Right, so oil.
WTI is on track for its longest winning streak in 6 months after careening into a bear market.
Wednesday’s EIA data showed U.S. output falling 100k bbl to 9.25m b/d last week, the largest dip in nearly a year, and that’s taken some pressure off prices.
That said, we’re obviously not out of the woods. In fact, we’re still deep in those motherfuckers – the woods that is.
“The issues that the market was dealing with not that long ago lie not too far below the surface, so a break higher to the upside might be elusive on a more sustainable basis,” Daniel Hynes, ANZ analyst in Sydney said Friday, adding that although “there are some fundamental signs of improvement, there’s clearly some impatience.”
Yes, “clearly.” Because despite the gains we’ve seen over the past several days, oil in New York and London is heading for its biggest monthly loss since July.
This is effectively a game of chicken between OPEC economies and US production and as we’ve noted on more occasions that we care to count, OPEC is driving a tank and US producers are riding a bike.
See, some folks have gotten it in their heads that US operators are going to be able to ride this staring contest out (again) and that the folks in Riyadh are going to blink because they’re uncomfortable with the fiscal squeeze. That’s probably not a great bet.
Remember, one of the reasons otherwise insolvent production capacity was able to survive the previous downturn was tied to wide open capital markets. The Fed, by creating a relentless hunt for yield, ironically fostered a deflationary environment by allowing imperiled operators to hibernate (as opposed to going bust). Once the OPEC cuts went into effect, that further incentivized investors to throw good money after bad in US Energy.
So far, energy credit hasn’t caught up to the underperformance in energy equity. And that’s a big part of why this charade has continued amid the most recent move lower in prices. Have a look:
We’ve argued that for once, equity is ahead of credit in pricing in reality.
Indeed, HY Energy has just now started to blow out relative to HY as a whole, throwing the whole “HY Energy will ‘mean revert’ and trade inside of HY” meme for a loop:
Of course there’s more nuance to it than that on both the fiscal side for OPEC and the credit market side for US energy.
Here to elaborate in a follow-up to a piece out earlier this week (see here) is Goldman…
Who will blink first? OPEC or credit?
OPEC is the traditional low-cost producer, with new projects in Saudi Arabia, Iraq and Iran breaking even at $20-40/bl on an E&P basis. Exhibit 1 shows that the GCC countries have the lowest breakevens in the industry. This is followed by Russia and the best of deepwater, which breaks even at $30-50/bl. US shale requires US$50-55/bl for the bulk of its 190 bn bls resource base, on our estimates.
While on an E&P basis OPEC’s breakevens are the lowest in the industry, the country’s budget breakevens are now amongst the highest in the industry, reversing the competitive advantage in the 2010-14 period. As seen in Exhibit 2, OPEC on aggregate requires c.$70/bl to balance its budget in 2017/18E, US$10-30/bl higher than the cash need of the listed players in the industry (calculated to pay their capex and dividends, as opposed to balancing national budgets for OPEC countries). In this respect, OPEC’s relative position has deteriorated over the last years: in 2010-14, OPEC had both the lowest E&P and the lowest cash breakevens in the industry, with a US$ 10-40/bl advantage vs. the listed players in the industry.
While the industry has adapted to lower oil prices, through increased efficiency and cost deflation, OPEC budget needs have been sticky, making it difficult for them to lower their fiscal breakevens. This puts OPEC in the position to require the highest oil price in the industry, giving them little headroom to cope with low oil prices.
OPEC fiscal breakevens have converged, generating similar needs for oil price support.
Exhibit 3 shows that the OPEC + Russia cost curve (to balance budgets) flattened significantly over the last five years, with most of the countries requiring US$60-80/bl to balance budgets as opposed to a range of US$40-120/bl in 2013.
We believe that this more consistent need for a high and stable oil price played an important part in helping reach the agreement in November and may help the countries reach an agreement on a further cut if oil price weakness continues in the coming months.
Exhibit 4 puts the OPEC budget breakeven in comparison with the listed players need to fund capex and dividends.
We find that Russian, Canadian and US integrateds fully cover capex and dividends at or below $55/bl in 2017E, after lowering their cash breakevens meaningfully during the downturn. These industry groups now require lower oil prices for FCF breakeven than most OPEC countries for fiscal breakeven. LatAm and European integrateds, burdened by highercost producing assets and higher dividend yields, respectively, need c. $60/bl to achieve FCF breakeven in 2017E.
At current rates of production, we estimate that US oily E&Ps require >$70/bl for FCF breakeven. However we expect that number to fall rapidly in 2018-19; while we expect some high-quality names to grow within cash flow by 2020, we see US E&Ps on aggregate, and particularly high yield and private producers, continuing to outspend FCF as long as the high-yield credit markets remain open.
In our report Oil market rebalancing: focus on credit, not OPEC, we argued that the oil market was heading into a period of oversupply, unless US shale growth slowed. Two of three drivers of excessive shale growth had already started to reverse at that point, including: 1) cyclical cost deflation turning into cyclical cost inflation, lifting shale breakeven prices; and 2) volatility rising, making hedging more expensive. However, we argued that the third and most important driver of moderation (sub-investment grade credit) still had to correct in order to slow activity. High yield credit has started to tighten (yield-to-worst increased from 6.6% to 8.0% since May 15), but is still far from what we consider a ‘shutoff’ level required to materially moderate future shale growth.
Mechanics of rebalancing #1: The credit market
Almost a quarter of US oil production depends on high yield funding. In practice, we believe this means the HY market will more efficiently “solve” for the right yield needed to accelerate or slow growth. We have observed that different credit quality buckets have different yield thresholds at which HY funding availability is cut off. For CCC rated names, which represent about 11% of US oil production, the HY market effectively shuts when the broader HY Energy yield reaches 10%. For B rated names, that level appears closer to 13%. For example, assuming a 30% base decline rate, we estimate that the average HY E&P yields would need to trade to 10% to correct a 300k b/d oversupply in one year (i.e., CCC oil production * 30%).
The US energy high yield market has started to tighten, but is still far from what we consider to be the “shutoff” yield, with E&P HY yield to worst currently at 8.0%.
The US energy credit market had not adjusted in line with the oil price correction since the beginning of the year, but has started to correct over the past month. Energy equities have underperformed energy credit by 25% ytd (vol-adjusted). We believe a further adjustment in the credit market may be needed to rationalize E&P capex, and to contain 2018-19E US oil growth. Ultimately, we believe strength in energy credit suggests limited concerns regarding downside tail risks.
So obviously, there are some arguments in there that would suggest OPEC economies need higher oil prices more than US producers.
But do keep in mind that nothing is said about the capacity of GCC countries to borrow and further, it is difficult to imagine that the disconnect in Energy credit and equity returns (shown in Exhibit 22 above) won’t correct. If we had to guess, credit will widen to bridge that gap.
Oh, by the way, OPEC and its partners aren’t planning on discussing deeper cuts when they meet next month, according to the UAE energy minister.