Still long energy for 2018
I’ve been consistently surprised by how buoyant oil prices have become in recent months. I’m that fool in the corner – along with a few other fools I might add – who thought oil might crash below $20 a barrel. Let’s just say I was wrong on that score. But to be fair I did realize quite early on that after oil prices stabilized there would be relentless pressure to keep oil in a “sensible” trading range i.e $40 to $60 a barrel. Too many producers – not just OPEC – needed oil to stay in that sensible trading range to make the economics of production (and their national balance sheets) work. Crucially, also the developing world economy is looking to be in much better shape than we first thought and although energy efficiency is inexorably increasing, demand for energy products is very strong.
The next real surprise to me was that oil prices pushed decisively above my $40 to $60 range I envisaged and have now stabilised much closer $70 a barrel. There’s even a note out last week from Goldman Sachs – see below – that suggests we could see a decisive push above $70 a barrel. Needless to say this is causing blind panic amongst the reflation brigade which is also helping push the slow sell off in conventional bonds – inflation is coming and the Fed will hike up interest rates even more than we think. Maybe, but I have my doubts.
These firm oil prices are proving an enormous ‘come on’ for every Jonny come lately oil and gas producer with a new resource production plan. We’ve only seen a steady increase in new rig counts in the unconventional sector in North America to date but the mere whiff of $70 plus prices will get the capital markets in a frenzy of excitement – which in turn will result in the tap being opened to max for new shale capital projects.
My medium term – 1 to 2 year – guestimate is that prices will nevertheless stumble and move back towards the $60 trading range but in the meantime I think we’ll have a very benign market for the E&P outfits and the PE financiers. In this scenario I’d still be very long my favoured bets on the space:
- Riverstone for its North American PE interest, although the recent results weren’t great. See the note below from Matthew Hose at Jefferies.
- The North Sea E&P players such as Premier, Enquest and everyone’s favourite moonshot stock Hurricane Energy.
- Last but no means least the retail bonds of Enquest and Premier Oil look attractive for more income orientated investors. For the first time in ages for instance Enquest will be paying actual cash interest on their bonds, although I wouldn’t expect that to last too long!
Note on Riverstone from Jefferies by Matthew Hose
” This was a disappointing quarter for RSE, particularly the write-down to Three Rivers III. The impact of US tax reform should provide a useful boost to the year-end NAV though, and more importantly, reduces the gross to net return leakage ahead of what could be a fruitful year for portfolio realisations.
Portfolio valuations: RSE reported an aggregate gross portfolio valuation (excluding realisations) of $1,876m at 31/12/17, reflecting a 1.4x gross Multiple on Invested Capital (MOIC), down from the 1.5x reported for Q3. Of the $96m decrease in gross valuation during the quarter, the largest contributions were from Three Rivers III (-$58m), Meritage III (-$17m), and Fieldwood Energy (-$17m). The former, we note, was previously indicated in press reports as a prospect for sale, although with M&A transaction multiples in the Permian basin having now eased off (following the ‘Permania’ boom), a write-down seems prudent. On the latter, the valuation weakness is alongside
the recent S&P ratings downgrade of the corporate credit rating to D from CCC, with Fieldwood having reportedly entered into forbearance agreements with certain creditors.
Investments/realisations: Only $12m was invested over the quarter, against $87m of (gross) realisations from the Centennial (CDEV) secondary offering. The investment was spread between Castex 2014, Sierra, CNOR, and Liberty II.
Balance sheet: Factoring in the reported investment/realisation activity, we estimate RSE held c.$154m of cash at the year-end, equivalent to 9% of NAV. This was against outstanding commitments of $353m, albeit with the usual caveats regarding their flexible structuring and the potential for the release of commitments as further holdings are realised.
NAV: Updating our model for investments/realisations, the revised valuations (factoring in incentive fees and tax where necessary), and marking-to-market CDEV to date, gives us a current estimated NAV of $1680.5m, or $19.89/£14.08 per share, to which the shares trade on a 9.8% discount. This relatively narrow discount looks to reflect the decline in the NAV from the lower gross portfolio valuation, but also that recent USD weakness does not yet appear to have been reflected in RSE’s share price.
US tax reform: One offsetting factor here however is US tax reform. The 21% corporate tax rate under the reforms will reduce the accrual for the tax liability of gains (taxed as income) made in the NAV. This should result in a c.2-3% uplift to the year-end NAV. More importantly, the reduction in the tax accrual will be of continual benefit to shareholders, crucially helping to narrow the gross to net leakage on RSE’s returns. We explain this further in our note here
Goldman Sachs Note on Oil – Oil: The New Oil Order on hiatus
The rebalancing of the oil market has likely been achieved, six months sooner than we had expected. The decline in excess inventories was fast-forwarded in late 2017 by stellar demand growth, high OPEC compliance, heavy maintenance as well as collapsing Venezuela production. We expect many of these drivers to remain in place in 2018. The momentum of global growth and the rotation in its leadership to EM economies is leading us to raise our oil demand growth forecast even further above consensus expectations. In addition, we believe that the OPEC ramp-up in production will lag this normalization in inventories, requiring a shale supply response. As a result, we are raising our 3, 6 and 12-mo Brent oil price forecasts from $62.0/bbl to $75.0, $82.5 and $75.0/bbl, above current forwards. This forecast upgrade reflects a steeper level of backwardation – given a lower inventory path – as well as an expected increase in marginal costs – given higher activity levels and non-engineering cost inflation due to a weaker dollar and higher oil input prices.
Greater backwardation will provide investors with even higher returns than implied by our price path and we forecast +24% petroleum total returns over the next 6 months. Inventories falling below average levels and the resulting greater price impact of potential future disruptions will also lead to a rise in oil price volatility. While record-high speculative positions may exacerbate this volatility, we find that these do not yet reflect the overweight allocation to commodities that we recommend.
Importantly, all the pillars of the New Oil Order remain intact in our view so this is a cyclical call. We expect that the shale response, OPEC’s eventual ramp-up and higher non-OPEC production will all bring prices lower sequentially with our 2020 Brent forecast at $60. The New Oil Order is on hiatus with its next point of reckoning likely a few years away