Eric Nuttall, Partner and Senior Portfolio Manager, Ninepoint Partners LP
Originally Published on June 28, 2022
Fear can be an investor’s worst enemy. It may induce inaction, cloud judgement, degrade conviction and, at its worst, lead to panic and capitulation. Over the past two weeks, energy stocks have fallen sharply, with some down 30 per cent or more, resulting in the worst price decline since March 2020, when WTI oil tumbled by more than half to US$20 due to the outbreak of COVID-19.
Today, WTI oil trades comfortably above US$100. So why the panic? Sky-high global inflation and rising interest rates to combat it have meaningfully increased fears of an imminent recession and ensuing weakness in oil demand. Do recessions necessarily mean falling demand, and if so, what does it mean for the oil price and energy stocks?
To begin, let’s be clear: today, we are categorically seeing no signs of weakness in demand on a global basis. There are two real-time measures that we use to evaluate demand: time spreads (the premium paid for barrels today versus a later date) and global oil inventory levels relative to average levels. If oil demand was weakening, we would see it in both indicators, and instead of weakness, the premium being paid for immediate barrels has been rising since May, while the global inventory deficit to normal levels continues to widen to record levels.
Oddly then, while panic is rising these two signals suggest that oil fundamentals are in fact further strengthening, and therefore any fears of oil demand weakness must not relate to what is, but rather what may be.
F.E.A.R. can at times appropriately stand for “false evidence that appears real” and I believe this to be the case today. A modest pullback in oil and the absolute pummelling of energy stocks has reinforced the belief that oil demand is or will soon collapse, and price weakness has begotten more price weakness, with stocks stuck in a negative feedback loop. We saw a very similar pattern in March of 2020 when uncertainty was at its highest and despite oil still trading above $100 WTI to me the panic in the market last week approached what it felt like in the early days of the COVID outbreak. What is the best antidote to panic and F.E.A.R.? Facts.
Historically, periods of global oil demand contraction are very rare, corresponding to only the most severe of economic contractions, namely the COVID demand shock of 2020 and the global financial crisis of 2008/09. In other times when certain countries or continents entered a recession, such as the United States in 1980 and 1990, while the rate of oil demand growth slowed it still remained positive. Recency bias then may be inflaming demand fears, obfuscating the fact that the price of oil is not just dictated by demand, but also supply. With the imminent exhaustion of OPEC spare capacity, stagnant production growth projected from the global supermajors through the end of the decade, short-cycle U.S. shale growth limited by shareholders’ demands for returns and ongoing shortages in labour and steel, and potential production declines in Russia owing to sanctions and the exodus of E&P and service companies, we believe that any moderation in demand growth will be more than offset by production-growth challenges.
We are not alone in that view. Energy Aspects, a globally respected energy research firm, despite forecasting a recession in both the United States and Europe next year, estimates that global inventories will fall by 300,000 barrels per day in 2023, owing to the supply challenges listed above. Cornerstone Analytics, another firm whose work we greatly respect, similarly forecasts inventories to continue to fall dramatically even if demand were to weaken from a recession.
What if we are wrong and demand does indeed fall more than expected? With inventories today at such low levels relative to normal, even a one million barrel per day delta would have to persist for nearly a year for OECD inventories to reach normal levels.
Another insurance policy is that OPEC now has a proven playbook to use in times when the market is significantly out of balance, and with oil prices just now back to levels that allow the majority of OPEC members to be going concerns, should demand weaken we would expect OPEC to be highly responsive with supply cuts.
What of energy stocks? We estimate that most Canadian energy stocks, especially smaller ones, are discounting a WTI oil price of approximately US$50-$55. Slashing nearly one-third off the current price to US$70 would mean that energy stocks still remain profoundly mispriced, trading on average at 17 per cent free cash flow yields, and with most companies pledging 75 per cent or more of free cash flow to go to shareholder returns, this portends a 12 per cent dividend yield even under a very bearish oil price scenario.
What if we are right and US$100 WTI serves as a fundamental floor for the next four-to-six years or longer? With WTI at US$100, we estimate that the average Canadian energy stock is trading at a 31 per cent free cash flow yield, can privatize and become debt free with just 3.1 years of free cash flow and has an enterprise value to cash flow ratio of 2.1x — a two-third’s discount to historical averages.
With the sector approaching “debt free” status by Q1 of next year and strongly committed to returning the majority of excess free cash flow to shareholders, investors should be comforted in knowing that while energy stocks have corrected painfully these past weeks, the one thing that has not gone down is the massive amounts of free cashflow that is hitting the bank accounts of energy companies daily, soon to become more visible with Q2 reporting in several weeks’ time.
Just as in 2020, this too shall pass. It is mind blowing to me to have to talk about panic and fear with oil trading comfortably above US$100, corporate balance sheets in stellar shape and what I believe to be imminent returns to investors, but here we are.
Don’t succumb to the fear of the moment. Tune out the noise and focus on what matters: supply growth is structurally challenged for years to come and in our opinion will outweigh any temporary demand weakness resulting from a recession. We remain bullish.