East Daley analyst: One clear lesson is that energy cycles are a force for creation as well as destruction.
The oil and gas industry confronts an extraordinary set of challenges navigating the fallout of the COVID-19 virus. There is no comparable benchmark for the crisis at hand, and no roadmap to consult for managing during a global pandemic.
Uncertainty and fear are pervasive, but we are confident in one prediction: This downturn, like every energy cycle of the past, will create new infrastructure needs and investment opportunities as a consequence of market disruption.
The industry has been blindsided as economies around the world shuttered to arrest COVID-19 spread. The situation is particularly difficult for oil markets, which confront three major obstacles.
First, the global response to coronavirus has dealt a disproportionate blow to petroleum demand. Transportation needs dominate the call on oil, and there is so much less movement by road, air and sea amid shelter-in-place conditions. The International Energy Agency estimates that global oil consumption fell 29 MMbbl/d in April, a stunning collapse without historical precedent.
Second, oil markets were already oversupplied before Covid-19 struck. U.S. oil production rose 1.2 MMbbl/d last year and is up 3.4 MMbbl/d since 2016 due to tight shale development. Meanwhile, global economic activity slowed through 2019, particularly in China, leading to below-expectations crude demand. Loose market conditions are reflected in high storage inventories, which have limited the flexibility of producers and distributors to manage imbalances caused by plummeting oil demand.
Finally, oil market psychology was wounded by the recent stalemate between Saudi Arabia and Russia over supply cuts. The expanded OPEC+ coalition had underpinned bullish sentiment since forming in late 2016 to help manage global oil supply, indirectly creating market space to accommodate robust growth in U.S. tight-oil production. The potential dissolution of the OPEC+ group raises the specter of an all-out price war as petro-states compete for market share, squeezing independent E&Ps in the process.
Energy prices have sold off aggressively amid the fallout, reflecting pervasive fear that oversupply and slowing demand will not correct anytime soon. WTI crude futures have plunged to around $20/bbl from above $60/bbl at the start of 2020. Energy equities are also beaten down and badly trail the broader market. The XLE, the sector-wide energy ETF, fell 36.7% year-to-date through April 30, more than twice the decline of 15.9% in the S&P 500 over the same period.
The immediate imperative for energy companies is to preserve cash flow. Producers are laying down rigs, shutting in wells and slashing capital budgets. Midstream companies are abandoning pipeline expansions amid lowered supply expectations.
The forward price curve for oil increasingly reflects extreme downside market risks. East Daley Capital has modeled a low-case scenario that assumes depressed oil prices continue for several years, with WTI remaining below $40/bbl this year and under $50/bbl through 2023. It also forecasted U.S. oil production would decline rapidly in such a scenario, down 1.3 MMbbl/d through May 2021 from a peak in early 2020, exclusive of any voluntary well shut-ins by producers. While this outcome would be devastating, it is also clear that the resulting pain would not be evenly distributed across industry commodities or assets.
Reduced drilling activity is hitting U.S. oil and gas basins differently. Revisions to E&P budgets suggest that rig counts will decline fastest in plays like the Bakken and Denver-Julesburg (D-J) Basin, while drilling in the Permian Basin appears more resilient. The impact to midstream assets that serve these basins will vary as a result.
And while the situation for oil is bleak, natural gas appears better positioned to navigate coronavirus. Gas demand is more sensitive to weather and therefore should hold up better than oil amid demand-side strains. Moreover, reduced oil drilling should staunch the rising flow of natural gas produced in association at the wellhead. In a downside crude modeling scenario, East Daley Capital found that U.S. oil basins would shed 4.3 Bcf/d of associated gas production by 2021.
Energy markets are cyclical by nature. The industry has never seen an event like COVID-19, but it has experienced unforeseen shocks: hurricanes, tsunamis and global recessions. Investors and industry can look to these past shocks for clues to navigate the challenges ahead.
One clear lesson: energy cycles are a force for creation as well as destruction. For example, U.S. natural gas market volatility in the 2000s incentivized drilling and experimentation in shale rock, leading to a domestic industry renaissance. Some 20 years later, the shock of shale abundance continues to ripple through oil and gas markets.
So much of current focus is on the immediate devastation to cash flow and investor expectations caused by coronavirus. Yet like wildfire consuming a forest, these disruptions also help let in sunlight and sow the seeds for regeneration and growth in the future.
Where can investors look now for “green shoots” amid the dislocation caused by coronavirus?
A good place to consider is natural gas-focused infrastructure. E&Ps in low-cost gas basins such as the Marcellus in the Northeast and the Haynesville in Louisiana are poised to see a lift if a downside oil scenario continues to play out. East Daley believes natural gas prices in the range of $2.50–$3.00/MMBtu are necessary to incentivize new drilling in these basins, well above forward prices.
Private midstream operators also deserve a close look. Private G&P assets often fly under investors’ radar, but legacy systems in some gas-focused basins should have the ability to capture increased volumes if producers expand drilling into a higher natural gas futures strip.
Now more than ever, midstream executives must arm themselves with the right information to understand the risks inherent to unfolding events and to identify nascent investment opportunities. Volatility is higher while data has never been more prevalent to move markets at lightning speed. The trick is to leverage the data, to cut through the noise for actionable intelligence.
Executives also must steel themselves for difficult decisions ahead. Coronavirus has further soured negative sentiment among midstream investors. With expectations set low, executives have a unique opportunity to think strategically and act boldly.
Brave actions may mean selling non-core assets at low multiples if proceeds can be leveraged into a broader strategy and higher future returns. It may require that pipelines proactively renegotiate shipper contracts, sacrificing near-term cash flow for greater future certainty while generating counterparty goodwill. Or it could mean acquiring out-of-favor assets at attractive prices, if those assets can be melded into a greater company vision.
Contrarian decisions may create short-term pain but, when anchored in a thoughtful strategy, can lead to outsized rewards by shareholders down the road. Companies must first define a strategy that makes sense in a difficult commodity environment, and then build a footprint that aligns with the strategy.
It will be no easy task. Energy markets have never been more interconnected, dynamic or complex. Changes in the outlook for crude, natural gas and NGL have ramifications that transcend each commodity market. Midstream companies, many involved in gathering and processing of multiple products in different basins, are particularly difficult to value. Yet their complexity also creates opportunity and optionality amid volatility. By drilling down into the fundamentals of the different commodities that drive asset-level cash flows, investors can discover opportunities where midstream assets are mispriced.
Capital will continue to flow into the energy sector during coronavirus, though it is likely to flow in new directions. To navigate these challenges, successful executive teams will remain nimble and vigilant, and be willing to revisit one-, three- and five-year plans on a frequent and structured basis. They will listen honestly to what new data is telling them and question their assumptions on prevailing market trends. And they will solicit counsel from truly independent advisers who can provide a frank outside perspective, rather than reinforcing internal biases.
Justin Carlson is the co-founder and chief strategy officer of East Daley Capital. For more information, visit www.eastdaley.com.