Thursday, 13 April 2017

The problem with the Energy sector & Tullow Oil (LSE:TLW)

Energy stocks. 

They are cheap by (recent) historical standards.

Now the issue is when will the oil price rise again in order to drive up earnings and a recovery cycle in the sector. In a normal business cycle commodities tend to see a drop in demand, followed by a cutting of investment in production followed by a rise in demand and therefore a sweet spot of rising prices before a new capital investment cycle kicks in. As long as the music is playing they have to get up and keep investing.

[None of what I have to say about this is original it simply sums up the position for my own understanding of the energy stocks in my portfolio.]

So with the downturn in oil prices now well into its third year one might expect the cycle to start to turn around. The protracted downturn after such a strong price environment during the 2010-2014 period has rather caught the industry out hence the trouble for my investments in Tullow Oil and Diamond Offshore.

This time it is different. 

But also the same.

It is different because unlike the 2010-2014 boom in oil prices the US is not creating new money. In fact headwind no.1 US is tightening monetary policy. This is bad for oil and bad for all commodities priced in dollars. A reduction in the global supply for dollars means a reduction in the price of commodities as there are fewer dollars around to chase the goods of global trade. 

Headwind no.2; OPEC. Recent high prices mean many countries like Saudi and Venezuela have been able to fund huge social giveaways. Now the price has halved they need to pump twice as much to meet costs. They cant do this because they have a production quota in the cartel. But at this point to raise prices they need to cut more, just when they can least afford it – so the incentive to break ranks and pump more means discipline is poor. This is to be expected. (Conversely when prices are high OPEC exacerbates the problem as there is an incentive to slacken production to make maximum revenue on your finite resource.)

Now maybe OPEC cuts would be more effective, threats of further cuts even have bumped the price, but for headwind no.3 – US shale. US shale is back in fashion as this previously high cost operation has managed to get its costs down so it is profitable with $50/bbl oil. This means with the present oil price whatever Saudi and OPEC cut the US is trying to make up with domestic production. Therefore US shale can make up the shortfall as the marginal producer – this effectively damages OPECs power because their biggest customer is becoming more self-sufficient. 

Wikipedia: Oil producers (2016)

Now ultimately the attrition rates of shale wells are high – they need far greater capital investment and the best formations have been exploited first. But in the near term the pressure on the oil market is intense.

The residual headwind is no.4 – Global Growth. With China slowing down (world no.2 consumer) and European demand falling for several years who can pick up the slack on the demand side? With a tightening dollar being negative for emerging markets (as they all hold dollar reserves and dollars become more scarce) it is difficult to see what can drive the price higher in the near term.

Wikipedia: Oil consumers (2015)

So there you have it. This makes energy stocks cheap, especially ones like Diamond Offshore – who wants deep water rigs when you can just drill onshore shale. They are likely to stay cheap until this turns around. So I view them a bit like options.

That said with TLW recently showing some unexpectedly strong share price performance I have been trimming my position quite a bit as it rose above my near term (Oil ~$60) fair value of ~£2.30. I still like it long term but having risen above the price it traded at the time of the rights issue announcement (while being now ex rights) it seemed a good time to sell down some shares once they went ex-rights to fund buying the new shares in due course. I think the buying has been driven by the short term rise in the oil price since the rights announcement with Brent oil up ~10% principally it would seem on geopolitical matters.

Eventually the capital cycle will turn assuming the earth does not enter a permanent depression. 

This is because every year several million barrels of extracted production must be replaced just to meet current demand excluding any increase in demand from global growth. This requires investment and with available oil becoming harder to find on land more investment is likely to be targeting offshore. The investment of course won't come until there is a crunch in the supply/demand balance for oil. That may be driven by fundamentals or by the dollar or increasingly it is difficult to see which is the dog and which is the wagging tail.

What could change the current status quo for higher oil prices:

  • A reversal in the direction of US tightening or at least dovish Fed comment
  • Higher than expected global growth especially China
  • Rising costs for US shale as less attractive fields are exploited driving down marginal production
  • Tighter than expected OPEC compliance
  • War and conflict
I would say the first and last reasons look the most likely over the next 6 months given slowing US data and problems in Syria.

What could extend the current status quo for higher oil prices:
  • A hawkish fed and the reversal of QE
  • A major onshore oil field discovery
  • Better shale drilling technology and attrition rates
  • Peace and serenity
  • Serious OPEC non compliance

Disclaimer: I have an interest in LON:TLW and NYSE:DO shares at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

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