You can read everywhere that due to the “coming recession” in Western countries, energy demand is going to take a hit and push prices down. Likewise, you also find headlines that Chinese recovery demand might come in below expectations. It is a foregone conclusion that prices of energy will go down – everything circles around demand. But is this the big picture? What would happen if a massive supply shock took market participants by surprise? You won’t be surprised, but prepared, with this latest Weekly.
Summary and key takeaways from today’s Weekly
– It is quite a challenge for me to see what will drive production growth (or even keep it stable) over the next one to two years in the US shale industry which at its peak reached “another Saudi-Arabia”.
– Due to it being the only growth engine of worldwide oil supply over more than the last decade, the looming production plateau (in a better case scenario) and the subsequent coming decline are akin to an un-voluntary production cut by the shale industry.
– At the same time, energy companies are harvesting the low-hanging fruits and returning capital to shareholders. Energy stocks are a core of a portfolio for me!
Commonly, it is no secret – and unfortunately a wrong belief disproved by history – that with an economic recession commodity prices are falling together with everything else. Although the core behind this thought is true – there is a business cycle that leads to price swings and exaggerations in both directions – the whole concept often is not understood properly.
As I wrote in my Weekly “Commodity stocks and recessions – clearing up a common misconception” (see here), it is necessary to distinguish between a general business cycle for non-commodity companies on one hand and a commodity spending cycle for commodity businesses on the other. If you haven’t done so, please read this article first.
Actually, it is only the latter – the commodity spending cycle of commodity businesses – that can be used reliably as an indicator for investment decisions in resource companies.
It only happened once (!) since 1900 that the overall business cycle peaked together with the commodity spending cycle – in 2008. Likely this is also the reason why many associate a recession with falling commodity prices.
Since their highs last year, both, oil and gas prices, have come down substantially. This is commonly viewed as a precursor of the looming recession, everyone is talking about.
However, what is completely neglected by the vast majority is the supply side. My readers know that I am focussing on the supply side, as it is structurally slow-moving and thus a WAY better indictor of what is to come than fragile and fast-changing demand. Demand is guessing what could happen. Supply is hard facts.
The situation is akin to a tightened spring.
Instead of expecting a massive energy crash, I’d like to point in the other direction. You should be better prepared for higher, not lower energy prices. There are several reasons and many arguments in favor of this thesis.
In this latest episode of my Weeklies, we are going to uncover those fundamentals that really matter. It is not about guesstimating how demand could potentially develop.
That is coffee talk.
I am going to put the hard facts on the (coffee) table for you.
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A historical relationship is broken – part I
Part of the commodity spending cycle of resource companies historically has been that in bad times, there is a lack of capital taking (over)supply down until prices recover again, and during better times, when commodity prices drive higher cash flows, spending goes up, too, until oversupply starts the whole cycle again.
In the oil and gas industry, part of this spending cycle and a factor necessary to watch is the so called “rig count”. A rig is a platform combined with machinery, that is used to drill for oil and other related petroleum products, like liquids and natural gas. In an up-cycle, usually energy companies spend more on rigs to increase their drilling activity and their output, simply because the money is available.
This worked for so long, until oversupply killed the market and thus energy prices.
Accordingly, you should expect:
- higher energy prices = higher rig count
- lower energy prices = lower rig count
At least for as long as supply and demand rebalance again.
Here is a screenshot of the active rig count in the US over a time span of 36 years, from 1987 until the most recent, as per 31 March 2023. First, focus only on the big picture:
In this long-term view, you see that the total rig count is, as expected, highly cyclical, producing wild up and down swings.
So far, so unspectacular.
Now, let’s compare it to the price of WTI oil that the next chart shows over the same time frame:
Here we should see two things.
First, the rig count didn’t peak with the oil price in 2008, but eight years later, even after the oil price entered its bear market of the 2010s.
This shows the enormous oversupply that send the market into the basement.
The second thing – and more important – is that although we had a higher oil price since 2020, temporarily even reaching the highs of 2013–2014 again – and this is important now – the rig count is where it was in 1987 and way below (only ca. a third of) the big high of 2016 at around 1.600 rigs. But likewise, below the next (lower) high of 2018.
If you look closely, you will see that the rig count sits also below the 2019 level.
In other words, spending is still depressed.
Although there has been a recovery in rigs, it has been comparatively modest to date. Energy companies are not spending more, at least not measured by historical patterns.
Don’t over-interpret higher CAPEX numbers of energy companies, because they are “inflated” by labor-shortages, higher salaries and higher equipments costs. Increases in capital spent are not necessarily an indicator for higher industry activity as the not-growing rig count shows!
The reason for this reluctance?
There is not a single reason. It is rather a combination of several factors:
- political pressure to invest in ESG and the threat of windfall profit taxes
- pressure from activists
- lessons learned from the last bust and the subsequent depressed prices
- shareholder demands (returning capital instead of spending it)
- a more complex factor, we’re going to look at, later (spoiler: it has to do with the headline of this article)
Despite the foregone conclusion that energy companies with higher energy prices were going to increase drilling activities, this did NOT happen this time, although oil prices would have justified it. Rig counts are still a third below 2018 and two thirds below 2016, yes, even below 2019.
Taking all the above together, what the energy companies did, is even logical and rational.
This way, they act in the best possible way to meet the wishes and requirements of all parties, at least somehow. Additionally, they keep parts of their reserves untouched and only drill what is necessary, at least it seems so.
As an interesting side effect, many oil and gas companies now have the cleanest balance sheets they’ve ever had (even better than many other sectors have):
Due to low spending activities, margins, returns on capital and cash flows reached record highs last year. And all this without increasing volume, i.e. upstream output.
At the same time, valuations are pretty low in many cases.
Many don’t seem to believe this is sustainable.
But the odds are in favor of even higher energy prices, making oil and gas companies – at least for me – slightly provocatively said, core investments, akin to staples companies. Oil is needed everywhere.
And this time, there’s a good chance, prices will remain heavily supported.
In the next sections, we’ll drill deeper.
A historical relationship is broken – part II
In my article “Are evil energy (oil) stocks already priced too ambitiously for a recession?” (see here), I wrote that the powers in the energy markets are shifting back again.
While OPEC, the cartel of some important oil producing countries, led by Saudi-Arabia, has lost its influence in the 1980s for decades, the kingdom is striking back now. Together with some non-OPEC members (formally), called OPEC+, they are holding close talks and collaborate.
This past Sunday, 02 April 2023, OPEC+ striked again, after they had already cut production by 2 mn. barrels or the the equivalent of 2% of total world production in October 2022:
This came as a surprise for mainstream media and those using it as their source of information. Of course, Western politicians don’t like this move either.
In my Weekly back then from October 2022, I wrote:
It was also Saudi-Arabia that had a deal with the USA. Upon request, the Saudis would adjust production to move the price of oil in the “right” direction. In return, the Saudis were protected by the biggest military and received arms and weapons.
This is my observation of the last months. The current US administration seems to have angered the Saudis and thus broken their decades-long relationship. Thus, this mighty “swing-producer” could make decisions that are against what Western countries would like to see, as higher energy costs were the main driving force behind the currently high inflation rates, not seen since the early 1980’s.“Are evil energy (oil) stocks already priced too ambitiously for a recession?” (see here)
You see that this step was by no means surprising, but rather a matter of time and overall price levels of especially oil.
One should not underestimate OPEC+.
They will protect their interests, especially after the ties with the USA have loosened considerably, to put it mildly. You can see that this trend is in motion, as Saudi-Arabia und the UAE (another OPEC member) are more drawn towards BRICS, away from the West:
Just to put this into context:
Inside of BRICS – and some countries that also openly discuss joining – there are many commodity and especially energy producers. We are talking at this point about Russia (third largest), Brazil (eighth largest), Indonesia, Mexico (tenth largest) and others more (see here and here).
These shifts are going likely to have significant ramifications that should not be underestimated!
Together, OPEC and its “plus-members” are already producing more than 40% of total world oil supply. You can also see on the next chart that OPEC+ production is not reaching the early-2020 levels again – no matter whether intentionally or not.
This block is already big enough to influence oil prices.
OPEC+ is mighty.
OPEC+ plus BRICS would be even mightier.
However, this article is not about speculating how much power and influence of this group – in whatever form – could grow.
The relative market share and the overall power could even grow more in the future, without their own action, as there is something in the making that is not widely discussed at the moment.
A historical relationship is broken – part III
After we already discussed two factors that can influence the oil and gas market on their own, here comes the real game changer and the core of this Weekly.
Let’s have a look at the US shale industry.
Why is the shale industry so important? While it is commonly associated with contaminated water as well as dirty environments on one side and many bankrupt “frackers” on the other, though partly true, this completely misses the big picture.
Did you know that the US shale industry is the sole reason for oil production growth of the last decade? I am talking of worldwide production! In other words: Only due to shale oil and gas (inclusive of the boom that led to massive oversupplies), prices have been really low and affordable in the 2010s.
Here is the proof.
The first chart shows the development of the overall US oil and oil-liquids production over the last one hundred years:
The heyday of conventional US oil production was in the early 1970s. Many don’t know that. Since then, the US has been pretty import-dependent as domestic production halved over the subsequent 40 years, until around 2009.
Due to fracking – or shale production – it was possible to not only reach and even surpass former highs again. The shale revolution made the US a net oil exporter and even the biggest oil producer in the world!
Here is another chart showing some more context (don’t be confused by TWh instead of barrels as the message is the same):
The next chart compares OPEC to non-OPEC production:
Coincidentally – or not – the whole increase of non-OPEC (and factually total world, as OPEC was not growing) production of around 5–6k TWh since 2009 is the same amount that US oil production grew (see again the chart above).
If you prefer a more vivid comparison: The US shale industry that came from nowhere until its peak is the whole equivalent of another Saudi-Arabia (look at the charts above)!
This is a SIGNIFICANT leg to the whole story of the last decade.
Now, let’s have a look at the shale regions and some output data more closely. The following chart shows the areas of the USA where shale energy is produced:
From this report, on page 2, we get a deeper insight into oil and gas production per region:
The most important oil production regions are the Bakken, Eagle Ford and Permian Basin. For gas, it’s Appalachia, Permian and Haynesville.
Let’s first have a look at the three oil regions.
First, the Bakken:
The brownish-colored charts show that:
- oil production had its peak in 2019
- the highs have not been reached again, slowly moving sideways-down since the 2021 recovery
- rig count near the decade-low, hasn’t increased in proportion to the oil price
- new-well production declining (!)
While the first three points are obvious, the last one is a sign for declining productivity. This means, the same effort does not produce the same results anymore, but less! This, together with the high being in 2019, could be a sign that this field has already reached its peak-performance.
The situation with gas is comparable, there are only differences in the details.
It does not get better with a non-increase in capital spending. Or, you could also say higher spending is needed only to keep up the current production volumes, as productivity is declining!
Next one, the Eagle Ford from Southern-Texas:
A similar picture.
The peak in oil production, however, has already been in 2015. Rig count is also low and productivity (new-well oil production) down again since 2020. Gas seems to come around slightly better than oil on an output basis, but everything else is similar. Productivity also went south and no new volume highs have been made.
This is obviously the most mature field that is being harvested where possible, but a higher output should rather not be expected.
And the third of this group, the Permian, being the big hope, covering areas of Western-Texas and South-Eastern New Mexico:
At first sight, it seems that there is hope. Oil and gas volumes are still rising and even reaching new highs. However, here likewise, productivity is already declining, while at the same time rig count is not being increased meaningfully and certainly not close to the former highs.
What’s the message in this case?
It seems as if volume growth was made possible by tapping the most productive wells available. The best results with the lowest effort possible, so to speak. However, as productivity is declining at the Permian, too, it seems as if the volume-high should not be too far away, either.
This is something the Wall Street Journal also tapped into:
They start this article as follows (the rest is behind a paywall, but I could read it for free after a newsletter sign-up, bold by me):
The boom in oil production that over the last decade made the U.S. the world’s largest producer is waning, suggesting the era of shale growth is nearing its peak.
Frackers are hitting fewer big gushers in the Permian Basin, America’s busiest oil patch, the latest sign they have drained their catalog of good wells. Shale companies’ biggest and best wells are producing less oil, according to data reviewed by The Wall Street Journal.Wall Street Journal (see here)
In their article, the WSJ is citing key executives of big shale producers. One of them even said without making a secret of it, that the world will rely on supplies from the Middle East over the next decades.
Let that sink in for a while.
So far, due to having more than twice the combined output of the Bakken and Eagle Ford fields (and overall rising to new highs), the Permian was able to hold up overall US oil production.
However, what is taking place in the Permian is similar to what happened in the Bakken and Eagle Ford years ago, as they obviously already plateaued.
When you have a look into the EIA report and see the situation for gas production in the Appalachia and Haynesville, you’ll notice that Appalachia is showing signs of a peak in volumes with declining productivity. Haynesville is holding up so far volume-wise, but productivity is also declining.
The bottom line is, while energy producers are still reluctant to increase capital spending on new production meaningfully, they will be forced to increase it only to keep up current volumes up!
Looking a bit more into the future, there’s a not too low chance that this reluctance could lead even to an un-voluntary production cut by the US! Now tell me please, where is new supply coming from as US shale was the only new supply of the last 10–15 years?
This spiral has the potential to cause a supply shock that could even reach panic-like scenarios like in the 1970s where energy prices made jumps that were unimaginable, prior to the facts. For me, the energy crisis is not over. Be on-guard! With this in mind, you can guess whether inflation likely will go up or down? Energy prices affect the cost of everything in our everyday lives.
A last point to add is the strategic oil reserve.
Last year, the current administration released a rather unprecedented amount of around 200 mn. barrels. There has never been such a massive draw-down for as long as the chart below shows!
Being on a nearly 40-year low, the tank is run pretty empty.
As the administration announced during 2022, they were looking to refill the storage at prices in the low 70s of WTI:
Guess what, the price briefly has been there – and nothing happened! Now, the talk is to refill by the end of this year.
Other media are already hinting at this “missed opportunity”:
I am not sure whether this was a good move.
But what I am sure about is that a suddenly higher increase in demand from the government will propel prices higher, even more so, if it is accommodated by a panic.
However, the bottom line is that the supply situation is so fragile that it can lead to a massive price jump in oil over the next months, or a few years, at the latest.
What to do?
In September 2022, I published a research report for my Premium Members about a shale company operating in the Permian Basin. The price of the stock is around where it was as of my publication (however, two fat dividends could be collected since).
Am I now afraid that my thesis was wrong as oil came down temporarily? No, I see the current price weakness as an opportunity for a first entry or depending on when a potential first buy occurred, to load up.
I am still expecting quite comfortably a dividend yield of 8%. It can even jump into double-digits, as the dividend is paid variably, depending on business results. The last two quarterly dividends represented a yield of more than 10% on an annualized basis.
This company I wrote about is one of the big fish in the Permian. As the situation will likely be forcing higher acquisition activities, again (after many bankruptcies and takeovers in 2020), this business for me is the right pick to benefit from struggling smaller competitors, as well as from own operations.
It is quite a challenge for me to see what will drive production growth (or even keep it stable) over the next one to two years in the US shale industry which at its peak reached “another Saudi-Arabia”.
Due to it being the only growth engine of worldwide oil supply over more than the last decade, the looming production plateau (in a better case scenario) and the subsequent coming decline are akin to an un-voluntary production cut by the shale industry.
At the same time, energy companies are harvesting the low-hanging fruits and returning capital to shareholders. Energy stocks are a core of a portfolio for me!
By the way, I have sent this mentioned research report back then to all my free newsletter subscribers – as a thank you for their support. It pays being in my newsletter and even more so a Premium Member.
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