Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

Energy Performance Is Dismal, but the Story Is in Its Prospects

Despite the Dow making new highs, sentiment in the energy patch is as ugly as we can remember it, and there has been no shortage of news flow that might warrant such negativity. This is further evidenced by poor performance for the group, as the XOP SPDR Oil & Gas Exploration and Production ETF is off 3.9 percent, the Energy Select SPDR fund is off 1 percent, and the VanEck Vectors Oil Services ETF is off 3.3 percent, bringing those year-to-date numbers to -17.2 percent, +4.76 percent, and -16.6 percent, respectively. For the week, we saw a significant and unexpected domestic crude inventory build as we struggle to draw down elevated levels of global inventories.

During reporting season, what has crystallized is that productivity gains in one of the key drivers of global supply growth appear to have peaked. We saw production shortfalls that, thematically, seem to share the common thread of technical issues such as well spacing and water handling. We also saw wells that came on with higher-than-expected ratios of gas versus oil (GOR), which are less economic and produce lower returns. So, seemingly, on a company-by-company basis, risk is elevated. We believe that bad news has been priced into these stocks aggressively, although we acknowledge that corporate focus needs to continue to shift from growth to returns, and companies need to do an effective job of articulating a capital allocation strategy. We are pleased to see some capital expenditure cuts, and we think there will be more to come – which, at the margin, will slow supply growth.

Then there is the matter of the Saudi Aramco IPO, which could be one of the largest IPOs in history, despite the fact that only 1.5 percent of the company will be offered. The stock will not trade on a major exchange. The prospectus was just released yesterday, and we have not had the opportunity to go through it. We recognize that this IPO is crucial to the strategic goals of Saudi Arabia and their “Vision 2030” policy to diversify their economy and reduce the country’s dependence on energy. However, we question the wisdom of launching an IPO in a group where there is already too much energy paper that investors do not seem to want. It is already indicated to come out below reportedly where the two trillion dollar valuation Crown Prince Mohammad Bin Salman would like to see it priced. It will be interesting to see how local investors embrace this offering. Even at a $1.5 trillion valuation, it is easy to find alternatives in the energy patch that would offer a similar yield, more transparency, less geopolitical risk, and more liquidity. To us, this seems like a very tough sell.

Despite all of the above, we continue to find reasons to be constructive on the sector. In addition to the possibility that trade talks will wind down to a productive close, the fact that the rig count continues to drop is nothing but constructive – especially if you couple this idea with the fact that, incrementally, wells are less productive than they were two years ago. We continue to see rigs being let go, even in the highest-return domestic basins. We agree with OPEC Secretary General Barkindo that this is likely to level off US production, and we may even see it start to decline. We should finally see the needle move on global inventory draws, despite the International Energy Agency (IEA) assertion to the contrary.

Baker Hughes US Rig Count

Additionally, we believe OPEC is committed to supporting prices into 2020, particularly given the aforementioned fragility of the Aramco IPO as well as the fragile economies and social issues for key OPEC producing countries, in particular Iran. We also are seeing larger development-stage projects in non-OPEC countries run into challenges, both with geology and resource quality.

We have company in our keen interest in the space, and we are starting to see very smart and successful investors with longer-term capital to deploy begin to scoop up very cheap assets. Historically this can provide a floor in terms of valuations. We observe that tax-loss selling season is upon us, and we are likely to see better valuations into year-end. In short, we continue to monitor the space with a very interested eye, albeit largely from the sidelines as it pertains to the MAPS strategies.

We thank you for your continued interest and support.

Best Regards,

David McAlvany
Chief Executive Officer