Thematic Investing in US Energy



A truism in energy investing is the high degree of dependence on underlying commodity prices – and what I mean by energy for the purpose of this article is largely oil and gas upstream but also to a lesser extent, merchant power, petrochemicals, refineries, midstream, and even renewables.

Commodity prices, by nature, are determined by macro landscape and there is an added layer of complexity stemming from uncertainty of upstream explorations. Absent insider information (and not just any insider information), most experts cannot predict medium-term strategy or behavior of OPEC countries (or a major producing country like Russia) and even most industry insiders could not have predicted the emergence and the magnitude of resource potential of Marcellus and how it would transform US into a net exporter of natural gas.

Furthermore, while investing in energy with a “long-term” view has its validity, unlike most other sectors, “full-cycle” return of E&P sector is not always positive. When you combine this with the above mentioned premise that the impact of underlying commodity prices is one of the dictating metrics of your investment success, timing is critical in energy investing. This is perhaps why many people say energy sector is where generalist investors come to get killed.

This is not to say that energy investing is purely trading volatility or making a speculative bet on commodity prices. As a pro-cyclical industry, when you know the right themes to look for and even when you are roughly right on timing, opportunities to generate significant returns in a relatively short time-horizon makes it a fascinating space. Also, energy space in itself is so expansive and heavily impacts many sectors across various value chains that you can construct a balanced portfolio using the elements of the energy sector alone.

One way to start developing your investment acumen in the energy space is to follow the “mini-themes” of US unconventionals. There is enough going on and capital spent in the US alone for you to capture adequate returns without having to make predictions around global macro factors and geopolitical trends – you will never be completely immune from OPEC decisions but you can construct an analytical framework that reduces randomness and identify companies that are better positioned to capitalize from overarching energy themes in the US before the market prices them in.

Below is a historic flow chart-style summary of US unconventional energy themes from Russell Braziel’s book, The Domino Effect (with edits). Again, when you contain the analytical framework to the US market and focus on how the shale revolution shapes the “localized” behavior and capital decisions, over time, you can identify themes that are predictable and apply them to your investment and valuation framework.

  1. Shale technologies emerge and natural gas recovery increases exponentially
  2. Gas production increases
  3. Gas prices fall
  4. Crude and natural gas prices diverge
  5. Producers shift to crude & liquids
  6. Liquids production increases
  7. NGL prices decline
  8. Petrochemical companies make a lot of money
  9. Crude production increases
  10. Midcontinent crude prices fall
  11. Land locked refineries make a lot of money
  12. Wet and associated gas increase
  13. Gas prices stay low
  14. Power generators shift to gas
  15. Coal demand for power gen falls
  16. Gas demand for power generators industrials grows
  17. Bakken production increases pipe takeaway constraints emerge
  18. Crude slate dumbbell
  19. More light crude than refinery capacity
  20. New Gulf pipes; supply backs out imports
  21. Decline in world crude prices
  22. Ethane production surplus
  23. Ethane surplus to be exported
  24. Propane export growth continues
  25. Northeast gas production skyrockets
  26. Lower Appalachian gas prices (widening differential between Henry Hub and local Appalachian prices)
  27. New pipeline takeaway capacity in the Appalachia
  28. Low crude prices kill international shale
  29. Crude prices change political landscape
  30. Dramatic reduction in drilling

Step 30 (dramatic reduction in drilling) is the last step of the flow chart in the book which was published in October 2015.

A lot has happened since then and the energy landscape of US continues to change – no one will have a crystal ball on what OPEC supply will be in 2018 or if and when there will be an unexpected supply outage in Nigeria or Venezuela but there are overarching themes that dictate the US energy market today which will inevitably lead to a certain outcome in the near future. Few ending thoughts…

  • Oil rigs in the US jumped nearly 100 rigs in the last 3 months, of which more than 50% are from the Permian. Is there enough midstream especially in the Delaware?
  • Despite difficulties with easements, DAPL seems like it will go through in 2017 with the new administration. Once DAPL comes online, Bakken will have more pipe capacity out of the basin (>1MM bbls/d) than its production (currently slightly less than 1MM bbls/d) – what does this mean for Bakken differentials for producers and how negatively will it impact crude-by- rail midstream players in the basin?
  • In the near-term, Appalachian gas production will more or less be mirroring pipeline capacity out of the basin. However, there is more than 15bcf/d of pipeline capacity coming online before 2020. One can handicap timing around when this capacity will come online but an additional 15bcf/d of capacity is almost doubling the capacity out of the basin (current production of roughly 22bcf/d) – are there too many people throwing the baby out with the bathwater because of Atlantic Sunrise? What does this mean for price differentials going forward in the Appalachia and what does this mean for power plants that source gas in the M2/M3 market? There are about 50 rigs running in the Appalachia at the end of 2016 – does the market know how many rigs are required to keep production flat? How many rigs will you need to fill up an additional 15bcf/d of capacity in the next 3-4 years? Does the market even need an additional 15bcf/d of gas? What does this mean for long-term gas price?
  • As Appalachia sorts out its problems in the next few years, how much market share will Haynesville/Cotton Valley and dry gas window of Eagle Ford capture (if any)?
  • Will Trump administration’s stance towards Mexico hinder additional gas exports to Mexico?
  • Will he push down the cost structure of coal mining such that coal-to- gas switching price will put pressure on gas prices?
  • With oil prices finally seeing the light at the end of the tunnel, will wet gas production come back? Less ethane rejection with more petrochemical capacity? How resilient are US petrochemical suppliers if there is a global recession (is the ethane advantage over naphtha even relevant at that point)? Will more LNG export projects become commercially viable?
  • If rising interest rates is a matter of when and not if, in a normalized world of 2% or even 3% interest rate, what is the right long-term yield profile of MLP’s? Who is the next mega-MLP to simplify their corporate structure and remove IDR burdens for the LP unitholders?
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