The Energy Report: In a recent Frank Talk, you quoted
BCA Research with a prediction that oil markets will rebalance in 2016. What
is that based on?
Samuel Pelaez: This chart shows that the U.S. has come off its peak
production quite a bit. We reached peak production in April at about 9.6
million barrels (9.6 MMbbl). We're about 400 thousand barrels (400 Mbbl) off
from that level. This goes a long way to rebalancing the supply/demand
dynamics globally. Even though the U.S. has been a major contributor to
rebalancing the supply in the markets, we have not seen the supply come off
to the levels we were initially expecting. We thought about 1.2 MMbbl could
be curtailed, but only managed to get about 400 Mbbl.
One reason for the continued production is that banks are pressuring
explorers and producers (E&Ps) to bring in cash flow. The only way for
these companies to bring in more cash flow is to continue growing production,
or at least maintaining production. On top of that, we've seen massive
efficiency gains in shale productivity. So even though the rig count has
fallen dramatically, the U.S. has been able to sustain production at a
relatively good level, which actually bodes really well going forward, from a
U.S. supply perspective.
Now, what really needs to change for a supply/demand rebalance is for
OPEC's volumes to stabilize. Toward the end of the year we saw that even
though the U.S. was cutting production, OPEC production grew. In November,
during their last meeting of the year, they unofficially abandoned their
quota system, which they had brought from 30.5 MMbbl all the way up to 31.5
MMbbl. We saw 700 Mbbl of increased production come in toward the end of the
year, which more than offset the U.S. supply volume. So even though we think
supply is going the right way and OPEC's boosted production may not be
sustainable, we believe we're coming to that point where supply will continue
to erode gradually as a result of low oil prices.
More interestingly, on the demand side of the equation, China, the largest
oil consumer, actually imported a record amount of oil in December, a total
of 7.8 MMbbl of oil equivalent a day. That's 16% growth month over month. It
is clearly taking advantage of lower oil prices, and we expect that dynamic
to continue going forward. The lower oil prices resulted in dramatic
increases in gasoline consumption around the world. More importantly, China
is expanding its strategic oil reserves to take advantage of this window of
opportunity, which gives you a sense that it doesn't think it is sustainable
going forward.
Purchasing Managers Indexes (PMIs) are the best leading indicator for
commodity demand, especially in China. As of now, global PMIs-including China
PMIs-are in a negative downtrend. That means that the one-month number is
below the three-month trend. Until that changes, we don't expect a
significant price recovery. However, as we go into the summer peak driving
season and the peak oil demand season, we expect inventory draws. We've seen massive
inventory build-ups. We may see that turnaround. That will make us more
comfortable that prices have bottomed, supply growth will start outpacing
demand growth and we will slowly and gradually move toward a rebalanced
market toward the end of the year.
TER: Do your supply side calculations include Iran? What impact
could that have when it starts shipping oil again?
SP: It's actually very hard to forecast OPEC supply. But we do
expect to see Iran volumes increase since sanctions were lifted. Iran has
said it is ready to increase production by about 500 Mbbl. We think that is
realistic. It believes it can grow to 1 MMbbl, which essentially will take it
to pre-sanction level. We don't expect it to go above that, considering the
lack of investment over the past few years and that major significant
investments will be required for Iran to be able to grow production back up
to 4 MMbbl per day (4MMbbl/d). So yes, we do expect that to be a significant
driver in terms of volumes earlier in the year; however, we don't expect that
to fully materialize. There are both upsides and downsides to this because
it's very hard to estimate what the market is pricing in, but we believe in
Q1/16 and perhaps all the way until seasonal factors kick in during Q2/16
we'll continue to see pressure on the prices down.
TER: Do you agree, Frank?
Frank Holmes: I do. I think that the pivot point is going to be the
Federal Reserve trying to mitigate financial-meltdown bank lending in the
energy patch. That could change the guidelines for asset sales. I think
what's going to happen is we're going to get a bottoming, we're going to see
supply drop and we're going to see all future funding for a lot of these
operations come to an end, which will fast track this contraction in the energy
supply in the U.S.
I also think Iran is a real threat. Costs are so much lower there. In the
short term, money can be made meeting Iran's technology needs. In fact, it
needs Boeing Co. (BA:NYSE) planes. It needs parts. It needs all the necessary
chemicals and upgraded drilling equipment for the energy space. So there will
be many companies that are going to benefit, but that will still put pressure
on energy prices.
TER: Another thing that's changing is that after years of
restrictions, the ban on exporting oil from the U.S. has been lifted. How
much of an impact could that have on oil prices?
FH: More supply. If energy is to spike, then America will make that
trade-off very quickly from supplying domestic chemical companies to
exporting to higher price markets.
SP: I think more than the overall impact to global oil prices, it
achieves a more globally efficient allocation of the resources. That would
benefit American producers because the U.S. has nearly doubled its oil
production in the last five years, but most of it is in the ultralight
condensate space. Those are volumes that refiners in the States don't need.
But Mexico could use for its gasoline. This allows producers to sell product
internationally without a discount. We had West Texas Intermediate (WTI)
discounts for the longest time, I think up to $30 relative to Brent, and it
was because of the abundance of this condensate and light crude oil in the
US. It was great for refiners at the time. Now, producers will be able to get
better international prices relative to Brent. That is why we saw that
WTI-Brent spread collapse. Overall, I think it benefits everybody in the
States.
I have heard some criticism about consumer gasoline prices rising as a
result. That is simply not true because there has never been a ban on exports
of gasoline, only on raw products. The U.S. has always had gasoline prices
that are commensurate with international markets. In that regard, it doesn't
change anything.
TER: When I interviewed Chen Lin recently, he was hoping for $20 a barrel
($20/bbl) oil because he said that would lead to a faster jump back up in
price. We dipped below $30/bbl recently. How many oil and gas juniors can
survive to see that upside if Chen is right?
SP: I absolutely agree with him. Although we don't hope for prices
to continue to collapse, the lower prices go, the more pain is inflicted and
the quicker the supply responds from swing producers, especially tight oil,
which is the more expensive kind of oil.
The Wall Street Journal published a piece recently saying that
E&Ps are losing $2 billion ($2B) a week at $30/bbl oil. That's just in
the U.S. Even though marginal cost curves, which is something we look at
frequently, are now pointing at about $25/bbl globally for that marginal
barrel of oil, it ignores all the capex, the general and administrative
(G&A) expense, the debt servicing, etc. So I struggle to believe that there
are many companies making money at these prices. They can continue to pump
out some production, the ones that have already been established, but there
will be no new supply additions at these prices.
FH: The currency also impacts it. If you're an American producer,
you're much more severely impacted by oil prices falling because your costs
are in dollars. However, if you're in Canada, the currency has declined so
much that you're still able to marginally stay in the game as a player. The
same thing happens with Colombia. The currency declines have been so severe
for some of these countries that companies operating there can survive even
with these low energy prices.
TER: How many oil and gas juniors are still in your portfolio? How
do you decide who to keep?
SP: We have reviewed the juniors in our portfolio and we remain
committed to a narrow number of companies, specifically those with proven
management that have been able to demonstrate their ability to be first
movers into key growth areas.
One of those names is BNK Petroleum Inc. (BKX:TSX). It has one of the best
assets in all of Oklahoma. It has continued to beat everybody's estimates in
terms of the decline rates. It has been able to squeeze more oil out of every
well in this play than anybody ever predicted. Those are the kinds of plays
we like. We like those big growth opportunities with proven management. It
also has come a long way in cutting costs. I think its G&A was cut by 50%
year over year. We see great optionality for the ability to grow going
forward. It will need a little bit of a better price just like everybody
else, but we're comfortable holding it today because the cost adjustments it
has been able to implement will allow it to survive this trough.
FH: I know some oil companies that have cut their Houston office,
but have added people in Calgary because their currency has declined so much.
So the cost of intellectual capital, seismic research, etc. is a lot cheaper
there for an international oil company. BNK originally came out of Calgary,
so its cost structure has declined because of the Canadian dollar.
TER: How are the majors shifting their focus to take advantage of
global opportunities? What role do they play in a diversified energy
portfolio?
SP: By definition, the integrated majors are the best way to ride a
storm. They've traditionally been the defensive names in the space, and they
continue to be so. If you look at last year's performance, they massively outperformed
the energy sector. That's even before you factor in the dividends, which are
obviously much more sustainable. The role they play is critical, and it
changes over time. But I think at this juncture, when we're expecting even
lower equity returns, dividends and share repurchases become a big and
important part of your returns.
We prefer American versus European majors. The U.S. majors have a much
greater exposure to profitable downstream sectors. The U.S. downstream sector
as a whole is more profitable than the European one, owing to greater
gasoline demand, overall better crack spreads, better margins and overall
profitability.
We look for majors that are focusing on extracting the most profitability
out of their downstream space right now in order to continue to sustain their
dividend growth. I think this is the big driver of the valuations of these
companies. We look for those that have strong free cash flow yields, robust
balance sheets, sustainable dividends and a focus on the downstream space.
We own Exxon Mobil Corp. (XOM:NYSE). The company has positioned
itself as the best major to weather the storm. We see a number of major
integrateds repositioning their portfolios in light of the price collapse,
but we think Exxon was way ahead in doing this and the downstream exposure
will allow it to weather the storm better than most of its peers. It will
also become more active in the mergers and acquisitions space once it
recovers.
TER: Are there still opportunities in the midstream space? Do they
have less exposure to price risk?
SP: Absolutely. This is especially true after 2015. Master limited
partnerships (MLPs) and midstream as a whole was the worst performing
subsector in the energy space last year. That is because there's this
investor view within the MLP space of "one size fits all." This
couldn't be further from the truth. Investors argued that MLPs and midstreams
will see falling dividend growth as a result of lower volumes and expected
supply cuts. As we've seen, the supply cuts did materialize, but not to the
extent that was initially thought. Also, the rate hike had a big effect on
the underperformance of MLPs, but now we know that further rate hikes are not
so clear in coming in the future. As I mentioned earlier, yields and
dividends become a more important portion of your return this year. Building
on that, I think within the MLP space we have a lot of pockets of value. I
wouldn't recommend the sector as a whole, but I would recommend those MLPs
whose toplines have the least correlation to oil prices. Some of them have
great exposure to volumes from shale plays that continue to grow even at
current prices. Those who participate in that specific space and have robust
balance sheets will be able to sustain their payout rates, and those yields
will become very important this year.
We particularly like a company called EQT
Midstream Partners LP (EQM:NYSE). This is a midstream company with
pipelines and storage capacities in the Marcellus. It has a very robust
balance sheet and low debt relative to its peers. It has a top-tier growth
profile, posting a 40% growth trailing 12 months. It also has one of the
highest cash flow returns in invested capital in the space. We expect it to
continue to grow, especially as it expands to the Utica Formation, and
continue to pay about a 4% dividend yield, which is very sustainable
considering it's only a 60% payout rate. More importantly, EQT is highly
insulated from declines in volumes because it operates more like a utility in
the sense that it contracts out its capacity ahead of time to producers, so
it's not subject to the stock changes in volumes. This also provides greater
visibility into its revenue, into its earnings and into the sustainability
and eventual growth of its dividend.
TER: What are the prospects for the refiners in this scenario? What
companies do you like in that space?
FH: It is important to ask who is going to benefit from cheaper gas
besides the consumer at the gas pump. There are so many manufacturing
companies that are experiencing expanding margins because their energy input
is a big part of their costs. Refineries definitely benefit, but so do
chemical companies.
SP: The fundamentals for refiners are very basic. Input costs are
coming down as crude prices come down whereas their output, which is mainly
gasoline and distillates, is priced off of a mix of demand and cost. So
they're insulated on the cost side, and actually gasoline demand posted a
record last year. This results in fatter margins, which drives profitability,
dividend payouts, share buyback programs and overall great stock performance.
Record gasoline demand in 2015 is expected to continue into 2016,
resulting in strong double-digit crack spreads in January, one of the weakest
seasonal periods. This is incredibly favorable for refiner markets.
Ironically, the refiners sold off into the first two weeks of the year, kind
of mimicking what they did last year when the seasonality kicked in, but that
only set them up for 2015 when they were the best performing sector within
the energy space.
A few companies are poised to profit from the upcoming spring turnaround
season and are better able to profit from this tightening in the supply,
leading into the best oil and gasoline demand season, which is the summer.
In light of that, we like Valero
Energy Corp. (VLO:NYSE), here in San Antonio. It has the best free cash
flow yield in the sector at 9%. That's 50% above the average for its peers.
This is a result of its complex system that allows it to take multiple kinds
of crude. It can go out and shop for the cheapest and extract very good
products out of pretty much any of them. It also has a large scale, and most
of the exposure is in the Gulf, which offers more access to cheaper product
and, thus, expanded margins. We expect it to continue to grow its dividend
and the share repurchase programs. We have this as one of the core holdings
in our portfolio. [Editor's note: Valero raised its dividend by 20% on
Thursday after the interview was conducted.]
We also like Marathon Petroleum Corp. (MPC:NYSE). It has one of the
strongest growth rates in the industry. Although it has significant capital
commitments, we've seen in the past that the cash flow return on invested
capital is one of the highest in the energy space. That speaks to the capital
discipline. It's actually a great time to be building something because the
energy sector is in a downturn, meaning there is a lot of labor available, a
lot of contracting equipment and a lot of willingness to see these things
through. It is exposed to this cyclical tailwind.
We also like Tesoro Corp. (TSO:NYSE). Even though it is not in the
Gulf, we're still comfortable sacrificing some of that exposure as a
trade-off to the present profitability and growth that it's been able to get
out of the California refineries. California is the biggest gasoline consumer
in the U.S. Tesoro has a prime location to benefit from that.
On the chemicals side, input costs for Dow
Chemical Co. (DOW:NYSE), LyondellBasell
Industries NV (LYB:NYSE) and other diversified chemical companies are
directly priced off of crude. So you normally see them selling off with the
whole energy space when in fact what's selling off is their input. Their
output is sold to consumers, packagers, paint companies and a bunch of other
industries that use their chemicals. But this plays to the same dynamic that
we like in the refiners and in the integrateds. It's that further downstream
exposure, being closer to the consumer and a little bit more distant from the
prime commodity where we've seen much of the carnage. That's the reason we
like the chemicals, too.
TER: So there are some winners still in the space.
FH: Yes, and a big part is how fast you move to see if there are
tipping points for energy prices that trigger bankruptcies. I think you're
going to get a lot of bankruptcies this quarter and writedowns of reserves.
It's another reason why there will be a drop in supply as the industry goes
through this contraction. Any time you've had a commodity down for 36 months,
it will trigger a resetting of reserves and impact loan repayment.
The airline industry is another industry that's had a big windfall from
dropping energy prices to the tune of expansion that this past year was $20B
of additional free cash flow. With oil at $30/bbl, this industry will
probably push close to $35B of free cash flow this year.
TER: Our readers are used to investing in junior mining companies
that can have really big wins. How can they get that same bang for their buck
in companies as large as the airlines?
FH: The airlines are pretty volatile. In fact, they have the same
DNA of volatility as junior mining stocks. They are going to go through a
rerating soon. Everyone expected them to undercut each other, and they
didn't. Instead, they started buying back their stock. I think that these
airlines will benefit from that.
TER: What final words of advice do you have for investors looking
at their portfolios in the wake of a volatile first few weeks of the year and
a rough three years?
FH: We have always been advocates of 5% bullion and 5% actively
managed gold mining companies like our World Precious Minerals Fund. When we
come to individual names, we've always stuck with Franco-Nevada
Corp. (FNV:TSX; FNV:NYSE) because it's a high-margin business and it
invests in a lot of juniors, so you get that portfolio.
Roger Gibson, a pension fund consult, advocated back in 1997 that
investors keep 25% in resources and rebalance each year. He lost a lot of his
customers, but they all came back in 2003 after the tech collapse because
they recognized his wisdom. I agree with his advice, but you need smart
people like Sam on active management to take advantage of a changing market
like this.
SP: Even in the current price environment, there are numerous
opportunities to profit within the energy space. We discussed a number of
downstream exposure opportunities. They're all beneficiaries within the
further energy complex of lower crude prices. We feel like some investors are
apprehensive to take on some of these opportunities because some of them
played out last year, but that doesn't necessarily mean they can't play out
again this year. We look for a confluence of factors in terms of supply and
demand to tell us the market has changed, and we have not yet gotten to that
point. We want to see supply curtailments materializing, whether it's in the
U.S. or OPEC. We also want to see demand growth from China and the rest of
the world that is confirmed by PMIs crossing one month above the three-month,
so that we can feel confident that the trend has changed. Until that happens,
we feel confident in recommending the downstream exposure.
TER: Thank you both for your time.
Frank Holmes is CEO and chief investment officer at U.S.
Global Investors Inc., which manages a diversified family of mutual funds and
hedge funds specializing in natural resources, emerging markets and gold and
precious metals. Holmes purchased a controlling interest in U.S. Global
Investors in 1989 and became the firm's chief investment officer in 1999.
Under his guidance, the company's funds have received numerous awards and
honors including more than two dozen Lipper Fund Awards and certificates. In
2006, Holmes was selected mining fund manager of the year by the Mining
Journal. He is also the co-author of "The Goldwatcher: Demystifying
Gold Investing." He is also a regular commentator on the financial
television networks CNBC, Bloomberg and Fox Business, and has been profiled
by Fortune, Barron's, The Financial Times and other publications.
Samuel Pelaez is an investment analyst covering global
resources. He joined Galileo Global Equity Advisors in 2015 after having
worked as an investment analyst at U.S. Global Investors, a boutique
U.S.-based investment management firm. Samuel graduated from the University
of Cambridge in the UK with a Masters in Finance, having previously graduated
from the Schulich School of Business (with Distinction) in Toronto, Canada.
Samuel has passed all three levels of the CFA program and will be eligible
for award of the CFA charter upon completion of the required work experience.
