Recession Worries in the Oil Patch with Eric Nuttall

Michael Hainsworth:
When it comes to investing in the oil patch, one of the world’s top energy analysts  isn’t taking his eye off the ball. Eric Nuttall says energy investors have been captivated by the Russian invasion of Ukraine. He calls it a year-long slog. But investment decisions are being dominated by economics, not geopolitics. And investors are preparing for a recession. But what do the market fundamentals tell us? And how can we use them as leading indicators for that predicted financial crisis?

Eric Nuttall:
It feels like you're fighting a boogeyman, so to speak, of, "Well, it's not the fear of what is, but the fear of what may be." Because as we track oil demand as closely as possible, there's little signs to show any erosion in demand growth.

And we can measure that a few ways. We can get what the countries themselves are reporting and people who track imports and exports. So we look at India, record demand in April and May. China, record demand in April. We can look at data providers such as Rystad that tracks real-time air traffic demand, and implied demand. And as of today, literally on a year-over-year basis, the tracked  demand's up 1.4 million barrels per day. And that's encompassing what, half of global consumption.

So we cannot see any evidence in a holistic measurement to suggest that demand is weak. Every stat that we look at, whether it's U.S. government data on gasoline demand, diesel demand is perking up. Every indication is this summer's going to be a record demand for air travel. Everybody reports it on Twitter, et cetera, hotels are full and airports are full, et cetera. And so yes, it's been this dominant recessionary narrative that I think has been the biggest headwind for energy investors for the past year.

Michael Hainsworth:
So if it is all about economics, weren't we talking about a recession, like you and me, like a year ago?

Eric Nuttall:
Yes, we were. And we would know this is the most talked about anticipated recession. It was supposed to happen by now. And here we are. So now I hear, well, gee it  may be a late 2023, late 2024 event. And yet what people are not realizing is that even in a recession, what usually falls is not oil demand. What usually falls is the rate of growth in oil demand. Plus, take into account the GEA of China that continues to normalize. It's got its fits and starts and it's not immediately improving overnight, but I checked in this morning. Road congestion improving. International flights, improving. Domestic has been relatively strong. So you just can't focus on demand, you have to look at supply and ultimately what that means for global inventories, which makes us very, very bullish heading into the summertime.

Michael Hainsworth:
You rhymed off a whole bunch of potential indicators for us as investors to keep an eye on. Tell me about the real-time demand indicators that you are specifically actively keeping an eye on and what that tells you about the likelihood of a recession as we get into the second half of 2023.

Eric Nuttall:
So we do get better access than most simply because we're paying for it, so it's very expensive, but very, very valuable information. But for somebody at home, just do a Google search and look up China demand, India to U.S. gasoline demand, et cetera. Search for travel queries and anticipated record demand for air travel this summer, et cetera.

But if you want to be a little more granular, we use a few different data providers. One is Kepler. So they use satellites to track every vessel in the world and every storage tank on the planet with oil in it. And so we get, it's a one-week lag, but we get oil inventory data, we track inventories because that's really the nexus of supply and demand. And so if inventories are rising, it typically would suggest the market is oversupplied, so that's going to suggest either supply is stronger than we thought or demand is weaker.

We subscribe to a firm called Rysad. So they've got hundreds of people that track literally several hundreds data inputs to track the number of planes flying, the type of plane flying, is it wide-body, is it a dinky little plane, et cetera, because that's important to determine implied oil consumption. They track trucks on the road, cars on the road, and globally.

And so those are the two tools that we're using to measure demand because we need to ensure that our thesis is playing out. And our thesis revolves around continued not only seasonal increases in demand. G1 is the weakest or perhaps it gets stronger. We've got to track China demand normalization and then we've got to track supply. And so that's where there's been a couple surprises this year that we weren't anticipating.

Michael Hainsworth:
Before we get into the supply side of the equation, let me just sort of wrap up my questions to you on the demand component to this. Brent Crude futures are down 14% since the start of the year. I'm being told that it's the rising interest rate environment that's to blame for futures prices being down. Do you agree with that connection? What's Ninepoint’s outlook on rates?

Eric Nuttall:
What I think the reason is that you have to appreciate there are two markets for oil. There is the physical market, which is the largest commodity in the world and demand today's about 102 to 103 million barrels. And then you have the financial or the paper market for oil, which is 30 times bigger than the physical market. And so if you're in the physical market, you're buying barrels to consume them. You're a refinery, you're an airline. If you're in the paper market, you're a financial guy and you're trading it and using the financialization of those contracts to express either a positive or a negative view on the economy.

And so what we see is beginning a year ago, June, that's really when concerns on the U.S. and global economy due to the extremely aggressive increase in rates and this beginning of the narrative about recession, recession, recession. And what we've seen is, the interest in oil, the optimism in oil as measured by that length in oil contracts, you know, you take longs versus shorts, we've now fallen to a level where we're back to the April 2020 lows, meaning the length in oil contracts is the same today, people are as pessimistic today as in April 2020 when we were all locked in our homes and nobody was flying and driving.

And so it's been that selling in the paper market that I think has overwhelmed a neutral to bullish setup in the physical market

Michael Hainsworth:
…and because of that 30:1 ratio, you can have a scenario where the tail wags the dog?

Eric Nuttall:
Ultimately the physical market prevails and that's why we follow demand and supply and ultimately, inventories. But it feels like there's just, we're in this period of time where this dominant, overwhelming recessionary narrative is not allowing the physical market tightness to be reflected in the price.

Michael Hainsworth:
We don't see equity prices down as much as futures prices, but the S&P 500's energy basket is down about 8% since the start of the year. What is your outlook for the second half of 2023? Is there a catalyst to improve sentiment?

Eric Nuttall:
Yeah, so we're down about 14, 12, 14% year to date. It feels like we're down 50 as measured by sentiment. It's critically important to realize that this is likely a year of two halves. The first half of the year was all about seasonal weakness. We have to believe that Russian production is ultimately going to fall. We finally have evidence of that just in the past couple of weeks. This worry about a recession, you have to absorb the final barrels from strategic petroleum reserve release, that's finally going to be over and done with in the next week. We had the announcement of OPEC additional cuts, Saudi making additional cuts, but those weren't really coming to effect until June, July.

And so the first half you had all of those headwinds which are now becoming tailwinds. As we look to next month, July and onwards, what do we have? We have a seasonal uptick in demand, very meaningful uptick. We have Chinese demand normalization. We have the Russia cut of 500,000 barrels per day that we can actually see is coming to fruition. We have the additional cut by OPEC plus of over a million barrels per day, and we can track exports, there's strong compliance to that. And most importantly, now we have another million barrel per day cut from Saudi Arabia and we can measure the compliance there, I think is going to be phenomenally strong.

And so our thesis is, inventories are really going to start to drop in July and August by a historic magnitude. And that drawdown in inventories will send a overwhelmingly bullish signal to the paper market that will overwhelm this recessionary narrative. We believe that even if you believe any recession in OECD countries have demand fall by 600,000 barrel per day, even though it's rising so far this year, even if you account for an increase in Iranian production, even if you assume that there's some modest cheating on the part of Russia, even though we have evidence to suggest that that's not the case, the end the conclusion is we still have inventories ending this year at at least a five-year low.

And so when we look at the current oil price, when we look at sentiment as measured by net length where people are as bearish, as pessimistic as April of 2020, and yet we just have to wait a few more weeks and we can see the beginning of this significant draw in inventories, that's what makes us excited. And so when we look at energy stocks, even at the current oil price and whether this is true or not, we'll see, but if everybody is as uber bearish, everybody knows they're entering a recession because we've been talking about it for a year and yet we still trade at $70. And so it feels like $70 is baking in that outcome.

Well, when I look at energy stocks, the average energy stock is trading at 11% free cash flow yield at $70 oil, meaning they could pay an 11% dividend while keeping production flat or they could buy back 11% of their stock. If you dare to dream in just a slightly higher oil price, I still believe we end this year at $80 to $100 oil, the average energy stock trades at a 17% free cash flow yield.

And so our thesis is that sector ultimately rates to a 10 to 12% free cash flow yield. And again, that's average. And typically we tried to pick stocks that are trading, we can buy names literally now with the current oil price trading at a 20 to 24% free cash flow yield. And so you don't have to buy in to the belief of higher oil prices to get us excited about a select basket of stocks, even though that is ultimately where we think we're heading in the next several weeks to months.

Michael Hainsworth:
If the free cash flow is so substantial within the industry, what's the best way to redeploy that cash within any given energy company?

Eric Nuttall:
We have been crystal clear to our holdings and as companies who we own five to 9.9% of, that it is incumbent on them once the companies reach their final debt targets, once they get to that level that we fully expect to get 75% of their free cash flow at a minimum to come back to us in the form of share buybacks. Because in this environment where people are overwhelmed negativity due to recessionary and economic concerns, our plan B is for buybacks. If companies trading at a 20 to 30 to 40 to 50%, in some cases, free cash flow yield at $70, $80, $90 oil, use that free cash flow and aggressively buy back their stock, it has to forcibly drive a rerating in their share prices. And so it's the combination of aggressive buybacks c ombined with what we think will inevitably be a return of investors back to the sector that will lead to meaningful upside in energy stocks. And so whether that's the next month or the next couple of months, that's ultimately where we see things headed.

Michael Hainsworth:
So then let's talk in more detail about the supply side of this equation. Saudi Aramco believes that the market fundamentals remain sound for the second half demand and it sounds like you also believe that China and India will offset the recession risk in the developed markets.

Eric Nuttall:
Yes. And so that's even if there is a recession. Demand falling is very rare. It typically happened obviously in COVID, prior recessions, with the greatest financial crisis. It was very unique period of time. More plain vanilla recessions demand still grew. And so when you look at Saudi Arabia announcing this additional 1 million barrel per day cut a month and a bit ago, people assume, oh my god, they must know something. We got the oil price falling and I keep hearing about recession every day, it must mean demand is weak. And here we have Saudi cutting, they must know something as well. They must know the demand is weak, even though we can categorically show that that is not the case.

And so I think it comes down to Saudi seeing this disconnect between the two markets, the paper market and the physical market, believing that a fair price for oil should be meaningfully higher given where the inventories are today and where they are heading. And so we feel strongly the demand is strong. We've been caught off guard slightly this year by Iran where the U.S. has turned willfully a blind eye to sanctions that they put in place and have allowed for Iran to liquidate most of their floating storage that they held. It was as much as 70 million barrels of oil and condensate at one point. And we've also seen their exports increase from roughly 1.1 million barrels per day to one and a half. So that's been 400,000 barrels per day of exports that we weren't accounted for.

But even when you account for that now, even if you assume Russia is maybe going to cheat a little, even though the data is showing that they're not, even if you assume recession in OECD countries, the developed economies, when you look at growth elsewhere, which we can visibly see, what it still ultimately leads me to is global oil inventories ending this year at a multi-year low. And historically, there's been a very strong relationship between where inventories go and where oil goes. As inventories fall, as we expect them to do, it will eventually put meaningful upward pressure on the oil price.

Michael Hainsworth:
So Malaysia's state oil firm PETRONAS is reporting a slowdown in demand and growing refinery capacity. What does that mean for market pressure?

Eric Nuttall:
So there is an increase in refining capacity globally this year for the next several years. I think it's roughly three to four million barrels per day in the next couple of years. We've got one small one coming on in Mexico, which is very bullish for Canadian heavy oil because Mexico has typically been an exporter of heavy oil as they'll eventually, it's been overdue by several quarters. But once that refinery comes back online, they'll go from the net exporter of heavy crude to a domestic consumer for products, so that's bullish for Canadian heavy differentials.

But there's a very large refinery in Nigeria, again, massive refinery coming online. So it speaks to increased demand for crude to convert it into product, but a weak implication for crack spread. So it makes me want to be long the producer and neutral the refinery because I just think that the margins for refineries are not going to be as strong. We have seen crack spread, so that refining margin come off over the past year, but it's important to note those were from very, very high levels. So people, and again this another false narrative is, "Oh my God, refining crack spreads are falling, it must mean demand is weak." Well, it's only because they came off of nosebleed all-time high levels in 2022, so it's not a very good comp.

Michael Hainsworth:
What did you make of the IEA's medium-term reports? Sure, you're looking at the end of 2023 and you're thinking maybe $80 to $100 a barrel, but the IEA is figuring that global oil demand will slow significantly by about 2028. What do we do with this information?

Eric Nuttall:
I ignore it. So you have to, and this is looking for confirmation bias, but you have to evaluate the source of the information and look at the assumptions going into that. And so without getting specific to a specific organization, there are some organizations that are governments that were established by western governments and have the unexpressed intention of talking the oil price down by faulty demand assumptions.

When you look at a new organization that has had to revise upwardly their demand forecast for I think 14 of the past 14 months, where the energy minister of Saudi Arabia went out of his way to call them out and to say it takes a particular talent to be so unbelievably wrong over and over and over again. What we look to is in terms of short-term outlook, obviously driven by the economy, demand normalization. Medium-term is more non-OECD countries because 100 and roughly 6% of demand growth from the past 20 years has not come from Canada and U.S. and Japan, it has come from emerging economies and then substitutions, alternatives, EVs, et cetera.

Longer term, we believe that we'll be consuming the same amount of oil today by 2045. So when you look at the challenges to mass adoption, the unaffordability of EVs in much of the world, copper shortages where we're going to be short copper by the end of this decade. And if you think building an oil sand mine in Canada is tricky, go try to build a new copper mine where lead time can be as much as 20 years. So we feel good that you've got visible demand growth till about the mid-2030s. We could reference other studies where they assume that if you hit mass hyperadoption of EVs, demand still grows for at least the next 10 years.

What gets me excited is even if the rate of demand growth slows, which ultimately it will, I cannot evaluate or to see where the necessary supply is going to come from. Because when you have OPEC warning that you've got two countries with the ability to grow production, many others are flatlining to declining. When you do have significant political challenges and countries like Venezuela, which is resource-rich, but is unable to meaningfully grow production. And also when you have the prospect of peak US shale over the next year to two years, we are, you wouldn't know it. And I still stick to, we're in this silent energy crisis. Or at least we were, maybe we're not today, but we will be again soon because there is this structural mismatch between demand growth and supply growth. And so these false narratives put out by institutions creates so much uncertainty that it disallows boards to sanction new projects. It injects too much risk into this fear of peak demand will lead to the reality of peak supply. And we can see that in much of the world.

Michael Hainsworth:
You just finished telling me that you want to see the excess free cash flow turned into share buybacks as opposed to increasing capacity.

Eric Nuttall:
Absolutely. The greatest line I got, it was two odd months ago just meeting with a U.S. shale company. And he said, "Eric, my job is not to balance the oil market. My job is to make you money as my shareholder and my part owner." And so it's not the role of Canadian oil and gas companies to balance the market. It's our time to be rewarded for the misery of the past 10 years. And when you tack on this year, because we're down 12 odd percent.

This has been a challenging sector. We've had some very good years and there's been some very awful years and I continue to beat the drum of this, it's our time to be rewarded for the patience of that time period. And so until energy stocks better reflect fair value, which they sure as heck don't today, because I can buy names below two times cashflow at the current oil price trading at 20, 30% free cash yields, it's comical. And so until valuations better reflect where they should trade at, oil companies have the sole mandate and the sole priority to reward their owners, their shareholders. And the greatest, highest confidence action to lead to that rerating is a meaningful share buybacks so long as the balance sheets and free cash flow will allow.

Michael Hainsworth:
So you told us that you would go long on the producers and neutral on refineries. What is your advice beyond that for the average investor? When we think about regions as well as the types of producers that are pulling the product out of the ground, and we look at the declines we've seen since the start of the year and your expectations for a better second half.

Eric Nuttall:
We search the world for the best opportunities and we continue to be led back to Canada into heavy oil stocks. We would have an 80 to 85% leaning, as much as we can at least, in Canadian heavy oil stocks. When we look at, when people get past this recessionary narrative, as inventories continue to fall, as people realize that the elasticity of demand for oil is a lot lot less than they thought, and as oil we think increases in the next several quarters, the greatest opportunity is in companies with long life reserves, low corporate declines, super strong balance sheets, record free cash flow, and most importantly, the commitment to return that free cash flow back to us in the form of buybacks.

When we look at U.S. shale companies, there's a challenge in terms of inventory depth and inventory quality. Their average quality is getting worse, not better. You don't get that with the Canadian oil sense. Their decline rate is much, much higher. So you have to spend more money to sustain production. You don't get that in the Canadian oil sense. Canada, we're building out on new pipeline that line flow should start by the end of this year. Now it's almost 600,000 barrels per day of new takeaway capacity and customer diversification.

We already have that discount for Canadian heavy oil, have fallen now to about $11 per barrel. So it's incredibly low now, so we don't have to hope that things improve. And if you just dare to dream and assume a higher oil price, you can buy to these names trading at 20 to 30% free cash flow yields at $80 oil where we think early next year they'll be at a position to return all of that back to us. And so while a stock trading at a 20% free cash flow yield, so let's say a 20% dividend yield, so long as the market believes that to be sustainable, will it stay at that valuation? We would suggest not. And so we think that's, a name like that reiterates to a 10 to 12% free cash flow yield. Well that's 100% upside in that kind of name.

And so those are the types of names that we want own. We don't want to own service stocks because leading edge pricing is falling, it's not going up. We don't own natural gas. We have almost record-high inventories now, you've got to call the summer weather, you've got to call the winter weather, unless we've got a wickedly hot summer and a really cold winter, gas is stocked for at least the next year until USL&G exports increases.

So you got to wait well over a year. We don't want to be long with refineries because there's a lot of global refining capacity coming online this year and for the next several years. And so the road continues to take us back to these companies that are just awash in free cash flow, have their strongest balance sheets in history, are sitting on decades-worth of inventory, and have promised that in the coming quarters we're going to get not just 50% of free cashflow, but 75 to 100%. That excites me.