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January 2018 | Eugene Khmelnik, Global Industry Analyst

GIA Spotlight Series — Oil

Eugene Khmelnik, who specializes in the oil sector, examines what rising interest rates may mean for the shale industry, which has so far only existed under extremely loose monetary policy. He also outlines where he sees potential areas of opportunity, notably among US exploration and production companies and LPG exporters.

Key points

  • Despite an increase of over 100% since early 2016, the oil price remains within its long-term trading range.
  • Possible triggers for it to break above that range include the impact on shale production of steeper-than-expected rises in US interest rates, as well as geopolitical risks.
  • I see potential opportunities among some US exporters of liquefied petroleum gas and, more broadly, among US exploration and production and midstream companies if the oil price stays around or above current levels.

We believe our GIAs — specialist stock pickers for whom industry research is a career path — are one of Wellington’s key differentiators. Their role is to use fundamental analysis to identify investment opportunities for clients’ portfolios. It is our belief that stock selection based on in-depth knowledge of an industry has the potential to generate strong investment performance over the long term.

INTRODUCING OUR ANALYST

How did you come to be an oil analyst?

Directly after completing a bachelor’s degree in finance, I joined Wellington in 2008 as part of the Launch Research Associate program. This two-year rotational program is designed to give graduates a series of placements with different teams around the firm. My first placement was with Karl Bandtel, who then led the oil team. The team needed help and I loved the sector. It was an exciting time, with the start of the shale revolution in North America. I was fortunate enough to be asked to stay on the team and have been able to grow relationships with shale management teams as their companies have evolved.

What attracted you to Wellington?

The firm has a great culture of sharing knowledge. As a younger member of the team, I have constantly benefited from older members passing on their accumulated wisdom. That applies not only to my sector, but equally to the broader financial markets.

My team’s dialogue with our credit analysts has been especially productive. In 2016, oil fell as low as US$29, causing widespread bankruptcies in the sector. It was an excellent example of collaboration, where we, on the equity side, had in-depth knowledge of oil companies’ assets and the credit analysts understood the covenants — the legal agreements between the bond issuers and buyers — and the specific debt metrics. They helped us to better appreciate which companies were likely to break their covenants, while we helped them understand which companies could still make a profit with oil prices so low.

INDUSTRY OF FOCUS: OIL EXPLORATION AND PRODUCTION

The oil price has been in a steady upward trend since June 2017 and has now more than doubled since its 2016 low. Where do you see it going from here?

It’s hard to predict commodity prices with any precision (Figure 1). And the further out you go, the more difficult it becomes. But, when the market is at an extreme, it is easier to take a position on a commodity price.

Figure 1

Oil price predictions are rarely accurate

To figure out when that is, we look at a range of factors. These include whether capital is leaving the industry, the number of initial public offerings, and the rig count. We also look at high-yield energy spreads. When they rose above 10% in 2008 – 2009 and again in 2016, they signified an extreme. We also look at sentiment — how investors are positioned in energy relative to history and to other sectors.

Currently, the oil price appears rangebound. When prices approach the upper end of the range, short-term projects (such as shale) come on stream to take advantage, putting downward pressure on the price. When prices approach the lower bound, those projects become uneconomical. Oil has probably the highest natural decline rate of any commodity. So the price often doesn’t stay low for long.

What could drive the oil price to break out above this range?

If rising inflation leads to higher interest rates, that could rein in shale production more than the market is expecting. Shale has vast supply at a low cost, and it’s driving the US to become much more energy-independent. But the industry is only 10 years old and has never had to cope with high interest rates. The amount of capital expenditure (capex) on shale — and on energy in general — may prove to be unsustainable.

Unlike much of the rest of the economy, which is service-oriented, energy requires a lot of capital because of its natural decline rates: Oil and gas wells are constantly being depleted. In recent years, energy companies have seen significant flows from the high-yield market and private and public equity. That is starting to change. Markets are requiring these companies to focus more on returns and less on growth, so that they can return some of their cash flow to investors via dividends or buybacks.

It’s good to see greater capital discipline in the sector. However, when interest rates return to more normal levels, the cost of capital for these companies will rise even further. Capital flows from the private equity and high-yield markets may dry up, which could finally take the oil price out of its trading range.

What else could cause a rise in the price?

An alternative driver might be the reintroduction of a geopolitical risk premium. There are several sources of uncertainty currently, including the new ruler in Saudi Arabia, the Trump administration’s stance on Iran, and the instability in Venezuela.

Are there any particular areas of potential opportunity in the market?

It’s important to remember that not every stock is a play on the oil price. For example, the shale revolution has turned the US from a major importer of oil and petroleum products to an exporter. One niche area we’re looking at is tankers for liquefied petroleum gas (LPG), a cheap and abundant by-product of oil and gas drilling. As domestic demand can’t keep up with the supply, it is exported in specialized tankers to places such as China, India, and Latin America. We think exports of LPG products will continue to increase, which should benefit some of these tanker companies.

Over the past 12 months, many US oil stocks have significantly underperformed the oil price. These include not only exploration and production companies, but also midstream master limited partnerships (transportation, storage, and royalties businesses). They could do well if the oil price stays at current levels; it doesn’t need to rise further from here.

How about outside the US?

In Europe, a lot of the oil majors have kept pace with the oil price because shareholders like their focus on capital returns, so we see fewer valuation opportunities there.

The right geological conditions for shale exist in parts of Europe and China, but they are in areas of higher population density than the shale basins of North America. In addition, governments in these countries tend to own the mineral rights. In the US, landowners do, which means they get a royalty. One of the few places outside North America that we are watching closely is Argentina. Several large overseas companies are coming in and doing joint ventures with local businesses.

Do you see any common misconceptions about the market?

We generally find that the market focuses too much on the upside and not enough on downside protection. That’s because most people who invest specifically in energy are looking for a levered play on oil and gas prices, and they will have a target price in mind.

Yet downside and upside risks are asymmetrical: A 20% gain doesn’t make up for a 20% loss. So we prefer to look at ranges for every stock we own. We want to make sure we understand the downside and upside potential as well as possible and then aim to select stocks where the range of projected returns is in our favor, not just stocks with high potential upside.

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