In a difficult tape for energy stocks, the upstream segment of the market has taken an absolute beating, with the Bloomberg North American Independent E&P Index giving up almost 36 percent of its value on the year.
These painful losses represent a reversal of similar gains that the index had racked up in the back half of 2016 through the end of January 2017, when investors piled into shares of US exploration and production companies in anticipation of oil prices rallying to at least $60 per barrel.
West Texas Intermediate (WTI) crude oil has given up almost 15 percent of its value this year, but the massive swing in institutional positioning has hit the sector hard.
Hedge funds and other institutional investors bought the OPEC-led recovery story hook, line and sinker earlier this year. That’s why hedge funds’ aggregate reported long positions in WTI and Brent futures reached a record 1 million barrels in February. Actively managed mutual funds also went long energy stocks for similar reasons.
When the faster-than-expected recovery in US oil production blew this thesis apart, institutional investors decamped for greener pastures en masse.
Eventually, this selling pressure will dissipate and value-oriented portfolio managers will start to enter the picture. This inflection point may come sooner rather than later, as the S&P 500 Energy Index trades at its steepest-ever discount relative to the S&P 500.
Fundamentals in the oil market have also improved. Our skepticism regarding the effectiveness of OPEC’s production cuts hinged on our belief that US oil and gas producers would ramp up their activity levels with WTI at $50 per barrel and that their output growth would surprise the market. We weren’t wrong on that score: US oil production has surged by 1.08 million barrels per day since October 2016, offsetting the preponderance of the 1.2-million-barrel-per-day supply cut contemplated by the OPEC agreement.
However, this headwind may have started to dissipate. The US oil-directed rig count has started to trend lower after more than doubling over the past 12 months—a clear inflection. In recent years, changes in the rig count take about 20 weeks to show up in weekly production figures.
Just as many investors underestimated US shale operator’s ability to grow output in the first half of the year, the market also overlooks the potential for a decline in the rig count and lower capital expenditures to moderate production growth. This trend could start to appear in the weekly data as soon as October or November and could take root by early 2018.
Best-in-class operators in the Permian Basin and other low-cost fields have managed to deliver dramatic production growth while living within cash flow. We expect the industry to allocate capital more conservatively in 2018, resulting in more free cash flow and addressing concerns about the upstream growth model in the current environment.
Thoughts on Upstream Capital Spending
Second-quarter earnings season featured a handful of examples of companies tapping the breaks on their spending plans, though the spending cuts that attracted the biggest headlines—Anadarko Petroleum Corp (NYSE: APC) and Hess Corp (NYSE: HES)—involved offshore exploration and won’t affect either company’s production guidance.
However, the market punished the handful of marginal exploration and production companies that announced plans to scale back activity levels because of recent weakness in energy prices.
Debt-laden Whiting Petroleum (NYSE: WLL), for example, dropped two rigs from its development programs in the Bakken Shale and posted production numbers that fell short of expectations.
Sanchez Energy Corp (NYSE: SN), which made a big splash earlier this year with the acquisition of Anadarko Petroleum’s assets in the Eagle Ford Shale, slashed $75 million to $100 million from its 2018 spending plan and announced that the company would run five rigs, instead of eight, starting in September.
Management attributed these strategic decisions to weaker-than-expected oil prices and the push to generate positive free cash flow next year, though the company’s elevated leverage levels likely figured into the equation as well.
Among the upstream operators in our coverage universe, Oasis Petroleum (NYSE: OAS) and Continental Resources’ (NYSE: CLR) management teams expressed a willingness to reduce capital expenditures in the second half of the year if oil prices hover around $45 or less.
As early entrants in the Bakken Shale, both companies generally have higher levels of debt relative the newer generation of upstream operators that offer pure-play exposure to the Permian Basin.
Although operators continue to post impressive productivity gains in the Bakken Shale, their leverage profiles and the superior economics associated with stacked plays in the STACK and Permian Basin will make it difficult to take market share in an environment where oil prices remain lower for longer.
Whereas activity levels in the Bakken Shale and Eagle Ford Shale appear more sensitive to oil prices, many of the exploration and production companies that we follow in the Permian Basin reiterated their guidance for robust output growth this year and in 2018.
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Elliott and Roger on Jul. 1, 2019
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