May 2020

Many Levered Up Balance Sheets

Amplifying the misery has been an overly aggressive capital structure in many of the stocks, some of which may need to raise capital should the commodity remain at historic lows.

Figure 2: Net Debt to Equity (High indicated highly geared) and Interest Cover ratios (High number indicates increasing cover from EBITDA for interest payments) for selected ASX listed Energy stocks (source: Resonant Asset Management, Refinitiv)

What now for the sector ? If the oil price were to gravitate back towards the 40-50 US$ range, then all manner of financial leverage risks would suddenly be put on the back burner – a scenario that could see the stocks double.

In this note we look at the key issues driving the oil price, which whether we like it or not, is the key factor in deciding whether or not as investors we should think about adding these stocks to their portfolios.

April Madness

April was a historic month – never before have we seen oil futures fall into negative territory. How this event occurred, and the future outlook for the oil price, holds the key to understanding its trajectory over the next few months

Figure 3: WTI Futures front contract (source: Refinitiv)

Modern commodities markets are a largely symbiotic relationship between speculators, hedgers and producers.

Producers care about storage deeply, particularly when inventories are running sky high in an environment such as this, with demand so low.

Speculators haven’t historically considered storage, their focus is more geopolitical and global macro-economic.

Hedgers are merely looking to manage an existing exposure in their books, so typically price insensitive, and motivated by neutralising risk.

What happened at the futures expiry in mid-April is that some speculators suddenly realised that producers were deeply focused on storage, to an extent they had not considered possible or likely. In fact so focused, that there were no buyers a day before expiry.

Will this repeat next month?

Speculators have already modified their approach to tackle storage in a more considered way.

We know this because the major vehicles for speculators, ETFs that purport to track the oil price, have switched from buying the front to spreading across multiple future expiries, and announcing that the roll will take place over a ten day period rather than in the immediate run up to expiry (for details, see: USO Portfolio Changes).

We can therefore expect a smoother ride as a staggered and incremental roll takes over a prolonged period.

In part however this is necessary because we have seen breathtaking inflows into these ETFs, and therefore into a long oil futures position. The NTAs of many of these funds has risen dramatically (3x since year end), especially when you consider that the price of these instruments has fallen dramatically (10x unit creation in end of February).

Figure 4: US Listed USO ETF Net Tangible Assets (Source: Refinitiv/Lipper)

Figure 5: US Listed USO ETF Equivalent Number of Units (Source: Refinitiv/Lipper, Resonant Asset Management)

What this suggests to us, is that the mean-reversion trade is very well supported already, and likely priced in already into the futures market. An end to the lockdown, and something of a return of demand, is largely anticipated. So how does demand look?

Figure 6: Indicative US Oil Demand (Source: Refinitiv Eikon , EMI Gasoline US Total Sales Volume) by Year – Dip down is 2020, other lines are 2014-2019

The problem for storage, is that, with every surplus in supply over demand there is incremental pressure on storage. How is production shifting to the new environment?

OPEC has already been squeezed diplomatically to cut production by around 20% – but the main swing factor, will be US domestic production. This may be why storage is less of a concern in May than in April:

Figure 7: North America Oil Rig Count (source: Refinitiv Eikon, Baker Hughes)

Rig count is now down more than 50% in record time: suggesting that the industry is adapting to new realities.

How we are playing this in portfolios

Our exposure to the Energy sector remains modest, because we feel that despite the production cuts, considerable risks still lie to the downside, and exceed current upside risks.

This is especially true when you consider how quickly speculators have moved back to a bullish position, as evidenced by the extreme buying of ETFs and other products in the US which is essentially a mean reversion trade.

We are sitting this one out, looking to play a recovery in other ways – for our portfolios, risk management remains a critical component, we will reconsider once the situation in energy markets becomes clearer, and we can benefit from a less pronounced recovery.