Commodities

With close to 20% of our portfolio exposed to the energy sector, this has been by far our largest performance detractor over the last year. Over the past 10 years, the sector has underperformed the broader share market by 55% and is priced at relative levels similar to January 2016 when oil prices fell below US$30 per barrel. And while Australian dollar oil prices are now back above A$90 per barrel, Australian oil and gas stock prices are nowhere near the levels reached the last time oil was trading at those levels.

Graph 1: Energy sector performance relative to the broader share market over the last 10 years

Source: Allan Gray, Iress as at 25 September 2019, Energy performance ratio is S&P/ASX 300 Energy sector ÷ S&P/ASX 300

Much of the weakness in the energy sector can be attributed to the fall in the oil price from levels above US$100 per barrel earlier this decade to today’s price of close to US$60 per barrel. Technological advancements in methods to extract oil from US onshore shale fields has led to sharply higher production levels from previously uneconomic oil basins which in turn has contributed to excess supply, inventory builds and weaker energy prices. More recently, demand has also played a role, with subdued world economic growth and the unknown impact of trade tensions on future demand having soured sentiment.

Australia’s energy sector and our exposure to this sector is comprised mainly of liquefied natural gas (LNG) producers. With gas likely to benefit from a change in the mix of hydrocarbons consumed in future (as the world moves away from dirtier coal), some of the structural headwinds that have plagued the energy space are less relevant for LNG producers. Despite this, the LNG producers have been every bit as weak as oil (and coal) producers. There have been two reasons for this: 

  1. Contracts to supply LNG are priced off prevailing oil prices (usually a fixed percentage of the oil price, known as the ‘slope’) so as oil prices fall, so do LNG prices, and . 
  2. The expected growth in gas consumption was well anticipated and a huge amount of supply has been brought to market resulting in excess supply similar to that impacting oil prices.

We acknowledge that blindly allocating capital to a broken thesis is a recipe for disaster. But flippantly selling investments where the thesis has not worked is not the recipe for success. Most of our excess performance over the years has come from holding the line and not capitulating when swathes of investors head for the exits.

While a mistimed investment in the energy sector is no reason to sell it, there are two areas where our thesis could be wrong. Firstly, oil prices may actually be high today with further technological advancements in shale production and lower future demand (e.g. from weak economic conditions or strong uptake in disrupting technologies like renewables) conspiring to create what many call a ‘value trap’. Secondly, it is possible that realised LNG prices will remain low creating headwinds over and above those inferred by potentially lower oil prices. We explore both these areas below.

Are oil prices high?

Whilst far from certain, it is commonly thought that US onshore shale producers are the marginal producers of oil and gas. Many of these producers are publicly listed so it is easy to measure their financial health. Graph 2 summarises our analysis of the cashflow break-evens and production growth of a number of US shale producers which collectively represent one-third of the US’s total daily production. This focus on cashflow is more important than usual with shale producers as they have to reinvest heavily just to keep production flat.

Graph 2: US shale producer break-evens and production growth

Source: Allan Gray, company financial statements as at 30 June 2019 (EOG, Marathon, Devon, Pioneer, Continental, Whiting, Apache, Anadarko, Noble, Concho)

With US oil prices in the low- to mid-US$50s per barrel, it is not possible to break even unless capital expenditures are curtailed. But this results in production levels declining. For production to grow at close to 10% per annum (as it has been) and for producers to break even, US oil prices in the low- to mid-US$60s are required (with global benchmark prices which determine LNG prices currently at a premium to this). This production growth may sound high, but it is also necessary when one considers the extent of the production declines in the more mature oil basins around the world and the extent of the underinvestment in conventional oil field discovery and development in recent years.

The above might be a generous assessment of producers’ financial health. Yes, technological advancements have helped produce oil more cheaply, but so too has the significant deflation in service provider costs. This tailwind may become a headwind if service providers regain some pricing power. On top of that, drillers have also been drawing on their drilled-but-uncompleted (DUC) well inventory in order to conserve cash. Future cash break-evens should increase as these DUCs are replenished or oil production will fall. And let’s not forget that at some point these companies may want to actually deliver cash returns on their investments (and pay their interest bills). All of this should support higher oil prices.

Image 1: Shale producing regions in the US

Source: US Energy Information Administration

It is also worth remembering that the most prospective acreage is always pursued first. Absent the discovery of prolific new basins, we could expect declining well economics to support higher oil prices in future. Much has been written recently about parent-child well interference leading to lower than expected production levels from new wells drilled near older wells. Shale oil production may, as a result, be more difficult and costly to grow from here. In Texas we’ve already seen peak oil in the Barnett and Eagle Ford shale districts. Only the Permian has been growing strongly and even that seems to be slowing down. Refer to Image 1 which illustrates shale producing regions in the US.

Table 1 shows daily production from the Texan part of the Permian. Oil production in 2019 is now 0.8% below 2018’s levels. Growth rates in gas production have also fallen significantly but remain positive.

Table 1: Daily production from the Texan part of the Permian

Source: Railroad Commission of Texas, subject to subsequent (often upwards) revisions

Today’s oil prices are unlikely to sustain current production levels. 

A vast amount of production is currently unprofitable (at least in an economic sense) and future production economics are likely to be more challenged than today’s. Unfortunately the same is less easy to conclude for gas prices.

Are gas prices too low?

Gas liquefaction facilities are expensive to build. As a result, investment decisions rarely proceed before foundation customers or offtake partners agree to purchase most of the anticipated production volumes (measured in millions of British Thermal Units or mmBTUs) at pre-agreed pricing (i.e. ‘slope’). Historically, the slope has ranged between 13% and 15% of the prevailing oil price. This results in average prices achieved by LNG exporters of around US$9/mmBTU in today’s environment.

Any uncontracted volumes are sold on ‘spot’ (whatever the prevailing market price is on that day). The significant increase in supply has resulted in recent spot prices in the low US$4s per mmBTU delivered into Asia and downward pressure on slopes for new contracts. It is very unlikely that foundation customers will walk away from their long-term supply contracts, but it is quite likely that price reopening mechanisms provided in each contract will result in lower slopes, certainly until supply growth moderates. The current glut will therefore not only impact current earnings to some degree, but also the likely return from the large expansion projects that Oil Search (PNG LNG and Papua LNG) and Woodside (Scarborough and Browse) are embarking on.

Some of the world’s lowest cost LNG production currently comes from the US, the source of a lot of the world’s recent new supply. But we believe that even low-cost US-based LNG production would lose money at current spot prices suggesting gas prices are too low. The shale boom has resulted in daily production increasing from 60 billion cubic feet (bcf) per day in 2006 to over 100bcf/day today. Much of this increase has come from Texas (Permian), Louisiana (Haynesville) and Pennsylvania (Marcellus) as shown in Graph 3. This growth has far outstripped domestic demand resulting in the need to export the surplus gas either via pipeline or through liquefaction and shipment.

Graph 3: US gas production

Source: US Energy Information Administration as at 30 June 2019

Given the glut of gas, LNG exporters have been able to purchase gas very cheaply. A gas pricing benchmark in Louisiana, the Henry Hub price, has fallen to US$2.60/mmBTU from over US$10/mmBTU prior to the glut. Transport costs (approximately 15% of Henry Hub), liquefaction tolls (US$2/mmBTU) and freight to Asia (US$1.25/mmBTU) allow liquefiers to deliver gas into Asia for about US$6.25/mmBTU. This is well in excess of current depressed spot prices but still well below the prices required for our Australian-listed LNG producers to make a reasonable return on their investments. But these economics only hold for as long as Henry Hub prices of US$2.60/mmBTU can be sustained.

Like oil, US gas prices may remain low for a number of years but current levels are too low for even the most prospective acreage to generate an economic return. 

Marcellus focused producers like Cabot Oil and Gas and EQT Corporation are very-low-cost producers with total costs of US$2-US$2.50/mmBTU. In its June 2019 quarterly update, Cabot flagged its intent to reduce capital expenditures and production growth in favour of maximising value for shareholders and free cashflows. Hardly the actions of a company making super-normal profits.

The situation in the Permian is more difficult to assess as gas is produced alongside oil. Permian producers treat their gas production as a nuisance by-product to their oil production, which is not usually a healthy backdrop for prices, especially as oil production has continued to climb. But there are definitely some early signs that drillers recognise their challenged economics and are positioning their businesses on a more sustainable footing before their bankers force this upon them. While gas prices appear to be too low today, it is hard to know what gas prices will be required to support a sustainable production base.

Investing is difficult and full of uncertainty and risks. The most effective protection remains price. Some but not all of the downside from lower gas prices is already factored into the share prices of Woodside and Oil Search, our two largest exposures to oil and gas markets. But turning the coin over reveals upside which gets us quite excited. Unsustainable economics from oil and gas producers are a necessary backdrop for significantly higher energy prices in future. These might underpin very profitable expansions which both companies expect to undertake and which consumers are likely to support in order to introduce diverse sources of supply (rather than becoming solely reliant on US-sourced LNG or gas from Qatar).

We’ve worked hard to build a portfolio of companies with expected investment returns skewed to the upside. Our energy investments have taken much longer than we anticipated to generate a return for our investors, but they remain attractive to us and we believe they can contribute handsomely to future returns.

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Contrarian investing is not for everyone, however there can be great rewards for the patient investor who embraces Allan Gray’s approach. To stay up to date with our latest thinking, hit the follow button below. 

This extract is from Allan Gray Australia’s September 2019 Quarterly Commentary. For further insights please visit our website 



Comments

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Nathan Thomas

Great article but I’m not sure I’ve been sold that these gas businesses have an economic moat. Seems they are price takers in a very irrational and competitive world.

Carlos Cobelas

are you not perhaps underestimating the move to renewable energies ( whether one believes in climate change or not ) ?