Open Square Capital 2Q18: Energy Stocks & Outperforming S&P by 97%

Smart Money
  • It’s only now, when a confluence of factors have driven us to a supply shortage is the world beginning to stir, slowly walking to the realization that this is a shortage and it will continue unabated. As the energy crisis gathers momentum, it will have far ranging and wider repercussions than even we have ventured to anticipate
  • YTD June 30, returns of 99.85% vs. S&P 500 of 2.65% (outperformance of 97.2%)
    • Since inception (8/1/15): Open Square returned 117.65% vs. S&P 500 of 37.35%
  • Although energy equities have started responding, we have barely begun. Energy stocks just comprise 6% of the value of the S&P 500 index when the long-term average is closer to 13%. According to a recent Goldman Sachs report, E&P stocks were valued as if oil was still $60/bbl, almost 20% lower than the WTI price now
  • Eventually as inventories draw further, prices will readjust. The entire curve will lift higher when the market understands and then believes that the oil shortage will be more acute and longer lasting than what the consensus believes today

Lurching and Searching

  • We entered the year with a supply deficit of 700kbpd but that number is temporarily lower thanks to refinery maintenance season. Even with tepid refinery demand, inventories fell in 1H18, a counter-seasonal trend when measured against the 5-year averages
  • As we emerge from refinery turnaround season, demand will return and the seasonal slump will abate and the backlog will clear, allowing oil prices to resume their upswing
  • It’s not just Trump, we’re at that stage of the oil cycle where a creeping shortage is becoming noticeable even for generalist investors, but most market watchers cling to the notion that help is on the way. As inventories tighten, the world will go through a series of stages to find an immediate salve
    • It will look to commercial inventories to serve as a buffer. As inventories run low, attention will shift to production, focusing on producers with spare capacity and short-cycle projects
  • As oil prices have increased, the search for reasons have followed. Thus far, the consensus has settled on geopolitics as the main culprit. US sanctions on Iran, Venezuelan turmoil, and OPEC/non-OPEC producers (“OPEC+”) manipulation now dominate the headlines
  • About the only thing many oil observers can agree on is who has spare capacity. The answer? Not many
    • IEA estimates that Russia, Saudi Arabia, UAE and Kuwait are likely the only four producers that have spare capacity (around 3M bpd in total) with Russia and Saudi Arabia accounting for the large majority of that
    • We think the number is south of that, closer to 2M bpd given historical production figures, but either figure represents a very thin margin of safety. Recently, OPEC+ agreed to make it even thinner
  • On June 22/23, OPEC+ met in Vienna, Austria. As you may recall, OPEC+ had previously agreed to cut oil production by 1.8M beginning in January 2017, and have since extended those cuts to the end of 2018
    • As low oil prices have taken their toll, collective OPEC+ production has fallen by 2.8M bpd, 1M bpd more than what was agreed to. Much of the 1M bpd of “over compliance” was involuntary as Venezuelan decay has reduced production by 800k bpd, and security challenges in Libya, Nigeria, and Angola have stifled production
    • Against this backdrop, the US also recently announced sanctions against Iran and Venezuela, which threatens to reduce production by another 0.5M to 1M bpd
    • In the end, OPEC+ agreed to raise production by 1M bpd, effectively bringing compliance back to 100%. The reality is that apart from the four aforementioned producers, many countries are incapable of producing more oil due to years of underinvestment or deteriorating security situations. So the real increase will be somewhere around 600k to 700k bpd, a proverbial 0.6% drop in the world’s oil bucket
  • At best, the increase only mitigates the low-end of further anticipated declines from Libya, Venezuela, and Iran, and insures that whatever over compliance OPEC+ came into the meeting with remains unchanged. In turn, this means that the current structural deficit also remains unaddressed
    • If our forecasts are correct, that deficit will soon accelerate beyond 1M bpd as we move into 2H18

US Takeaway Constraints

  • Today, increasing demand is almost wholly being met by US production increases. By the end of 2018, demand will have increased by 6.2M bpd in the last three years, which means the world will need as much oil as US shale producers can pump
  • In 2018/2019 (thus far), US producers have grown within cash flows, but overall production has increased markedly. The growth, however, looks increasingly capped by a new factor, pipeline constraints
  • Growth from the prolific Permian basin in Texas has exceeded the ability of regional pipelines to transport the oil out of the basin. New pipelines won’t be available to clear the excess until later 2019
    • As Scott Sheffield (Chairman of Pioneer) recently stated: “We will reach capacity in the next 3 to 4 months… Some companies will have to shut in production, some companies will move rigs away, and some companies will be able to continue growing because they have firm transportation”
  • There are few alternatives for clearing the bottleneck, and a shortage of truck drivers and rail operators reluctant to invest in rail infrastructure when the demand is transitory means pipelines are the primary assets to move oil
    • Since you can’t simply cap a well and come back to it later, US producers will have to slow completions
    • Pipeline availability will remain challenged in the next 12-18 months, and eventually the constraint will slow shale growth, and in turn, overall growth in US/global oil production

The Main Issue

  • As producers shrug at the shortage in self-interest and short-cycle projects fail to produce the requisite supplies, oil inventories have steadily and unsympathetically revealed the truth
  • Oil supplies are insufficient to meet today’s level of demand. Even if producers were to immediately deploy capital, there would still be a multi-year lag between the spend and when oil actually enters the market
  • Schlumberger recently showed that 15 regions accounting for approximately 27% of global production have decline rates that increased from 5% in 2015 to 7% in 2017
  • Excluding OPEC+ and the US, few countries can stem their declines let alone increase productions, which means overall global decline rates will continue to accelerate
  • The 3-5 year lag between energy investments and real world oil production means that 2019 will mark the beginning of a full blown supply shortfall
  • As oil inventories free fall and asset prices rerate, the stark reality becomes clear. A historic inventory build followed by a historic draw will not usher in a period of historic price increase

Open Square Capital 2Q18 Letter, July 2, 2018

Image Source: Open Square Capital, Reuters (John Kemp)