Head of Saxo Strats
Summary: Natural gas prices went below $2/MMBtu in today's session in almost unbearable territory making it even worse for the industry to service its debt and deliver returns to its shareholders. The energy sector has been structurally weak after the financial crisis with too high cost levels and debt overhang to deliver return on capital levels above the cost of capital. This is clearly unsustainable and the industry desperately needs higher prices or else bankruptcies will force the discipline and reign in supply to increase prices. Inflation might be the unpleasant force lurking underneath the unsustainable oil and gas industry.
The oil and gas industry is in trouble seen by the latest restructuring attempt by Chesapeake Energy and this weekend that McDermott International is preparing to file for bankruptcy. As we talked about in today’s Market Call natural gas prices went below $2/MMBtu in today’s session during what should have been the strong season and with the frightening outlook that the US gas industry is running out of time to get “its” winter. The troubles are evident despite low rates and a world economy still in expansion mode. Five years of walking in the desert could the energy be close to an important inflection point with rising prices and profitability?
Structural break since 2008
One of the key observations in the global energy sector is rising cost structure in the sector. During the period 2003-2008 the sector delivered easily +15% return on equity (ROE) but post the financial crisis we observe a distinct lower profitability at equal oil price levels. Take today’s Brent crude price of $65/brl and compare the two periods. In the early period the sector delivered +25% ROE at these price levels whereas the most recent period the ROE has been closer to 5-10%. These returns are not enough to satisfy the required rate of return from investors given the general equity return required and then adding sector risks such as cyclicality risk, elevated credit risk, “black” energy discount etc. The sector is essentially destroying capital at current levels and investments made for new discoveries have also been reduced substantially.
Many value investors have wrongly pointed at low valuation levels and fat dividends as arguments for buying the energy sector. We have basically been negative on the sector since 2015 when prices collapsed and all the metrics became so toxic that the entire operating model became defunct. The last five years have proven that value investors need more than valuations and dividends. If an entire sector is not operating at sustainable and attractive return on capital levels then the sector goes nowhere. The energy sector has delivered zero percent including dividends the past five years compared to the global equity market up almost 60% in the same period. If we can get the necessary bankruptcies to curb supply instead of relying on OPEC+ then we will endorse the sector with an overweight view, but for now the risks are still too high. But 2020 could be the year where the oil and gas industry becomes an opportunity despite the ongoing flood wave of green investments.
Debt load and inflation
What makes the situation even more dangerous for the energy sector is the leveraging that has accelerated since the price collapse in 2015. For 10 years the sector operated with stable low net-debt-to-EBITDA multiple but after 2015 this metric deteriorated badly and has now settled at levels four times the golden period from 2003-2008. With low rates the sector is barely managing the debt levels but if the world gets higher interest rates the fallout in the energy sector could be severe. What is interesting about the dynamics in the energy sector is that the low interest rates have sustained oil production and increased it substantially through debt financing. This is has caused oil supply to increase to levels compressing the oil price to such levels where the sector suddenly destroys credit and equity value. That’s an irony even in the world of Silicon Valley unicorns descending on Wall Street.
We are likely moving closer to a forced wave of bankruptcies and restructurings that could cause a material slowdown of oil production which would lift prices and profitability for the companies standing up after the reset. But higher energy prices mean higher inflation which could lead to higher interest rates which would then cause distress for more energy companies. A vicious feedback loop could happen. If investors want to get exposure to the energy sector we believe the best way to do it is by getting exposure to the energy companies with solid balance sheet and strong return on capital metrics.
Any way you look at it the industry needs higher prices or some new technology that unlocks efficiency gains that are large enough to operate profitable at current levels. The industry needs sustained oil prices above $80/brl to deliver the return on capital long-term that makes the sector viable for creditors and equity investors.
2024: The wasted year
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
