Upside for the Sweet 16 - Nov 23

[dan_s]

I am taking a hard look at each company in the Sweet 16 and I still see a lot of upside for this group because they are still trading at very low multiples of operating cash flows per share that I see coming in 2022. BTW I do think my 2022 forecasts are based on conservative assumptions.

Goldman Sachs top commodity sector analysts recently pointed out some headwinds that are keeping high quality upstream companies, like the Sweet 16, trading below historical valuations. Below is cut from a recent article on the sector. My comments are in blue.

There are 3 concerns / headwinds that are keeping many investor on the sidelines:

First, an investor payback for poor returns.
The oil upstream sector, especially shale, over-invested from 2014 through 2019, destroying significant equity and debt values. This has left investors wary of the sector, requiring producers to focus on returning cash to shareholders through debt buybacks and dividend payouts. Despite these efforts, the recent profitability has been too brief to overcome such damage to investors, leaving the sector trading at a large discount to both the broader market (S&P500) and long-dated oil prices. This is still a long ways away from maximizing shareholder returns, providing little mandate to raise capex, and with the forces of ESG now an additional headwind. Specifically, by cannibalizing investor’s capital away from oil and gas, ESG principles are further raising the cost of capital of producers, increasing the marginal cost of production that needs to be cleared by higher oil prices. This is the main reason why the producer response has been slow, with the return on capital employed of the two largest US producers - pointed out by the White House in a letter to the FTC yesterday - only now back to their cost of capital. < This concern should fade as quarterly financial results reported by the Sweet 16 keep improving. This is especially true for the "gassers" because natural gas and NGL prices didn't spike until late Q3 and a lot of "Bad Hedges" don't expire until year-end.

Second, demand uncertainty.
In the short-run, this uncertainty is due to the still present COVID risk, with measures to contain successive waves systematically weighing on mobility. The increasingly more important source of uncertainty is, however, that of the path to decarbonization. The focus on shifting away from hydrocarbons, while necessary, creates an uncertain return proposition for long-cycle oil and gas projects, which still represent the bulk of global supplies. The rational response to such uncertainty is to either delay investment or focus on short-cycle solutions. Beyond the volumetric uncertainty of where oil demand will be in ten years time, this uncertainty is increasingly regulatory, with still unclear rules in the US in terms of drilling, emissions and taxation. While action is indeed required in these areas to lower emissions, the lack of clarity is rationally delaying investment. We observed the same outcome in 2014 when a potential lift of the US crude export ban was still unclear, delaying any major investment in US refining capacity. < IMO the concept of "Peak Oil Demand" due a shift to more energy from renewables is grossly overstated. It will not happen for at least a decade because wind and solar will continue to disappoint and material costs will make a big move to electric vehicles to expensive for 95% of the world's population. FEAR of Covid has also faded; most people aren't afraid of a virus that has a 99% recovery rate. Have you noticed that few people care what Dr. Fauci says anymore?

Third, OPEC.
The group still has spare capacity and is only ramping up gradually. While it could do more, there are two reasons for such a slow response. First, half of its members can’t meet their quotas given their own under-investment. This complicates changing quotas as such a decision needs to be unanimous. Second, the slow supply response of shale producers has brought the group its pricing power back, leaving a slow ramp-up in output fiscally more beneficial than higher volumes. As we argued in 2014, this is the rational response to a steepening global cost curve, with prices finally get back to near core-OPEC’s fiscal breakevens. The nature of the current SPR release - presented in part as targeted at OPEC - raises the question of what the group does next. The rational decision would be to halt production hikes to offset it - since the positive price impact always exceeds the volumetric hit. Conceptually, such a decision could be argued to help support prices to the level needed to stimulate the (slow) recovery in drilling activity globally. A global shortage in coming years is indeed not in OPEC’s interest as it would lead inevitably to a global recession - and much lower oil revenues - or accelerate the energy transition away from oil. < OPEC+ has no fear of Team Biden. They are going to show Good Old Joe who has control of global oil prices and it isn't an old man that can't remember what he had for breakfast.

Ultimately, Goldman is correct that the decision to release oil from strategic reserves remains mostly political, precipitated by rising inflationary pressures across the economy. Yet, while oil prices are indeed up significantly, they are ultimately not historically elevated, especially when factoring in wealth effects. In the US for example, current spending on gasoline represents 4.3% of total US consumer expenditures, well below the 6% average level of the 2010-14 period, when the last emergency coordinated SPR release occurred. On a global scale, Goldman's estimate of oil consumer spending per GDP (based on retail prices covering 98% of global demand) shows that current prices are only in their 65th percentile since 2000. < IMO the spike in inflation is being caused by the supply chain problems. Yes, higher fuel prices are inflationary, but not to the level we are seeing today.

The political nature of this SPR release may lessen the sustainability of its bearish price impact. For example, structured as a loan, barrels would need to be returned at a later date, creating buying demand for deferred contracts as a hedge (an especially appealing strategy given the backwardated forward curves). The EIA’s forecast for lower oil prices next year as well as the historical pattern of US SPR volumes ending up exported would also point to the use of exchanges of barrels rather than a sale, just as JP Morgan predicted yesterday. With India, Korea and China having all already conducted swaps this year to be repaid in 2022, similar government loans would actually become an additional bullish catalyst next year when these barrels will have to be returned from commercial inventories. Meanwhile, the lack of bearish impact of past Chinese SPR releases is ultimately indicative of the scope of the current deficit.

So given Goldman's expectation that an SPR release - which is already more than fully priced in - will not lower oil prices in 2022, with risks to the bank's forecast skewed to the upside if a deal with Iran does not occur, Courvalin (GS oil expert) believes the White House will be pushed to consider additional actions to try to lower US gasoline prices. This is consistent with yesterday's news that the White House urged the FTC once again yesterday to investigate US retail gasoline prices, which have indeed outperformed crude oil prices in recent months. Of course, this outperformance reflects refining, regulatory and distribution dynamics, as pump prices need to reflect the historical pattern of a lagged pass through of crude prices into gasoline prices, the tight level of gasoline and diesel inventories, leading both to compete and outperform crude in order to defend refiners’ yield incentives, regional closures in US refining capacity, the impact of government biofuel mandates and elevated RINs values, and retail and distribution margins supported by rising input and labor costs. < In other words, this is way beyond the intelligence level of the Team Biden.

Of these, the Biden admin can only directly impact RIN values - pointing to weaker RFS blending requirements in 2021-22. Marketing margins have also remained elevated, making up 20% of current retail prices (at the high end of the historical range), with the FTC asked for a second time to investigate this sector. This may however still reflect the inflationary effects of the COVID shock, with costs per gallon sold increasing due to a still above-average number of employees as well as wage inflation.
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My Conclusion: Demand for oil-based products is seasonal. Demand for gasoline and diesel spikes June to September and demand for crude oil ramps up starting in April. Team Biden going to war with OPEC+ is going to backfire and I see a clear path to $100/bbl oil and $5/gallon gasoline arriving a few months before the 2022 mid-term elections.