a weaker Euro and Yen, which have languished amidst economic strains and energy crises. A higher DXY risks reducing oil demand and pressuring oil prices lower, as oil is priced in USD and has become more expensive in other major currencies. The short-term inverse correlation between oil prices and the DXY can be observed empirically:

price for dollar vs gold over time

Bison Interests

As can be seen above, in periods of US dollar strength relative to foreign currencies, oil prices tend to fall, although this effect is not immediate. Without taking a directional view on currencies, a DXY mean reversion or even slowdown in appreciation could be bullish for oil as foreign demand recovers.

Energy Crisis Induced Oil Demand

European natural gas imports from Russia have been constrained, sending European natural gas prices (TTF) nearly 10x above Henry Hub and now 3x higher on a barrel equivalent basis than Brent oil:

european vs US natural gas prices vs oil price

Bison Interests

This price spread is increasing demand for oil for power generation in Europe and in competing LNG importing markets like Asia. European countries such as France and Austria have directed their utilities to increase the use of oil for power generation, where possible. And individuals and businesses in Europe and Asia, concerned with power costs and potential reduced availability, are increasingly installing gasoline and diesel burning power generators. Last winter, up to 2MM bbl/d of oil and oil products were burned for power and heat in these markets. We have seen estimates of as much as 5MM bbl/d of potential related oil demand this coming winter.

SPR Inventories Nearing Record Lows

In response to higher oil prices, the Biden administration ordered a major release of oil from the Strategic Petroleum Reserve (SPR). The SPR is approaching dangerously low levels, limiting its availability and increasing the chance of a true shortage in a future potential crisis:

spr vs commercial crude oil inventory levels

Bison Interests, Cornerstone Futures

Over the last year, over 115MM barrels of oil have been released from the SPR, with a high of nearly 1MM bbl/d in May. And if the US were to continue releasing oil from the reserves at this pace, the reserve would shrink to a 40-year low of 358MM bbls. The SPR releases over the last year have done little to quell rising prices and have had a minimal impact on commercial inventories, while reducing remaining oil reserves available in case of an emergency.

The rapid depletion of the SPR uses up much needed oil reserves and may result in much higher prices moving forward. Release of the SPR is inherently limited and is increasingly strategically precarious as it is depleted. And the Biden administration has indicated it may replenish depleted SPR reserves, hoping for a lower price, but likely temporarily bolstering oil demand and potentially increasing prices. As seen above, the SPR release has barely stemmed the decline in US oil inventories, which may resume their prior decline rate as soon as the SPR release is done.

Market Structure is Tight and “Looking Through” the SPR Releases

Ironically, the futures market is also “looking through” the SPR releases, with spreads near multi-year highs. This illustrates the under-supply situation in the physical oil market, and the high premium paid for oil available today versus oil for delivery months in the future. Historically, such backwardations have been correlated with rising prices. Remarkably, the release of 1MM bbl/d of oil from the SPR has been insufficient to force the spreads lower:

oil time spreads

Bison Interests, Cornerstone Futures

Lack of OPEC+ Spare Capacity

The rapid depletion of oil reserves and spare production capacity is a global phenomenon. As OPEC+ repeatedly misses monthly production targets, our thesis on the lack of OPEC+ spare capacity is becoming more widely accepted. Industry insiders and executives, some of whom have worked closely with Saudi Aramco and other major producers, have sounded the alarm as well. And no surprise with the cartel struggling to grow its production, Biden’s recent visit to Saudi Arabia did not elicit more oil production.

As the world reluctantly comes to accept that the OPEC+ spare capacity likely can’t backstop additional demand this cycle, and as global production continues to disappoint consensus estimates due to years of underinvestment, oil prices may be pushed much higher. In a scenario where OPEC+ production flattens or even declines after the last agreed to production increase in 2022, there could be a ~2.6MM bbl/d oil supply deficit in the global market:

bison estimate of oil production from OPEC+ over time

Bison Interests

Oil Field Services Cost Inflation is Supporting Higher Prices

Oilfield services companies provide critical equipment and services to E&Ps, such as drilling rigs, pressure pumping equipment, proppant and tubulars. Oil and gas companies have seen significant cost inflation in these services, which is increasing their costs of production, reducing activity and ultimately supporting higher oil prices. And a very tight labor market is not helping. New drilling operations are often delayed, to the extent the oil companies are willing to pay the much higher prices.

As costs rise and as oilfield services capacity likely remains tight for some time, supply may continue to be restricted, potentially further supporting oil prices. This is a natural consequence of years of under-investment:

US annual oilfield services expenditures

Bison Interests, Bloomberg Intelligence

Much Higher Prices May be Needed to Clear the Market

The world has been underinvesting in the oil and gas value chain for years, driven by ESG divestment and other factors. This will take years to resolve itself, resulting in a likely scenario of structurally higher oil and gas prices—which may continue to stoke inflation across the economy. In the stagflation scenario we are describing, oil and gas investments may generate the highest real returns, similar to the inflation of the 1970’s:

inflation adjusted total returns for select asset classes from 1971 to 1981

Bison Interests, Marketwatch

“This time is different” are the four most dangerous words in finance. However, unlike the shale boom that led to the 2014 oil price collapse and perpetuated the downturn for years, investment is already lagging the price recovery, despite “windfall” E&P profits. Even with painfully high oil and gas prices, it appears unlikely that the regulatory environment will become easier to operate in: politicians prefer importing oil and gas from foreign countries, which often have fewer regulations and environmental restrictions, rather than loosening restrictions on domestic production. And some have begun to cite higher energy costs as “the price to pay” for a transition to alternative energy.

This Sell-Off is Similar to Prior Sell-Offs

On the Friday after Thanksgiving of 2021, there was a 12% drop in the price of oil on renewed fears related to a new variant of the Coronavirus—pundits and macro “experts” declared that commodities had peaked and that the oil trade was over. We reviewed and addressed these misconceptions in our white paper titled Embracing Volatility: Buying the Black Friday Sale on Oil, at a time where oil and gas equities were tanking and sentiment was negative. Oil and gas equities subsequently broke through recent highs and massively outperformed the broader market:

XOP vs SPY over time

Bison Interests

Looking Ahead

Demand continues to grow worldwide and particularly in developing countries, while the marginal cost of supply continues to rise due to services cost inflation, under-investment and regulatory burden. Ultimately, it may take years of much higher oil prices to incentivize producers to overcome these hurdles and invest in new production. Meanwhile, oil and gas producers and services companies will likely continue to benefit disproportionately, offering their investors a compelling opportunity.

Sources

WTF happened to WTI?

U.S. to let Eni, Repsol ship Venezuela oil to Europe for debt

EU parliament backs labelling gas and nuclear investments as green

Germany dims the lights to cope with Russia gas supply crunch

Bundestagsbeschluss: Grünes Licht für Kohle als Gas-Ersatz

Biden Visits Saudi Arabia This Week. Oil Is Top of Mind.

List of 152 developing countries of the Third World



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