Christmas 1998 wasn’t a happy time in the oil business. The price of Brent crude had just dipped below $10 a barrel. Within a month or so, energy’s weighting in the S&P 500, already low, would sink to just above 5%. The world was thought to be “drowning in oil,” while technology stocks – 21% of the market – were seemingly in short supply.
And yet, with oil trading at more than $70 a barrel as summer 2019 gets underway, energy stocks are somehow even less popular than they were back then:
The optimist with a long memory would remember that late-1990s kick in the teeth as marking the start of a decade-long super-cycle for oil prices (and equities), as well as a lost decade for overheated tech stocks. Today, there is much grumbling among energy executives that, despite oil prices having doubled since the trough in early 2016 and widespread commitment to prioritizing profits over production, their stocks remain relatively listless. Over that same period, the exploration and production sector is up by just 16% versus a 52% gain for the S&P 500.
Griping, or hoping tech falls out of favor, won’t do much good. One other point to take away from that chart is that energy’s weighting only came close to catching up with tech’s in mid-2008, when oil prices were in a bubble of their own. Unlike in the early 2000s, there is no peak-supply scare – quite the opposite in fact. It is worth pointing out that, despite Tesla Inc.’s share price almost halving over the past six months – not without reason – its market cap is still higher than that of all but a handful of U.S. oil companies. Regardless of what happens with Tesla from here, the E&P sector’s problems won’t be solved merely by some cyclical great rotation.
The usual mechanisms supporting a rally have broken down. Oil prices ought to be higher, given lackluster upstream investment (outside of the U.S. anyway), reasonable economic growth, OPEC restraint and rising geopolitical temperature. That they aren’t reflects concerns about demand – especially amid a Sino-U.S. trade war – and the continuing surge in shale-oil production.
And as the disconnect of the past few years has shown, oil equities don’t necessarily follow rallies in the underlying commodity anyway. That is partly a structural effect of shale, where higher oil prices can translate more quickly into higher production than with conventional projects – in part because E&P companies don’t need much persuading to raise output. The pace of drilling in the Permian basin may have eased off somewhat, but with an estimated inventory of eight months’ worth of uncompleted wells, fracking has not. And it’s fracking that brings up the barrels.
The industry’s predilection for production, rooted in c-suite compensation incentives, is the one thing it can control – unlike, say, relations with Tehran – and yet it so often fails to do so. Last summer’s rally in oil, itself a function of fickle geopolitical speculation, sparked a surge in E&P spending that teed up the crash that closed out 2018. Memories may be short in financial markets, but not that short.
While the sector by and large recommitted itself rhetorically to discipline on first-quarter earnings calls, it also outspent cash flow in that quarter. Taking a sample of 35 U.S. E&P companies with a market cap of at least $1 billion, it’s clear that any narrative about positive free cash flow is definitely a second-half story, with July through December accounting for more than the implied $7.3 billion total for the year, according to estimates compiled by Bloomberg. Incredibly, that’s only slightly more than the $7 billion expected from a sample of just six major U.S. refiners, though they sport roughly a third of the E&P group’s combined market cap.
Lack of faith in the E&P sector’s ability to sustainably generate and return cash flow extends to the debt markets, with high-yield bonds for the sector now yielding around 8.5%.
Brian Gibbons, sector analyst for CreditSights, identifies issues similar to what ails the equities. “By and large, investors are tired of the sector,” he says, adding “We are in a secular supply overhang here.” Single-B rated bonds make up almost two-thirds of the sector while triple-Cs make up another 10%. Gibbons wonders if the triple-C segment of the E&P bond market even has a future, partly because the old paradigm of these issuers carrying leverage at, say, 4 times Ebitda just doesn’t work when weak stocks have compressed valuation multiples overall. Single-B issuers, meanwhile, may not be distressed right now, but the risk of a sudden move down if oil prices drop outweighs the relatively marginal gains on offer if oil strengthens to, say, $80 or more.
A real supply shock would no doubt pull some generalist investors back into E&P stocks and bonds. But supply shocks these days also encourage alternatives to oil and more fracking. Dialing back the latter, especially, would address the supply overhang and also bolster faith in discipline on spending. In theory, the rising cost of capital should push this process along.
Yet frackers have shown a remarkable ability over the past few years to do more with less and even more with more. It is their very success in this regard, along with skewing rewards to management, that has made them unpopular.