Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
Energy Takes the Stage
We are now post-earnings reports, and conference season is upon us. We are beginning to hear commentary from companies across industries within our hard assets universe. From this we are able to extract big picture insights and themes, and their investment implications. We can also see more micro, company-specific developments and what they might mean from a bottom-up perspective or possible read-through for other opportunities.
One area of note for this week is energy. A large energy conference is currently underway. Given how universally unloved the sector is, with several positive tailwinds for the group, this has made us sit up and take notice. One mega-cap integrated energy company indicated that the environment was ripe for mergers and acquisitions activity. The law of large numbers is such that it becomes challenging to continue to make enough discoveries to grow reserves and production. Therefore, in order to arrest declining asset bases, companies must look to acquire. The valuation disparity between the largest integrated energy companies and independent E&Ps is wide, making potential acquisitions accretive and therefore perhaps more palatable for shareholders. The history of the resources sector as a whole is that ill-advised acquisitions happen at cycle peaks. Will this time be different? We believe it will, as companies are under enormous pressure from shareholders to unlock value as their investments have suffered.
Another theme we have heard this week has to do with the low oil price environment we have seen over the last few years and the implications of this going forward. In 2014, OPEC made the decision to essentially flood the market right before Thanksgiving. Energy prices collapsed. At the same time, we saw step change improvements in well productivity, bringing the entire global cost curve lower. In order to close cash flow deficits, companies were forced to “high grade” their asset inventory and drill their highest quality reserves first – to the extent that this was doable due to rules around leaseholds. It was, in essence, the low water mark for costs. The implications for today and going forward is that both capital and operating costs are likely to rise on a per barrel basis, and capital efficiency has likely peaked. We already see evidence that productivity growth has slowed, and we believe this trend will continue. Companies have pushed the limits of downspacing, and as a result we have seen damage to reservoirs due to well communication issues.
Somewhat paradoxically, we believe this is ultimately good news for the sector. The capital markets remain closed for energy companies, borrowing bases are likely to remain flat or decline, and, therefore, we believe that US production growth will ultimately slow. OPEC, in particular Saudi Arabia, appears to remain committed to reducing global inventories to help boost oil prices in front of the possible IPO of Aramco, as well as to balance their budget and fund state programs. Additionally, in the last three months, we have seen a more than 50 million-barrel draw from US inventories alone due to fewer crudes showing up on our shores. Tensions with OPEC, exempt Iran, show no signs of de-escalation. The US this week sanctioned the Iranian oil shipping network for an “oil for terror” scheme that has moved about 10 million barrels in the last few months and undermined OPEC goals. It is our belief that once the issue of China trade is resolved, the market will begin to focus once again on this tightening supply dynamic rather than the demand side of the equation.
We thank you for your continued support, and we look forward to seeing some of you in Durango from September 12 through the 14th. There will be no Hard Assets Insights next week as we look forward to our face-to-face dialog.
Chief Executive Officer