Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: Chevron Corporation (CVX) – March 2020 Security Analyst Meeting Presentation

By Callum Turcan

Over the Easter holiday weekend, members from the Organization of Petroleum Exporting Countries (‘OPEC’), non-OPEC members that are part of the OPEC+ group (countries that in the recent past have joined forces with OPEC to curtail global oil supplies in a formal manner), and non-OPEC members outside of the OPEC+ group such as Brazil (EWZ), Canada (EWC), and the United States (SPY) came to an agreement to cut their collective oil output by north of 10 million barrels per day. Global oil and other raw energy resource prices (USO, BNO) have been simply demolished year-to-date due to a combination of demand destruction from the ongoing coronavirus (‘COVID-19’) pandemic and the emergence of a price war between Saudi Arabia (KSA) and Russia (ERUS).

Please note that oil demand destruction due to the “cocooning” of households (and the related drop off in refined petroleum product demand from automobiles, airplanes, etc.) may be as high as 35 million barrels per day according to some analysts, an enormous figure that’s resulting in major stockpile buildups all over the world. Other analysts don’t necessarily see the level of demand destruction as that high (projections are being updated constantly); however, they are still calling for a drop off in demand that’s in the ten(s) of millions of oil barrels per day range (at least in the short-term, depending on how long the pandemic lasts). Even if this agreement is effectively implemented, that won’t result in oil prices (and other raw energy resource prices) returning to pre-COVID-19 levels in the short/medium-term, in our view, but will make emerging from this pandemic an easier task given that global oil storage capacity is nearing its limit.

As of this writing on April 13, oil prices are trading up modestly but are still down by well over 50% year-to-date.

The Big News

OPEC and OPEC+, led by Saudi Arabia and Russia, will reduce their collective output by 9.7 million barrels of crude per day while the Brazil, Canada, and the US will reportedly add an additional 3.7 million barrels of daily oil production to that curtailment program. Norway (NORW) has also signaled it would cut production if a broader agreement is reached, on a unilateral basis. As this agreement could last until 2022, if not longer, that should allow for the group to steadily reduce global oil stockpiles over time. However, we caution that the actual size of the cut comes down to compliance, and furthermore, there are legal obstacles to be aware of in Canada and the US, where output curtailments could run afoul of anti-trust and similar laws. Here’s a key excerpt from OPEC’s press release:

Adjust downwards their [OPEC and formal OPEC+ members] overall crude oil production by 9.7 mb/d, starting on 1 May 2020, for an initial period of two months that concludes on 30 June 2020. For the subsequent period of 6 months, from 1 July 2020 to 31 December 2020, the total adjustment agreed will be 7.7 mb/d. It will be followed by a 5.8 mb/d adjustment for a period of 16 months, from 1 January 2021 to 30 April 2022. The baseline for the calculation of the adjustments is the oil production of October 2018, except for the Kingdom of Saudi Arabia and The Russian Federation, both with the same baseline level of 11.0 mb/d. The agreement will be valid until 30 April 2022, however, the extension of this agreement will be reviewed during December 2021.

Mexico (EWW), a member of the OPEC+ group, was a major holdout during discussions as the nation wanted to only cut its oil production by 100,000 barrels per day, instead of the 400,000 barrels that Saudi Arabia and others were demanding. Saudi Arabia and others did not relent in their demands, given that if Mexico were to get a pass, other OPEC+ nations would likely follow suit. Conformity is required for any oil output curtailment deal to work. In addition to the commitments made within the deal, three Gulf States (Saudi Arabia, the UAE, and Kuwait) have reportedly agreed to reduce output by more than planned according to energy market research and news services firm Energy Intelligence.

Interestingly, President Trump also reportedly (according to the WSJ and other financial news outlets) indicated the US would cut an additional 300,000 barrels per day of daily oil supplies to meet the oil cartel’s demands of Mexico, and here’s where some problems lay: There’s a high likelihood US oil output is already shifting lower as upstream producers are aggressively cutting back drilling, and most importantly, well completion activity. The reason why reductions in completion activity matters the most is due to the part of the upstream process involving “fracking” or hydraulically stimulating horizontal wells, which are tapping into shale, chalk, limestone, and other formations, leading to raw energy resource production. Drilling wells simply grows the drilled but uncompleted (‘DUC’) inventory.

With that in mind, the US is likely to see its oil production trend lower over the coming months, if not much longer, due to the very high decline rates seen at “fracked” wells during their first several years of production (initial decline rates in the first year can be as high as ~80%, but "choke management techniques" can limit that to a degree, bringing the decline rate down to ~50-60% give or take). However, natural production declines aren’t the same as an abrupt halt in output. Whether the OPEC/OPEC+ group will accept such measures as a “production cut” remains to be seen. Additionally, members of the group (both formal and informal members) will likely “cheat” in the sense that compliance rates tend to be well below 100% for some nations (as seen in past production curtailment deals), with compliance at Gulf States (Saudi Arabia, Kuwait [FM, GULF], the UAE [UAE]) often well above 100% to offset that dynamic.

There’s a balancing act considering that, if Russia, Iraq, Kazakhstan, Mexico and other countries aren’t near full compliance, the Gulf States (led by Saudi Arabia) may decide that the deal just isn’t worth it. Not having every nation reach and maintain 100% compliance for a sustained period of time is to be expected, but the goal is to achieve a groupwide compliance rate near 100%, so every nation needs to at least give the appearance that they are trying.

Russia’s compliance rate will be very important. In the wake of talks initially "blowing up" in early-March 2020 (which we covered in detail here and here), Russia and especially Saudi Arabia aggressively ramped up their oil production levels as a price--and ultimately market share war--kicked into high gear. With Russia and Saudi Arabia now apparently willing to work together again, Russia will need to show it’s serious about reaching full compliance, or something close to it, in order for Saudi Arabia to stay committed to a deal.

On the non-OPEC, non-OPEC+ side of things, it will be much easier (legally and practically speaking) for Brazil, Canada, and Norway to curtail production. A lot of Brazil’s oil production is operated by Petrobras (PBR), a state-run oil firm, which has already pledged to cut 200,000 barrels per day in daily oil output off of the market. In the recent past, Canada’s province of Alberta has curtailed output due to adverse market conditions and would likely do so again (that curtailment was done through a government mandate to force all big companies to comply, though not all companies were onboard at the time). Various oil sands companies have already announced plans to cut production, including Cenovus Energy (CVE), but others are pushing back against such a move.

Norway’s state-run energy firm Equinor (EQNR), previously Statoil, could curtail output from mature fields and historically, Norway has joined up with OPEC-led supply curtailments (not in the agreements reached during the 2010s, however; Norway last agreed to cut output in 2002, and before then in the 1980s, 1990s, and early-2000s). Reducing output from higher-cost mature fields to bring nationwide crude production levels down would likely represent Norway’s best option for pursuing a unilateral output cut, given how the massive Johan Sverdrup oilfield reached first-oil last year and is in the process of ramping up.

A Potential Hurdle

With that in mind, the hardest part of this agreement, in our view, comes down to the US. How the US would cut 300,000 “additional” barrels of daily oil supplies off the market, on top of other “cuts” that were agreed to behind the scenes, remains to be seen. In the US, entities like the Railroad Commission of Texas haven’t mandated oil production cuts since the 1970s. Some have proposed having the commission use its power to limit oil production in Texas, but that has been met with stiff industry opposition, and the potential for widespread lawsuits (on top of which, only one of the three board members on the commission has publicly advocated for mandating oil production cuts, Ryan Sitton, and he lost his primary race this year to Jim Wright, both of whom are Republicans). Chairman Wayne Christian and Commissioner Christi Craddick, both Republicans, have not indicated they would support such a move, making any such proposal highly speculative at this point in time.

There are some other proposals out there, including one that involves forcing offshore upstream oil platforms offline in the US Gulf of Mexico, but that move has also faced enormous pushback from the industry. When it comes to production cuts (whether its oil or any other commodity), everyone wants everyone else to cut output but themselves. Private entities don’t want to be forced to cut production, and instead want the usual OPEC/OPEC+ group to do the heavy lifting. How this dynamic plays out going forward remains to be seen, but as the US is likely to experience meaningful oil output declines over the next several months and potentially years simply due to a reduction in capital expenditure expectations, that may be enough for the group to march forward with the agreement.

We caution that the oil production cut deal could break down at any time should one or more nations not meet their commitments. For an agreement of this size to work, all parties need to make a show of good faith, and that’s no easy task.

Concluding Thoughts

We remain wary of the oil and gas space, given recent events, and please note we removed the Energy Select Sector SPDR ETF (XLE) from our Best Ideas Newsletter and Dividend Growth Newsletter portfolios back in August 2019, well ahead of the raw energy resource pricing crash. Crude oil and other raw energy resource prices will likely shift higher, albeit from very low levels, due to this agreement but that doesn’t mean companies operating in the space will experience much relief.

Upstream companies (those that produce raw energy resources [XOP]) will need to contend with lower production levels, sharply lower realizations, and high fixed costs. Many companies in this space will likely go under. For example, Whiting Petroleum (WLL) recently filing for bankruptcy and that’s just the first of many, in our view, as highly-leveraged firms with “junk” credit ratings [HYG, JNK] remain largely locked out of credit markets (the Federal Reserve recently intervened in high yield debt markets in a big way, but that likely won’t save those that are already on the brink of bankruptcy).

Midstream companies (energy infrastructure firms that operate pipelines, processing plants, etc. [AMLP]) will need to contend with lower utilization rates as upstream production levels and refined petroleum product demand shifts lower (higher storage fees only mitigates a tiny portion of this downside, at least for most companies operating in the space), along with the potential for new contracts to be signed at much lower rates (re-contracting pricing risk is a major concern here). Oil field services companies (OIH) are contending with already-reduced pricing for their services, with many upstream companies calling for those rates to shift even lower, and that’s on top of subdued demand for oil field services. On the downstream front (refineries, petrochemical plants, etc. [CRAK]), subdued demand for refined petroleum products and the sharp slowdown in economic activity is decimating volumes and margins.

(Almost) nothing’s safe in the oil & gas space and beware of “dead cat” bounces. Kinder Morgan (KMI) is included in our Dividend Growth Newsletter portfolio at a very modest weighting and possesses the financial strength to ride out the storm given its recent divestment activity and the firm’s focus on natural gas. There are also a few best-of-breed energy companies we include in the High Yield Dividend Newsletter portfolio that are well-positioned to ride out the storm, but please note we recently reduced our portfolio’s exposure to those names.

Oil & Gas (Majors Industry) – BP CVX COP XOM RDS.A RDS.B TOT

Independent Oil & Gas Industry – APA COG CLR DVN EOG MRO OXY PXD

Industrial Minerals - ARLP, CCJ, CNX, HCR, NRP

Refining Industry – HES HFC MPC PSX VLO

Oil & Gas Pipeline Industry – ENB ET EPD KMI MMP

Energy Equipment & Services (Large) Industry – BKR HAL NBR NOV SLB FTI SI

Related: USO, BNO, UNG, ARMCO, XLE, XOP, VDE, AMLP, AMZA, HYG, JNK, LQD, CHK, WLL, KRE, KBE, PBR, EQNR, FM, GULF, EWW, NORW, EWC, SPY, KSA, ERUS, UAE, EWZ, CVE, OIH, CRAK

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Callum Turcan does not own shares in any of the securities mentioned above. Kinder Morgan Inc (KMI) is included in Valuentum’s simulated Dividend Growth Newsletter portfolio. BP plc (BP), Enterprise Products Partners L.P. (EPD), and Magellan Midstream Partners L.P. (MMP) are all included in Valuentum’s simulated High Yield Dividend Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.