7 Takeaways I Took From Goehring and Rozencwajg’s Latest Q3 Research Piece:
Goehring and Rozencwajg’s Q3 paper is titled “Why Won’t Energy Companies Drill?” A very important trend in the energy markets is the lack of investment in energy sources like fossil fuels. We want to distance ourselves from these over time. But currently, they are an integral aspect of modern life. They will be vital in the energy transition to cleaner energy sources. Here are the key points from the 22-page paper:
1) US Shale Production. – Low demand for oil during COVID led to prices dropping. As we have emerged into a world where Russian energy sources have been completely pulled from the market, we find ourselves in an energy crisis. It was trending towards this before. Our demand grows in general as the world continues to develop. More is not better. And we will reach a point where something breaks, and we can’t provide enough oil and gas for ourselves. So we need to pivot to different energy sources. But we’re not there yet. So why is production in the US and OPEC dropping?
2) Oil Price vs Rig Count. – Usually maintaining a strong correlation, with 70% of changes in drilling activity explained by the oil price. Since COVID, this relationship has separated. This means the oil price symbolises new drilling needs to take place. But that isn’t the case. Price has been rallying on OPEC production cuts, as they weren’t even hitting their production targets. The US inaction in production also was holding oil prices higher.
Are we now seeing the beginning of recession demand destruction in the short to medium term? The yield curve is inverted in the US. The 2-year and 10-year are inverted a massive 71.5 basis points. Considered the more important indicator by some, the 3-month and 10-year are now inverted, and the spread is growing. This is indicating a deeper and deeper recession. 2023 growth prospects are very low. So this is the oil price. But why is less drilling happening? If oil prices could retreat in a recession, why aren’t companies trying to lock in profits while prices are high?
The SPR releases have to stop at some point. Inventory levels are below 2007 levels, and global demand outweighs global production. It looks like the physical oil market is cooking up a supply crunch. Between politics and physics, physics always wins.
3) Reasons For Less Drilling. – Energy analysts are blaming capital discipline or lack of workers as reasons drilling hasn’t expanded. Capital discipline means only the most profitable projects are approved. This comes from investors unhappy with their returns.
4) Oil Companies Are Acting. – Drilling being low is a response from oil companies. Response to government, investors, and their own strategy teams. The main party to consider is government. The video of Joe Biden telling the little girl before he got into office that he was going to stop burning fossil fuels and save the planet. He’s stayed fairly true to his word (note: New projects in Texas, and reduced sanctions on Venezuela). But do you think he told this little girl she’ll be sat cold and dark because the wind turbine that powers her home only produces intermittent energy? And storage is shallow. Batteries could improve. But look at lithium prices. We need alternative battery materials that are cheaper. Or we need more supply of commodities. Could that come from asteroid mining? Not anytime soon to prevent the energy crisis.
To give oil companies even less incentive to drill more, Biden has proposed the idea of greater windfall profit taxes. So any extra drilling to take advantage of higher oil prices would just be taken in taxes. So again, companies have no reason to drill more.
Other government strategies listed in the research are:
Banning crude exports.
Reducing gasoline taxes (as the UK did by reducing fuel tax).
Implementing windfall taxes.
Banning drilling on federal lands.
Increasing subsidies for renewable energy.
Banning crude exports would lead to the US being even more self-sufficient. They are slowly isolating themselves. As I’ve discussed before, the US is one of the most self-sufficient countries in the world and has the capacity to survive by itself. This is something few countries can do. Whether it be the quality of agriculture land for food, or natural energy sources to run the country’s industry, there is usually at least one major aspect that means most countries need to rely on another. Not having a strong enough army to defend themselves, for example, no natural borders, or a commodity that is so necessary in the world that everyone needs it. The US has all these things.
Increasing subsidies for renewable energy wouldn’t solve the problem. It would increase spending. Sources that don’t provide intermittent energy supply are needed. Nuclear is needed. Would space-based solar energy be better? Or tidal? We do have options, but we had even more options 10 years ago. And a lot more time.
There is zero incentive for fossil fuel companies to increase production. This is bad government policy. One thing (maybe the only thing?) Liz Truss did do right was reversing the fracking ban, in the short term. To get where we want to be in the long term, we need fossil fuels. And fracking produces a lot fewer greenhouse gases than burning coal, for example. Germany has turned to burn coal in its energy decoupling from cheap Russian energy. All these energy sources have pros and cons. But if we want to transition to cleaner energy over time, we have to choose our cons, while we have a choice.
5) Energy Stock Valuations Are Still At Near-Record Lows. – Energy exploration and production companies are up 182% since the start of 2021. The S&P is up 9%. But valuations are still undervalued and underinvested.
It is fresh in everybody’s minds currently how sectors can become overvalued and enter bubble territory. A bubble always pops, and valuations come down to more sustainable levels, closer to the true value. If a sector is undervalued and underinvested, is essential to the operation of the global system and isn’t on a trend to obsoletion, then its importance to life on earth means it is still needed.
Simple mean reversion. High, overvalued, liquidity-fuelled booms naturally drop back down to earth. Low, undervalued, low liquidity flatlining can signify contrarian opportunities. This is striking me as one such example.
Over the last 10 years, the median valuation for stocks is:
· 22X Earnings
· 9X EBITDA
Currently, the energy sector is:
· 7X Earnings
· 4X EBITDA
6) Net-Debt Adjusted PV-10 Per Share (NAV). – PV10 calculates the present value of estimated future revenues from oil and gas companies. It is used to assess an energy company’s value and to estimate the value of the reserves these companies have. This calculation removes net debt from the calculation. Dividing by the share count gives the NAV per share calculation. The sector currently trades at 0.8X. Goehring and Rozencwajg state they have never seen the entire industry trade for less than NAV. This has led to a pivot away from drilling to stock market returns to investors through dividends or share repurchases that drive up prices. They provide an excellent calculation of how investing in drilling has very little effect on the ending stock price. In contrast, buying back shares would lead to a rise in stock price. This could be used to incite investors to put their money into energy stocks due to higher returns.
This is why drilling is so low according to Goehring and Rozencwajg. Depending on their financial conditions, it pays some companies more to return money to investors than to drill. And if/when economic conditions make it more suitable to drill, all their drill sites are still there, untouched.
So NAV is a key figure in how future revenues from the energy industry can be interpreted through drilling. This a figure worth monitoring.
7) What Do Energy Companies Hope to Achieve With This Approach? – It is clear that the current US government aren’t the biggest fan of oil and gas as energy sources. Their strategies to limit the industry further would bring stock prices down even more. So rather than taking them on and developing new projects, they can keep quiet, and increase revenues through their stock prices by buying back shares. They also have their finite resources still in the ground. They will be more valuable when there are fewer potential negative consequences for the industry. Goehring and Rozencwajg end by saying that drilling is being driven by valuations for the first time, not oil prices. Until more investment capital flows into the energy sector, disappointment will continue.
The research paper also covers other commodities:
· Natural Gas
· Coal
· Precious Metals (Gold and Silver)
· Agriculture
· Uranium
· Copper
It is well worth a read. My takeaways cover the first half of the paper and the oil analysis section. To read it yourself, you have to submit a name and email at this link to download it.
https://info.gorozen.com/2022-q3-commentary-why-wont-energy-companies-drill
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