The rise in the price of oil, with a barrel of Brent crude now back at a five year high of $85, has almost gone unnoticed this year in comparison with US monetary policy, trade wars and the stock market hegemony of the FAANGS. We believe that the causes of oil’s recovery have been multi-faceted, likely to endure for some time and that the energy sector currently offers some of the best opportunities in global stock markets. Moreover, in a stock market which is now wary of mature bull markets and high valuations inflated by low interest rates and quantitative easing, these opportunities are nascent recovery plays from decade long bear markets for which steepening yield curves reflecting robust economic growth should be supportive. If the normalisation of economic growth and interest rates are bad for Wall Street rather than Main Street this should be just fine for oil stocks.
US onshore and OPEC
For almost a decade the management of major international oil companies have been told by their shareholders to focus on cash generation and returning capital to shareholders. US shale has been the exception to this rule and the source of incremental global production (with the US now set to overtake Russia as the world’s leading crude producer, now producing 11m/b/d from just 6m/b/d in 2011). However, US onshore production has run ahead of the infrastructure needed to bring shale barrels to market: this has initially manifested itself in the Permian basin (with infrastructure bottlenecks not expected to be unblocked until at least H2 2019) and could now extend to other onshore basins. OPEC (and its allies) are also constrained: Venezuela seemingly in permanent decline, Iran now subject to sanctions; Russia already back at full production and Saudi Arabia either unwilling or unable to ramp up its theoretical capacity. As such, the oil market would seem to have lost (at least temporarily) both its key sources of swing supply: US shale and OPEC. This leaves international offshore oil producers, which have been in retrenchment for a decade, as now best placed to step up additional supply.
The new International Maritime Organisation (IMO) rules for shipping will also likely have an impact. From 2020, shipping will no longer be immune from environmental regulations on emissions allowing vessels to continue to burn high sulphur bunker fuel. Global maritime fleets will be faced with a choice: either refit their ships with costly, emissions reducing, scrubber equipment or switch to less polluting fuels, most likely diesel. The leading container shipping companies, who speak for nearly all the global demand, will comply for fear not just of enforcement but also reputational damage. The effect on the oil market cannot be underestimated: complex refineries able to produce the necessary less polluting fuel from low grade oil will make supernormal profits but overall demand will also significantly increase for the type of low sulphur crude more typically found offshore. We would highlight Sardinian refiner Saras as particularly well-placed here. Moreover, the likely spike in diesel refining margins will bring significant knock on cost inflation effects in other modes of transportation (air and car) to which the global economy will have to adjust.
There is an argument that the management of publicly quoted oil producers will simply not respond to the higher oil price and will hold their budget for new oil projects at $50 and not raise capital expenditure for 2019 from 2018 levels. Indeed, this argument is the basis for why the offshore oil services sector has stubbornly refused to meaningfully re-rate so far, despite its historically higher beta, to a higher oil price environment and dramatically changed environment for offshore exploration. It is not too exaggerated to suggest that without higher capex from Big Oil there might be a more dangerous spike in the price of oil that could endanger the global economy. As such, instead of berating OPEC with his tweets, it might be more appropriate for President Trump to redirect his ire to the overly-cautious management of the Seven Sisters.
The more constructive debate is the extent to which capital expenditure will rise, how quickly and who will see first benefit. We therefore see significant opportunities in areas of the oil services industry geared to the early stages of recovery. Our research indicates that the first oil services sub-sector to benefit from budget flush as early as Q4 this year will be the providers of seismic mapping data that allows oil producers to improve productivity from existing drilling, with momentum increasing into 2019 as exploration budgets move higher than a $50/barrel budget. The seismic industry has also seen a meaningful retrenchment in capacity over the last couple of years with Schlumberger-owned Western Geico, previously the global leader, retrenching and disposing of its ships, leaving TGS Nopec as the undisputed global leader at least in multi-client activity. The next stage of the recovery will likely see the utilisation of seismic vessels increase causing cost inflation in the value of new mapping data, from which the companies that continued to shoot multi-client surveys at bargain prices throughout the downturn will be well placed to benefit.
There is a well-known saying that the two best days of being a yacht owner are the day that you buy the boat and the day you sell it, such are the ongoing costs of ownership. The owners of oil rigs will recognise this all too well after seeing their highly valued assets turn to liabilities as oil companies cut back on offshore drilling with the rigs either operating at below cash break even, temporarily retired from the market or scrapped altogether. However, rig assets accumulated relatively inexpensively during the downturn are now highly sought-after in a tightening market where availability has already become more limited. Although the industry has already seen scrapping of older, less productive assets, further consolidation, viewed as desirable by leading industry players might further accelerate this process and hasten rapidly recovering pricing power. Indeed, as I write, Ensco and Rowan have just announced their intention to merge and consolidate the jack-up market, which is our favoured rig market of choice, given the additional costs of owning and operating deep water rigs (as opposed to shallow water jack-ups). We highlight Borr Drilling as our favoured play here, likely to get a free ride on the latest wave of consolidation.
Within European power generation markets we have also recently witnessed a recovery of the market for carbon permits which has increased the premium on clean energy generation, therefore penalising high carbon emitting fossil fuels such as coal. This has dramatically increased the arbitrage opportunities in international gas markets for the importation of cheap stranded gas via LNG (liquified natural gas). As such owners of LNG vessels, after years of marginal profitability, have seen their recent prospects dramatically improve with little new supply of ships expected until 2022. Outside of commoditised LNG tankers, we see continued opportunities in LNG vessels that roam the seas in search for stranded gas reserves without the need for gas having to be pumped back onshore into a permanent gasification terminal. We see Golar LNG as the most intriguing play here.
Sector leadership in a normalising macro
The return of a meaningful “risk free” rate in terms of Fed Funds and Treasury yields is sucking global liquidity from financial markets. But rising global economic activity should be positive for cyclical, commodity and financial sectors and indicate rising expectations for corporate profitability. Conversely, those sectors where profitability is insulated from economic growth but inversely correlated to discount rates, should suffer most from the withdrawal of global liquidity.
Yet stock market leadership is currently confused. When stock markets sell off owing to rising bond yields the knee jerk reaction of European equity investors, worn down by a decade of deflationary fears, is to gravitate back to the comfort blanket of defensive sectors. This in our view might only be justifiable if yield curves were flattening (or inverting), indicating that monetary policy was moving too quickly and that a policy error in terms of the withdrawal of liquidity could cause a global economic slowdown. But a market that favours Main Street rather than Wall Street should be just fine for oil and its equities.