Keep On Keepin’ On

With E&P earnings season underway, could momentum shift in favor of this unloved sector as E&Ps benefit from a mix of self-help, an improving commodity market and geopolitical tailwinds?

The improved tone for crude is in large part “a Saudi story,” according to Helima Croft, global head of commodity strategy for RBC Capital Markets. The de facto OPEC leader “has massively reversed production,” she observed in a recent CNBC interview. “Saudi Arabia is 400,000 barrels per day below its OPEC quota. And, importantly, it has slashed exports to the U.S., the most visible market.”

The Saudi action follows the debacle late last year when much larger than expected waivers were given by the U.S. Administration to several key purchasers of Iranian oil—but only after Saudi Arabia had boosted output to offset the expected loss of Iranian barrels. This and other factors contributed to a fourth-quarter collapse in crude, with West Texas Intermediate (WTI) falling about 38%.

U.S. crude prices have recently recouped a good part of the losses, albeit from a lower base at year-end. From its Dec. 31 close of $45.41 per barrel (bbl), the WTI price was up about 32% through the first quarter. During the first week of April, WTI tacked on further gains for a year-to-date increase of about 38%.

Subject to turns in trade war talks and potential geopolitical events, Croft said, current conditions represented “a very constructive place for oil.” As WTI and Brent prices touched five-month highs in early April, others expressed similar sentiment. Morgan Stanley, trimming its 2019 U.S. oil output forecast against what it termed a “tight backdrop,” predicted WTI would reach $75/bbl by the end of this year’s third quarter.

The rebound in oil prices, accompanied by only a muted move higher on the part of energy equities, offers some of the best risk-reward in the market, according to an early April report by the quantitative strategy team at J.P. Morgan. While WTI prices are up about 36%, it said, the S&P 500 Energy Index is up only 16%, marking a significant decoupling from historical trends.

The energy sector weighting in the S&P has slumped to about 5%, the lowest in roughly 15 years, and “sentiment has completely collapsed,” the report commented. “Despite improving fundamentals, institutional investor interest remains extremely low based on our recent meetings and big data indicators,” Energy companies were “ramping buybacks,” it added.

With hindsight, what clues on earnings can be gleaned from the improving fundamentals—but gyrating crude prices—of late?

Reviewing fourth-quarter results, AllianceBernstein senior research analyst Bob Brackett has regularly aggregated data from a sample group of E&Ps into a single imagined entity representing the “State of the Business” in the E&P sector. Its fourth-quarter findings: “E&Ps have now shown that they can generate free cash flow, be profitable and grow production at $60/bbl.”

The above was in spite of roughly a $9.80/bbl drop in the crude price from the third quarter to around $60/bbl in the fourth quarter. Factoring in natural gas, the blended realized price fell sequentially by roughly $3.70 to $45.43 per barrel of oil equivalent (boe). Production comprised approximately 61% liquids in the fourth quarter and grew sequentially by 3% for North America.

E&Ps maintained discipline in the fourth quarter, noted Brackett. In response to a 12.5% sequential drop in revenue and a 10.6% decline in cash flow from operations, E&Ps cut their organic capex (spent on exploration and development) by 8.5%. This resulted in the sector spending 80% of cash flow, up only modestly from the third quarter’s 77%, and generating $1.25/boe of total free cash flow.

“Free-cash-flow generation was strong, production grew quarter over quarter, despite lower blended realizations, and profitability was maintained,” summed up Brackett. The E&P sector is now generating “almost as much free cash flow” as back in the pre-shale, $100/bbl “old way,” even as it faces significantly lower commodity prices.

Of course, there is no shortage of geopolitical factors that could alter the course of crude prices: tension with Iran, including the issue of waivers; an economic collapse in Venezuela; and military factions fighting in Libya, to name just a few.

But with early estimates for oil and gas realizations for the March quarter at $54/bbl and $2.95 per thousand cubic feet, respectively, for a blended price hovering below $40/boe, a “true test” will come with earning for the first quarter, said Brackett.

 What advice does Brackett offer E&Ps? “Keep doing what you’re doing, but do more.”