On April 7, I attended The New York Hedge Fund Roundtable: Opportunities and Risks in Today’s Energy Markets.
There, experts in the energy industry came together for a panel discussion to address the current state of the energy markets, the opportunities and risks of this volatile sector, and predictions for the future.
The panel was moderated by Greg Zuckerman, Special Writer for The Wall Street Journal and author of The Frackers.
Other panelists, all of whom are figureheads in the energy sector, specifically with respect to the financial markets, included: Chris Carter, Managing Partner of Natural Gas Partners; Stewart Glickman, Energy Equity Analyst of S&P Capital IQ; Rob Santangelo, Managing Director of Credit Suisse; and Stephen Schork, Editor of The Schork Report.
Current State of Affairs
With a focus on the current market, attitudes were mixed and, overall, sanguine. This made for a truly interesting discussion.
Each panelist expressed their own agenda:
Santangelo pointed out that while raising capital for upstream businesses is, currently, at the highest rate on record, the focus is now shifting towards recapitalizing companies.
Carter emphasized that energy businesses have to deal with the practical realities and obvious challenges of cutting costs and improving efficiencies.
Additionally, Glickman reminded us of the recent decision made by Saudi Arabia, along with Russia and Venezuela, to freeze output at January levels, which dashed hopes of a cut in production. As a result, he stated, “Clients are questioning the stability, or lack thereof, in dividends.” He also emphasized that investors are getting reallocated to energy volatility after a lull in the market from 2011 through 2013.
And finally, an undeniably bearish Schork revealed that there has been a tremendous drop in the amount of investors’ interest in energy since 2014, particularly among banking clients. Now, he states, “[exploration and production companies (E&Ps)] are hoping for the opportunity to hedge and blood is still running in the streets.”
Oil in Excess
One issue, however, where there was unanimity, was that the world is undoubtedly awash in supply. Without a reduction in both the growth of supply and pace, there is little hope for a market turn around.
Carter raised an important supply side issue: Once Iran, Iraq, Libya, and Nigeria came back on line (after disruptions), their combined output doubled, rising from five million barrels per day (bpd) to 10.
This was nearly the equivalent of adding another Iraq to the supply glut. In fact, a few days later, Iraq announced that it’s producing at a record level of 4.55 million (bpd), only further exacerbating this surplus problem.
Another reason for the glut, according to Glickman, is that when crude was in a backwardation, “all focus was on growth and not efficiency.” He noted that, while everyone is looking for that inflection point, 2016-2017 is not the time to catch the bottom.
On a more sardonic note, Schork defined the state of the energy markets as “capital ill-discipline,” because of three myths:
- The first myth, according to Schork, is that Saudi Arabia is trying to disrupt the U.S. oil markets. Not only are they not trying to do this, he explains, they are incapable of doing so.
- The second is that the Saudis will lower output. Schork says, “Don’t believe it.” Because the Saudis operate under “Taqiyya,” a juridical term referring to when a Muslim is allowed to lie under law, they cannot be blindly trusted regarding their output.
- And the third myth is that commodity prices drive the economy. Schork states this is false, plain and simple. He explains that “low commodity prices are bad for the economy… the two most important issues are the Sunni-Shia split and the lousy economy.”
The upside, according to Santangelo, is that crude demand is steady and will continue to grow. Meanwhile, supply is dropping, mostly from the United States. Carter points out that the U.S. is now the swing producer.
In fact, in the summer of 2015, the U.S. was producing close to 9.7 million bpd, and is now at 9 million bpd as of April 1.
The problem, as Glickman points out, is that oil is an inelastic commodity, and there isn’t enough elasticity to drive prices up. In fact, he points out, we are in the first supply-driven crisis in 30 years.
Adding to this problematic scenario is the substitution factor. Schork reminds us that, while gas guzzlers like the Hummer were once status symbols, they’ve now been replaced.
Now, the Tesla and other fuel-efficient hybrid vehicles are changing the demand dynamic. As driverless technology becomes less a thing of the future, the energy industry will only continue to see a major evolution of their necessity.
As Carter noted, all eyes will be on the April 17 meeting of OPEC and non-OPEC producers in the Qatari capital of Doha, to discuss the output freeze.
To date, 15 OPEC and non-OPEC producers, accounting for about 73% of global oil output, are confirmed to be supporting this initiative. Even so, the “agreement” lacks any compliance or regulatory surveillance.
Until then, however, Zuckerman sought some positive comments by asking the panel for bullish scenarios that could, even temporarily, boost the market.
Carter sees $35 to $40 per barrel oil as unsustainable, as most global producers don’t profit at these levels. This means we should see tighter markets in 2016-17.
Furthermore, Glickman explained that, whereas 30 years ago decline rates were 4% to 5%, today they’re 65% to 70%. This raised the question of, “How long are those who slammed on the [production] breaks going to stay on the sidelines?” With 6,000 producers and 140 refiners in the U.S. alone, the market is fragmented and ripe for consolidation.
Zuckerman then questioned the recent rally in crude futures. He asked who was buying and whether or not it will prevent a shakeout.
Schork expressed concern that bullish speculators haven’t been present. In fact, “the last five to six week period was the biggest short covering ever. Producers are selling forwards while banks are kicking the can down the road.”
Furthermore, he stated that “there is tremendous stupidity in the markets,” and he questioned how many banks will be getting out of the business entirely.
Carter mentioned that the sector raised $10 billion in the first quarter, but only by 16 companies – therefore, only 10% have access to the capital markets and the other 90% don’t.
While we saw 15 bankruptcies in 2015, this year, the number, he believes, is more likely to come in at around 100.
Glickman noted that in the merger and acquisition (M&A) world, buyers are picking off assets rather than whole companies.
On the other hand, Santangelo believes that hedge funds, energy specialists, and households are now buying, with two-thirds of the bank’s deals involving lending relationships.
Taking Advantage of Volatility
The panel agreed that the future of the energy industry is all about disruptive businesses, citing important factors such as the rising health risks from smog in China, as well as the changing statistics of vehicle ownership per capita, and energy efficient vehicles gaining popularity.
Glickman stated that while the integrated E&Ps are talking about 2040 sustainability goals, reaching these goals will likely happen much sooner.
As explained by Schork, Royal Dutch Shell no longer wants to be considered an oil company, but rather a natural gas company.
He suggests going long both natural gas names and MLPs in the short term, and shorting oil, in the belief that West Texas Intermediate (WTI) crude will be under $30 per barrel by the end of the year. Perhaps even less.
Glickman suggests focusing on emerging markets, which are the incremental drivers of growth.
But the bottom line remains: We still need to soak up that excess 1.8 million bpd.