War, Recession and Oil Supply with Eric Nuttall

As a recession looms in 2023, energy investments are being hit by fears of a drop in demand. But as Eric Nuttall tells us, oil may end the year at $100 a barrel because the markets aren’t considering the other side of the equation: supply.

Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

Michael Hainsworth:

Typically when there's a war involving an oil producing nation, a risk premium is factored into the price for a barrel. But according to Eric Nuttall, crude today is $20 cheaper than where it should be. And that's just on geopolitics. He says We're discounting barrels thanks to increasing fears of something closer to home. Inflation fighting interest rate increases triggering a deep recession. One that the world's number one energy analyst says is leading investors to focus on the demand side of the equation, not the supply side. In an industry that could see a 25% increase in dividends in 2023 and pump prices up 30 cents from here.

Eric Nuttall:

What we've seen is a massive disconnect between the physical market for oil and the financial market for oil. And by that I mean I think fundamentals for oil have remained very strong. We track global inventories in real time and they've been falling all throughout the year despite some very, very serious headwinds. We've had the largest release in history from strategic stockpiles. We've had China in certain areas remain under lockdown due to its COVID zero policies impacting oil demand by about half a million barrels per day.

And so despite those two major headwinds, the market's been undersupplied. And so what we've seen then is a strong physical market for oil, but a weak financial demand for oil as people are concerned about rising interest rates inducing a global recession and the impact that that would have on oil demand, even though historically recessions do not necessarily mean a falling demand in oil instead of moderation in the rate of growth for demand.

Michael Hainsworth:

Okay, so to your point then, you're talking about the fact that there is concern about the demand side of the equation, but there is also the supply side of the equation. We started the year with 3.9 billion barrels of oil in stores. Today it's closer to 3.4 billion. What's the supply side of the equation looking like as we move forward?

Eric Nuttall:

It's an excellent point to raise because people forget that what makes the price of anything is not just the demand for it but the supply of it. What we've been writing about for some time and why we think we're in a structural bull market that's going to last at least the next six years is as demand continues to grow over the next 10 plus years, there are profound challenges to supply.

And so as we speak, shale CEOs are meeting their boardrooms, beginning to set their spending plans for 2023. In the face of a massive implosion in the oil price, rising concerns about a recession, what that means for demand, et cetera. And so even with very, very disappointing shale growth so far this year. The most recent month of data we have is for the month of July. So the first seven months of the year, shale grew less than 180,000 barrels per day, very, very weak.

And so what is their ability to grow or desire to grow next year in the face of weak oil pricing, uncertainties around the economy, service costs that are going to be up 20% plus. So you're bang for your buck for every dollar spend is less. Well economics are not as robust as they were this year, et cetera. So we think shale is setting up for another year of disappointment.

We then turned to OPEC where they publicly admitted that they had exhausted their spare capacity as of about a month ago. They're entertaining a cut as we speak now, but they have the inability to meaningfully grow because while they're growing their production, it's taking some time. Like the UAE is adding about a million barrels per day coming on in 2025. Saudi Aramco is a million coming on in 2027. And so it takes them a lot of time.

And then lastly, the super majors can't grow because they stopped spending enough in 2014. They're now at half of that level even though the oil price is high and they're under pressures to decarbonize, to spend more money on alternative forms of energy, to delever to pay dividends, et cetera. And so it's not just the demand. A recession will for sure moderate the rate of growth in demand. But the real story is on supply. With the normalization in Chinese demand with the potential for Russian production to be impacted, for fuel switching. Where in Europe it's much, much more expensive to burn gas for power than it is for oil. And so fuel switching alone could be enough to offset any weakness from a global impact of regional recessions. And so people are completely myopic when it comes to the supply side. They're just focusing on the demand side.

Michael Hainsworth:

You mentioned this is your view for the next six years. Why six years?

Eric Nuttall:

Yeah, so the logic behind that is the oil price has to go high enough, stay there long enough to do two things. One, to kill discretionary demand, which is incredibly difficult. The second thing is it has to allow for the global super majors to start spending again on large scale projects that are very risky, very expensive and very long leaded nature. We're all conditioned to think that prediction growth can come in four to six months. That's what we had for us shale.

For long cycle projects, which is what the world is relying on going forward. It's four to six years and in fact likely longer than that. And so that's the reason, that's the logic in terms of why we're in a multi-year bull market for oil. Multi-year relates to cycle time, the timeline it takes for the large projects to come on. And we're not even at the point today where large companies are thinking of spending enough.

Michael Hainsworth:

You said you're predicting a 20% cost inflation over the next year. We understand generally what's going on with inflation, but what's specifically going on with inflation in your space and how do you get to that 20% figure?

Eric Nuttall:

Well, we talk to companies routinely. They're guiding for 15 to 20. So we're airing on the side of caution. We continue to see labor inflation, the staffing shortages. There's been ongoing restrictions on the availability of steel and tubulars. And the last thing has been the service sector has been under enormous pressure, even more so than the MPs where they've been cannibalizing equipment to satisfy demand because they're working capital constraints. So that we're finally at the tipping point where they do need price increases to be viable concerns, to have enough working capital to invest back in their equipment and bringing up to working spec. So we still profoundly prefer EMPs over services even though service companies have pricing power. So it's just that one more reason why we think spending next year or at least incremental growth from incremental spending will be much, much moderated than relative to what people think.

Michael Hainsworth:

That's an interesting perspective about the swing in the pendulum. So much effort had been put into pulling back on production such that to get production back up and running again, it's just going to cost the industry that much more.

Eric Nuttall:

Yes. That much more and that much longer and even cycle time now for shale has been extended from four to six months to about a year. And so we just don't think people recognize the profound challenges to growing supply, even though you've had a price signal. And the biggest constraint admittedly are guys like me where we say our clients energy investors at large have experienced the most challenging decade in history of owning these businesses.

And so it's our time to get paid, it's our turn to be rewarded for that patience. And so instead of growing, which there's not an investor on this planet that wants, it's our turn to get paid in the form of meaningful buybacks and dividends. Because at $100 oil, we have the sector trading at about a 33% free cash flow yield. Meaning our average company can keep production flat and either pay us a 33% dividend or buy back a third of their stock effectively privatizing in three years time. And it's that meaningful action that I think will lead to a rerating evaluations because we now have companies trading at a quarter of where they used to trade several years ago. And so I think it's that meaningful return to capital that's going to lead to a rerating closer back to a reasonable valuation level is.

Michael Hainsworth:

I see a tweet from you that did something like a 20% share buyback today means a 25% dividend increase next year.

Eric Nuttall:

People don't appreciate the power of buybacks. So for one, if you buy back one fifth of your float, so let's say you have a hundred million shares today, you buy back 20%, you've got 80 million next year. Well, if the oil price stays constant, the amount of dividends in an absolute level, like total dollar amount stays the same, but you have 20% fewer shares to divide that by. Therefore it's a 25% increase next year in dividends.

And I see a lot of people like on Twitter and whatnot, wanting dividends, they want get paid, which I completely understand. But what drives the rerating in share prices? What makes people care? I'm firmly convinced that if companies in Canada across the board, and I feel like we're there today where boards from that I've presented in share my philosophy. If companies announced to the world, if you don't see the value in our shares, we do.

And if you don't want to buy them, well we do with free cash flow. So what we're going to do is we're going to buy back every single share we can out of free cash flow. And we have examples where they have 30, 35 years of reserves, therefore 30, 35 years of free cash flow, but I'm only paying for three of them.

And so those remaining 32 years is worth $40 billion. And so my pitch to boards is, well look at your stocks trading at $16, what's the value of the last share? Theoretically it's $40 billion. So you can drive your rerating from 16 to a much, much, much higher level. And you would say, well Eric, that's silly because that assumes the share price isn't going to go up as you buy them back. And that's exactly the point I'm making. I don't have to wait for a generalist investor to see the generational opportunity that I see. I need not have a generalist investor ever buy another share again, so long as these companies are meaningful enough with their share buybacks because we can have that rerating evaluations simply through meaningful return of free cashflow back to us in the form of share buybacks.

Michael Hainsworth:

So when do we hit the stage where dividend increases could be better spent elsewhere?

Eric Nuttall:

What we have to get to a point is for share prices to better reflect what I think fair value is for these companies, which is about a 12% to 14% free cash flow yield that triangulates to about a four to six times trading multiple versus 2.2 today. There will come a time, I believe when valuations do approach more reasonable levels, companies are still awash and free cash flow. They're sitting on well over a decade worth of inventory, therefore they don't have to suck their free cash flow away in the form of M&A. And so the buybacks gets moved into variable dividends. That's a more US model versus where we are in Canada. I think the day will come. And so I see this sector as a low to no growth model where the priority needs to be on buy backs today and in the near future. I'm optimistic in the next year to two years, that'll shift more towards variable dividends where we could be getting paid using current share prices dividend yields of over 20% easily.

Michael Hainsworth:

Bloomberg's David Fickling writes that peak oil has finally arrived adding no, really!

Eric Nuttall:

Yeah, I knew you were going to bring this up. You're trying to get me in trouble.

Michael Hainsworth:

How could I not?

Eric Nuttall:

So I write about energy ignorance and there's a reason for that. So let's define energy ignorance. Energy ignorance is the lack of knowledge of how hydrocarbons are used and the timeline and ability for them to replace fossil fuels. And so can windmills replace plastics? Can solar panels replace rubber and lubricants and asphalt?

What of a world where the population's going to grow by over a billion people between now and 2050 in areas of the world where they consume five barrels of oil a year and we consume over 20. And where their living standards are rising. So to is their hydrocarbon intensity. How successful is the conversation for us in the west to go to those in the developing and the emerging and say, you cannot have what we have. You cannot enjoy the lifestyle that we have such as refrigeration and power for that matter.

I got to meet the Secretary General of OPEC back in the summertime. He had unfortunately passed away afterwards. And he's from Nigeria, a country where they have over a hundred million people without even energy. And so their priority is not on decarbonization, it is not on building out wind turbines, it's on affordable and reliable energy. And you would think after the energy crisis that we see in Europe, affordability and reliability would be two priorities for energy policy makers in those countries as well. And so I just think only the mathematically challenged can arrive at the conclusion that we are a peak oil demand.

Michael Hainsworth:

Peak oil supply is a whole different matter though.

Eric Nuttall:

We're there. Tell me where the world's going to come up with the required 10 million barrels per day of supply growth over the next 10 years. I reference in of my most recent webcast, some work from Sanford Bernstein, Bob Brackett, who does really, really great work. And it's not a forecast, it's a model. And the model says, let's just assume that EV adoption rates, electric vehicle adoption rates are super aggressive, hydrogen adoption, super aggressive. We moderate GDP growth, we moderate oil intensity per unit, GDP growth, et cetera.

And his conclusion is oil demand grows out till about 2034. So let's say 10 years, 10 years that of million barrels pre demand growth, that's 10 million barrels of new capacity that we need. Where is it going to come from? OPEC's going to deliver two. US Shale at best I think can come up with five at best.

That's a 3 million barrel per day hole that the world faces. And so it boggles my mind how people, more people don't see what I see. You already have like Goldman Sachs in a report this morning saying this is one of the tightest oil markets in modern history. And when I see the wall that we're headed at and the consequence that that is going to have on a meaningfully high oil price. This concern about a near term recession and what that means for demand, it is so shortsighted and so misplaced when the real story is all about supply.

Michael Hainsworth:

Let's talk a little bit about what's going on right now. What did the market reaction to the Nordstream sabotage tell you?

Eric Nuttall:

Well, people don't really understand the significance of that. One from people that I talked to, it was a shot across the bow from an unnamed person saying, "You are vulnerable. I can attack you anywhere I want." And so the impact that I think will have on the risk premium on oil is growing. Secondly was is its threatens Europe's ability to satisfy natural gas demand over the wintertime.

Yes, their storage levels are adequate now, but that was reliant on ongoing imports. And so while they may be able to access LNG over the short term, maybe they can cut their near term demand by lowering their thermostats and whatnot. The real story is all about 2023 and 2024. And so this elongates the energy crisis that they face. It increases the likelihood of gas to oil switching, which could amount to 700,000 barrels per day, which nobody's thinking about. But to me it reminds or it should remind investors that right now there is zero risk premium in the oil price and there certainly should be. Oil should be at least $20 higher just based on fundamentals, where inventories are, let alone any risk premium.

Michael Hainsworth:

So are you attributing a $20 discount to what you think it should be at as it trades at about $82 on the front, to just recession fears?

Eric Nuttall:

Yes. It's this breakdown between the fundamentals for oil, ie the fundamental demand for oil expressed in falling inventories despite the largest SPR release in history, despite China under lockdown, all of these headwinds and the financial market for oil where people are worried about a recession, you've financialized the oil contract, people are using it as a way to express a negative view on the global economy. And it's not just me saying this, the most sophisticated producer and provider of oil in the world, Saudi Aramco is saying that they see a massive disconnect and importantly they're going to do something about it.

Michael Hainsworth:

There has been a lot of talk about the moral collapse of the frontline Russian soldiers in Putin's army right now in Ukraine specifically, and that at some point he may find himself or feel himself backed even further into a corner. There's a lot of discussion about the risk of tactical nuclear weapons being deployed. Do you see that, first of all as something that needs to be factored into the market? And if so, what do you think the market reaction looks like?

Eric Nuttall:

Oh, that's a tough one, Michael. Let's just set the table first. There has been no meaningful impact to Russian oil production yet. We have embargoes coming into place December 5th. There's a belief from some whom I trust that production could be impacted by upwards of a million barrels per day, at least over the short term as trade routes get figured out. That is not a consensus, that is not built into oil price. Any escalation would, in my mind, increase a risk premium given that there is no risk premium. But it would increase the risk premium in the oil price. But to quantify that on a hypothetical, especially a hypothetical nuclear situation, I don't know if I can intelligently quantify that right now. Other than to say, I think it would increase the risk premium oil significantly.

Michael Hainsworth:

Then let's step back into the way back machine and give us some insight into the historical impact on prices that war has had in the past.

Eric Nuttall:

So every situation is unique. At times it is a buy the rumor, sell the news. There is a short term impact juicing demand, but then at times there's a consequence on GDP growth, which impacts oil supply. So just at this point, what I'm trying to tell clients is focus on really what matters and everything else is additive to the bull thesis for oil energy stocks.

Like I own energy stocks today, not because of a potential for an escalation in a war in part of the world. I don't own it for the geopolitics. Why I'm bullish on energy stocks is I think demand's going to grow for the next 10 plus years, and I simply can't figure out where the heck the supply is going to come from. Where US shale growth is constrained by geology, it's constrained by investors themselves. Where OPEC has exhausted spare capacity, it's going to take them years to fix that, where the global super majors can't grow because they have to be woke and increasingly invest in alternatives and delever and pay dividends and where their shareholders don't want growth at all. That's really the both thesis for me. Anything additive to that is just, again, additive. It's not the basis for why I remain bullish.

Michael Hainsworth:

All right. Here's the dinner party question for the listener to be the smartest one in the room the night when we talk about gas prices. We're down 60 cents since the last time you and I spoke on this topic. What does that pump price look like to you and where does it go from here?

Eric Nuttall:

You've had crack spreads fall. They're normalizing a little more, meaning as oil price goes up, you should have a little more sensitivity on the oil price. We all have to remember that a large part of the gas price is taxes, especially carbon taxes, which are going to be going up significantly. I think we're going to see $100 all by the end of this year. You're looking at probably a 30 cent increase in gasoline, but that's just a guess.

Michael Hainsworth:

Eric, always great speaking with you. Thank you for your time.

Eric Nuttall:

Thanks so much.

The opinions, estimates and projections contained within this recording are solely those of Ninepoint Partners and are subject to change without notice. Ninepoint makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, Ninepoint assumes no responsibility for any losses or damages,  whether direct or indirect, which arise out of the use of this information. These views are not to be considered investment advice nor should they be considered a recommendation to buy or sell. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. Important information about the Ninepoint Partners Funds, including investment objectives and strategies, purchase options, and applicable management fees, and other charges and expenses, is contained in their respective prospectus, or offering memorandum. Please read these documents carefully before investing. We strongly recommend that you consult your investment advisor for a comprehensive review of your personal financial situation before undertaking any investment strategy. For more information visit ninepoint.com/legal. This report may not be reproduced, distributed, or published without the written consent of Ninepoint Partners LP.

Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.