BY G. ALLEN BROOKS, MANAGING DIRECTOR

 

Musings from the Oil Patch reflects an eclectic collection of stories and analyses dealing with issues and developments within the energy industry that have potentially significant implications for executives operating oilfield service companies. The newsletter is published on a semi-monthly schedule, but periodically the event and news flow may dictate a more frequent schedule. As always, we welcome your comments and observations.

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The next Musings of the Oil Patch will be published on February 19, 2019.

The oil price collapse during 2018’s fourth quarter was a rout driven by concerns over a slowing global economy and weakening energy demand, coupled with the fear that OPEC had been suckered into boosting its exports just as the sanctions on Iran proved to be less substantial than anticipated. That set the world up for an oil supply glut. That prospect not only stopped the rally, expected to carry oil prices back to $100 a barrel, but sent prices down instead. As commodity speculators unwound their long futures positions and started building short ones, oil was beaten down severely. The chaos of that quarter obscured changes in fundamentals impacting the long-term outlook for the oil business. Disruption is coming from the changing role of OPEC in global oil markets and its pricing, as well as the American shale revolution. Under the climate change banner, the energy landscape is shifting. Carbon is the issue. Surprisingly, the oil industry may the best positioned to actually lead the decarbonization of the world’s energy system, but it will require executives to think differently about their business going forward. We explore some of the those issues.

Energy stocks were the worst performing sector last year, but crude oil turned out to be the worst performing commodity over the past decade. Palladium took the decade’s performance crown. The poor investment performance of crude oil is consistent with oil stocks seeing their role in the market decline to nearly a point of irrelevance. Oil had a strong January and is well-positioned to generate a solid return this year, largely because of where it started 2019. Past performance, however, is not a guarantee of future results.

A big oil market disruptor on the horizon is IMO 2020. The initial price spread between high-sulfur (current) and low-sulfur (mandated) fuel in Asia is narrower than expected. Admittedly, there is not a strong demand for IMO 2020 compliant fuel yet, but the progress shippers and refiners are making to ensure adequate compliant fuel is available in 2020 may undercut the scaring oil price scenarios that have been predicted as a result of IMO 2020. We’ve never embraced those scary price scenarios ($250 a barrel), but recognize that any time you force such a massive structural change on an industry, there will be an impact, and higher prices are likely.

Tesla has increased the price of its Powerwall home battery storage system, countering the supposed trend for all renewables and associated infrastructure costs to constantly fall. Lower costs are the key to our renewable energy nirvana arriving soon. An analysis of what battery storage costs will be for a newly proposed rail line in the UK to be powered by wind turbines shows the project to be uneconomic, let alone a landgrab and a visual eyesore. As Australia, who purchased the Tesla Powerwall, found out during its latest heat wave/power outage, the battery provided 80 minutes of power and without the backup diesel-powered generators (first time they were ever used) the 25,000 people without electricity for the night would also have been without power the following day. We are always skeptical of “happy talk.”

While not the same as our past two oil industry cycle articles, in this issue we examine what has happened to the energy sector in the stock market and how its fortunes have been related to industry developments and trends. Using the energy sector weighting of the S&P 500 Index, we tracked it from 1979 to the end of 2018. Energy has gone from 29% to barely over 5% over that period. After falling to about 5.8% in 2000, energy increased in importance to slightly over 16% shortly before the 2008 financial crisis hot and when a period when oil prices were well above $100 a barrel and expectations called for them to go higher. The global recession and American shale changed energy’s outlook. After weathering the dot.com boom in 1999 and 2000, this time it had to battle the rise of the FANG stocks. So far, not so good. What is impacting energy stocks and company valuations today are not the same forces that depressed them in the 1980s and 1990s. These new forces have the potential to inflict substantial damage to the investment thesis for energy in the future. While energy in the stock market and energy in the real world appear disconnected, much like oil prices and energy stocks have been for the past decade, failing to understand the investment dynamics surrounding energy could prove to be a huge mistake.

Electric vehicles are thought to be the dream solution for a carbon-free transportation system. Sales of EVs soared in 2018, helped by the success of Tesla in the U.S. and subsidies, both here and around the world. The ending of the generous subsidy for Tesla may explain its success in the fourth quarter of 2018. It shipped a lot of cars while the full-subsidy was in effect. We will see what happens to demand with only a fraction of the full subsidy available this year. The company’s price cut and now 7% labor force cut suggest it knows is has a challenge this year. Despite Tesla’s success, EVs represented only 2% of U.S. auto sales last year, but EVs are well on their way to disrupting the oil business. The winds of change are sweeping through the global auto industry, as well as the energy and utility industries. Ignoring these trends may be dangerous for all the companies being impacted or about to be impacted, as well as investors and even corporate lenders. One of the big potential losers may be governments who will have to rethink both their carbon emissions and transportation policies, as well as figure out where their tax revenues will be coming from in the future. It’s a long road to a carbonless world, and the road will have many twists and turns. Chronicling and analyzing this journey is going to be a fun experience.

Canadian oil prices are on the rise, but the political landscape is becoming more muddled. A recent survey shows that building new oil and gas pipelines is popular in every one of Canada’s provinces but Quebec, where the Liberal Party reigns. With energy policy – pipelines and carbon taxes being the central features – already the key battle issue in the upcoming Canadian federal election, Americans should watch this theatre north of the border as a possible forerunner of the 2020 presidential election in the United States.

We continue our examination of oil industry cycles. In Part 2, we consider issues such as the value of the U.S. dollar and interest rates on oil prices, as well as transportation fuel dynamics and the trading performance of energy stocks. Halliburton’s history as a public company provides us with a long record of its share price and EBITDA – 46 and 24 years, respectively. Its share price performance and earnings results confirm how much energy stocks trade on future expectations. We also looked at the push for clean energy vehicles and their cost on energy’s macro outlook. Transportation fuel demand is key to the future of the oil business, especially in developed economies. Whether the transportation market is radically altered, or only evolves slowly will impact global oil consumption, especially as the dynamics of energy varies in economies around the world. History offers an important perspective for looking into the future, which is why we examine past cycles to better understand what drove them and what lessons we may learn for understanding future cycles.

The enigma of natural gas prices in the face of historically low gas storage volumes and surging output continues. Have gas traders bought into the global warming scenario that would reduce our need for large gas storage volumes to meet winter demand, especially given the continuing surge in associated natural gas output from the Permian Basin? The global warming thesis will receive a test this winter, as outlooks are split between those predicting a warm winter and those calling for a cooler-than-normal to a bone-chilling one. With gas prices having dropped below $3/Mcf at year-end due to an expected warm January, the question becomes: What happens if the warmth fails to materialize?

The energy market in Alberta is feeling better about its 2019 outlook – at least that is the message from oil prices. The price differential between WTI and WCS has contracted significantly following the province’s move to mandate a production cutback. This OPEC-like move, not employed since the 1980s oil price crash, will reduce supply by 8.7%, or 325,000 barrels per day. Hopefully, the cut will bring down bloated oil storage volumes quickly, allowing oil prices to rise. The price battle reflects the problems of the Canadian government’s energy policy and its failure to get several critical oil export pipelines built, while pushing for a nationwide carbon tax. The struggle also reflects the battle over oil company business strategies to either become fully integrated or remain merely a seller of oil production. Energy’s travails, hurting the largest industry in Alberta and in Canada, are playing out against the political backdrop of a growing “separatism” movement in the province and the upcoming re-election effort of liberal Rachel Notley. A shrinking price differential will ease Alberta’s pain, but maybe not end its war.

The Dallas Federal Reserve Bank’s survey of the local Texas energy economy shows it hit a huge pothole in the fourth quarter. Driven by the collapse of oil prices and the growing uncertainty about the price in 2019 and thereafter, energy job losses are mounting with many more jobs at risk. Should we worry, or is oil about to experience a huge rebound?