The Case For Oil & Emerging Markets
October 18, 2015
- Dec 2015 Brent Crude Oil: $50.44 (10/16/15 close)
- Dec 2017 Brent Crude Oil: $59.94
- Dec 2019 Brent Crude Oil: $63.19
- Dec 2015 Copper: $2.4035
- Dec 2017 Copper: $2.4135
- Dec 2019 Copper: $2.419
- VWO Emerging Markets Index: $36.37
- USD/BRL: 3.9229
- EUR/USD: 1.1345
- USD/JPY: 119.42
- Investor positioning in Energy and Emerging Market equities is extraordinarily one-sided at present, creating an attractive multi-month (quarter?) trade set-up
- Global oil market fundamentals likely have inflected, potentially creating an attractive 1- to 2-year investment set-up in oil-related equities specifically, but also Emerging Market equities generally
- Recent Federal Reserve commentary indicates increased focus on the U.S. Dollar as an outlet for monetary policy; and when looked at in conjunction with limited Eurozone QE expansion potential and an unlikely increase in the BOJ QQE program, the U.S. Dollar could in fact become a tailwind to the commodity-related complex
Conclusion: Even if more downside in the commodity-related complex materializes in the coming days and weeks, I believe the downside is extremely limited due to how stretched the rubber band has become. At worst, I believe well-selected idiosyncratic commodity-related equities will be ‘dead money’; while at best they could be the “2012 Bank Trade” of 2016.
I hate commodity-related investments and macro forecasts – notwithstanding the argument that we are all making a ‘huge’ macro forecast investing in equities and assuming the macro backdrop will not change materially – but I believe the current set-up in the oil- and Emerging Market-related equities is too compelling to pass up. I have chosen to express this view with a barbell approach – on one end, high quality, relatively ‘safe’ midstream operators with attractive long-term prospects largely regardless of the direction of commodities; and on the other end, highly leveraged directional commodity plays (though to be fair the barbell is somewhat lopsided, with a much higher weight in the ‘quality’ basket):
- Midstream Basket
- Williams Companies (NYSE: WMB): $42.28
- Boardwalk Pipeline Partners (NYSE: BWP): $12.83
- Phillips 66 (NYSE: PSX): $84.12
- Leveraged Basket
- California Resources (NYSE: CRC): $4.48
- Freeport-McMoRan (NYSE: FCX): $12.45
Midstream Basket. Commodity exposure, declining U.S. oil production, and a rising cost of capital have driven material declines across the midstream ‘space’. All are legitimate near-term concerns; but given the sheer scale of infrastructure projects required to meet current production constraints – projects already under construction, or well into the planning process – I believe at current valuations base business growth alone will generate adequate returns over the next 3 to 5 years…while commodity price recovery, higher production and/or a lower cost of capital will serve as gravy.
WMB – which turns into ETE/ETC in 1H16 – is a ‘Generally Undervalued’ pure-play midstream investment with no particular upside catalyst. Perhaps once the ETE deal closes some ‘uncertainty’ may lift, providing a near-term pop; but I like it as a very long-term investment. ETE has a fantastic management team with significant ‘skin in the game’; and with a disparate pile of midstream assets under the ETE umbrella, ETE will likely benefit from a long-term amortization of the ‘complexity discount’ as the WMB purchase limits any more large-scale M&A in the near future.
BWP is a bombed out ‘owner-operator’ that investors must look out to 2018 for a return to a normal distribution level. The market does not like to look out that far, so naturally it trades for an absurd discount. I smell consolidation before 2018…
PSX is a break-up story in waiting, but absolutely not necessary for a successful investment. Comprised of refining, chemical and midstream assets, PSX will likely always receive a ‘complexity discount’. That is fine – actually more than fine – as the Refining cash cow provides capital to return to shareholders while the Chemical segment self-funds its growth.
Leveraged Basket. As explained below, I believe the price of oil is set-up for an explosive move over the coming months and quarters. CRC is a direct play on this thesis – and even if I am wrong in the near-term, it has the cash flow and asset profile to survive its balance sheet while waiting for higher oil beyond 2016. Higher oil will partly benefit FCX directly via its O&G unit, but also indirectly by acting as a tailwind for Emerging Markets, and in turn the price of copper. Carl Icahn’s presence on the FCX BOD is an added bonus given the egregious incompetence demonstrated by FCX management over the last several years.
Thesis point #3 is more instinctual and a FWIW, so instead I will focus on the first two points in this section. The basic conclusion with regard to the USD is that the Fed really has no choice but to keep rate where they are given the ROW is at 0% or negative. The strong USD has had a significant effect on U.S. manufacturing, multinational earnings and Emerging Market USD-denominated liabilities, and as Ray Dalio recently said, the Fed is now the World’s central banker. Rates are not going materially higher, and if anything a 4th QE program could be in the works; so my instinct is that at worst the USD stops moving higher. I will leave it at that.
Thesis Point #1: Investor Positioning
According to the latest BAML Global Fund Manager Survey, Energy and Emerging Markets exposure is over 2 standard deviations below the mean of the survey’s history (Source: The Fat Pitch).
This extreme negative positioning is confirmed by data out of Ned Davis Research that I am unable to post here. And as discussed below, the NDR data leads me to believe we could be on the cusp of a ‘move’ far more powerful than a rally into year-end.
Being contrarian for contrarian’s sake is a fool’s errand – far more often than not it pays to get in harmony with the consensus positioning; but the current Energy/EM positioning, in my opinion, has become ‘so bad it’s good’. At worst we need a near- to medium-term snap-back rally in Energy/EM assets to clear out excessive negative positioning…
…but what concerns me about this line of thinking is that these types of positioning extremes occur at true fundamental bottoms, and as a result that I am potentially underestimating the size of the upcoming move in commodity-related equities. Perhaps we are not at a broad-based commodity fundamental bottom, but due to the extremely negative positioning we get a multi-quarter/year face-ripper that eventually succumbs to the forces of a secular commodity bear market. Either way, I will be on high alert for the potentially any upcoming rally is only the beginning of a longer-term move.
I am far from commodity supply/demand curve expert, but my familiarity with the oil sector specifically leads me to believe oil is economically unsustainable below $60…and perhaps even $80. What I am unsure about is if this can be extrapolated across the commodity complex.
Thesis Point #2: Oil Market Fundamentals
Major Oil Price Declines. Since 1986 there have been seven declines greater than 40%, and only two larger than the current case. In the large-scale declines of 1986, 1998 and 2008, oil went on to double within two years of the ultimate bottom. In all three cases the bottoming process was highly volatile with multiple retests/breaks of the initial low – so recent price action in the oil market is not outside of the historic norm. When this historic analysis is paired with a break-even analysis of marginal oil producers, a strong case can be made for much higher crude prices in the not-so-distant future.
Zach Schreiber. In an April 2015 ‘fireside chat’, Zach Schreiber lays out a fantastic numbers-based case for why crude is unsustainable at even $60 (the price at the time of his comments). In summary, he says that highly efficient operator EOG says it needs $60 to $65 even after 20% cost deflation; and that given the sharp decline rates of North American shale oil the global oil market will be under-supplied by upwards of 1MM BPD in 2016. His thoughts are confirmed by SLB commentary the other day…
SLB. On its 3Q15 earnings call, Schlumbergers laid out a (highly?) bullish case for the price of crude (Source: Seeking Alpha):
Bill Herbert – Simmons & Company
Wondering if we can talk about a little bit about the flexibility of the U.S. upstream value chain here as we’re getting deeper into this downturn. And I mean the supposition has been and perhaps continues to be the — once the recovery narrative is embraced by the industry that the industry can respond quickly and assertively to an increase in spending and activity. Do we still think that’s the case given the duress of the industry and the fact that many are not only cutting into fat and muscle but now bone.
Paal Kibsgaard – Chairman and CEO
So I think the industry is — so I think the market is probably overestimating how quickly the industry can respond whether it’s in North America or internationally. I think the fact that now four quarters into very low oil prices, the financial strength of many of our customers has significantly weakened and their appetite to invest is also a bit down. Any I think – any improvement in oil prices, I think will be to initially – is going to go towards the strength in the balance sheet and then the oil companies will likely assess how sustainable are these increases in oil prices before they start investing.
So there is a delay, I believe, between an improvement in oil prices and the decision to increase budgets. And there is going to be a further delay between increasing budgets and realizing that into higher oil field activity. And then there is going to be a delay in between higher oil activity and higher production. So I think there – the market is underestimating how long this period is going to take and just the fact that the industry is again looking to reduce investments when we have this significant pending supply impact coming. This shows that I think we are – we even have increasing chance of a potential spike in oil prices if investments aren’t increased in time.
In conclusion, the case for oil, oil-related equities and Emerging Markets can be summarized as follows:
- Extremely negative investor positioning simultaneously limits further downside and creates highly attractive near-term upside potential
- High probability potential for the price of oil to move significantly higher over the coming months/quarters and potentially years
- Higher oil could feed thru to commodities generally and Emerging Markets specifically as a positive feedback loop is created
- Increased Fed focus on the USD could provide a further tailwind to the commodity complex