What a week. The first big (but not last, in our view) bankruptcy on Wednesday followed by a Trump tweet on Thursday that set WTI on fire followed by speculation on Friday about what the outcome of a global supply curtailment could look like and accomplish. You’d think the week would finish there, but of course the virtual OPEC+ meeting got pushed back from Monday to Wednesday or Thursday this week yesterday amidst country spats.
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Despite stepping up the defensive efforts and the 46% YTD underperformance vs. the S&P500, we continue to see a challenging outlook for the E&Ps. Barring a V-shape recovery for oil prices, which we view as unlikely, we see the profile combination of declining volumes, rising financial risk, and reduced return limiting sector visibility and upside. However, we are reshuffling our stock picks as themes and relative value opportunities have emerged amongst the recent volatility.
A new theme that emerged late this week was basis differentials blowing out everywhere, as concerns grow that pipeline operators will be rejecting volumes due to storage running at max levels with refiners cutting run rates. This includes the Permian where the Mid-Cush spread widened out by $10.25/bbl, going from +$1.75/bbl on Wednesday to -$8.50/bbl on Friday. Even LLS, which has traded at a $2-8/bbl premium over WTI the past year, is now trading at a $3.85/bbl discount. We touch more on this inside and show the Mid-Cush spread and U.S. export data (that’s yet to crack). Also, timing couldn’t be better for our midstream team to have two fireside chats tomorrow with pipeline executives that can give a better picture of what’s happening in the physical market. Please join at 9am and 2:15pm EST tomorrow for discussions with ENB and PAA, the latter sending out notice to shippers last week.
After exploding from 10% two weeks ago to 23% last Friday, the HY Energy spread to U.S. Treasuries finally looks to have peaked. That’s a good thing, but spreads haven’t narrowed like the equities have rallied this week, suggesting to us the credit market hasn’t bought into the recovery just yet. This will be a key data point to watch, not only as a key signal the sector financial outlook is stabilizing, but potentially for the debt capital markets door to open.
After a round (and for some producers, two rounds) of downward capex adjustments for 2020, we’re again updating models across the board. Overall, the updated outlooks cut two ways. To the positive, they showed the sector playing defense with budgets mostly coming below expectations to support balance sheets and liquidity (average YE20 Net Debt/EBITDA drops 0.2x turn), but in doing so, they also showed volumes coming in below expectations. That’s the negative and it’s creating a headwind that can persist on the other side of the COVID-19 recovery, as we now see the sector needing WTI to rise above $40/bbl in 2021 to generate positive y-o-y cash flow growth and further de-lever. See updated company estimates within.
While there’s been significant downward pressure on domestic natural gas demand due to the record warm winter and COVID19 shutdowns, consumption for power generation has surprised to the upside so far in 2020. Using Genscape data, estimated YTD natural gas consumption for power generation has averaged 28.9Bcfpd vs. Wolfe’s 27.6Bcfpd 1Q20 estimate and 26.5Bcfpd in 1Q19. This y-o-y increase comes despite a 1% decline in overall power generation output, most likely due increased coal to gas switching as Henry Hub has averaged $1.89/mmbtu YTD vs. $2.87/mmbtu in 1Q19. Further backing up the impact of fuel switching, Genscape has 2020 YTD coal power burn down 40% vs. 1Q19 levels. In our supply/demand model, we estimate power consumption to average 31.3Bcfpd in 2020 (+0.4Bcfpd y-o-y) with similar annual increases in 2021-25 as renewables gain market share. See page 3 for the power consumption data.
For the week, our E&P Index finished -23% vs. the S&P500 -15% and WTI -29%. Stocks continue to trade in a highly volatile pattern, with a 90% spread (yes, 90%) between the top (SWN) and bottom (GPOR) stocks in our index this week, while FANG and CXO, tight Permian peers saw a 20% spread. This means it’s a daily battle to find relative value opportunities, and some of the best opportunities lie across the capital structure. Inside this week, we highlight trends and opportunities we see in credit, address a key question that’s come up regarding credit pricing as it relates to M&A, and give our take on the three-part debt offering that EOG launched Friday morning and pulled Friday afternoon (3/20/20).
For the week, due to the strong Friday finish (3/13/20), our E&P Index miraculously ended -8.1% vs. the S&P500 -8.8% and WTI -23%. We hope you and your family are healthy and everyone is doing ok through this challenging period.
While the shape of the U.S. oil and natural gas supply outlook is changing daily as updated budgets roll out, we see a portion of the production base acting differently due to the sector’s increased financial risk. Basin location, midstream commitments, and inventory duration are also factors changing forward outlooks, but to get a sense of how much supply could face decline due to growing bankruptcy risk, we added up the production base of 42 High Yield issuers as a proxy. There are a few stable producers in this group, such as PE, WPX, and MUR, but collectively we estimate that a sizeable 2.3mbpd of oil and 29.5Bcfpd of natural gas supply, or 18% and 30% of the current Lower48 supply, respectively, could soon be rapidly declining (and potentially never recover), if capital market access doesn’t open up. See page 5 for the list.
With a +10% move over the past month, front month natural gas has been a relative winner in the wake of the crude oil price collapse, and we believe there continues to be upside support as the supply outlook worsens. Domestically, the clear beneficiaries have been the Marcellus producers, particularly EQT and COG, who have outperformed our E&P Index by 87% and 65%, respectively, over the past 1 month, but with the Haynesville mostly in private hands, we believe investors can also look to Canada for additional natural gas exposure. Within our coverage, OVV and MUR have significant Montney exposure and but we’d also highlight three Canadian producers - Tourmaline (TOU.CN), Seven Generations (VII.CN), and Arc Resources (ARX.CN) - that have underperformed Marcellus peers over the past month, trade at lower EV/EBITDA multiples, and have similar, if not better balance sheets based on Consensus estimates.
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