Elliott Gue: Oil Price Washout Just Happened? Finding Low Cost Oil & Gas Producers & Pipeline Income

Introduction

In this podcast interview, Jason Bjork from Wall Street from East Street interviews Elliot Gue, founder of Capitalist Times and an expert in oil and natural gas stocks. They discuss recent trends in the oil and natural gas markets.

Recent Trends in Oil and Natural Gas Prices

Jason asks Elliot about recent trends in oil and natural gas prices. Elliot explains that there has been a rally lately in West Texas Intermediate crude prices, which are almost at $76 per barrel. Natural gas prices have also been high, at around $2.21 per unit.

• Jason asks if there has been a washout in the last month or so due to short-term traders going heavily net short on all oil plays.

• Elliot explains that he finds the Commitment of Traders data very useful for understanding market trends. He looks at the net speculative position in both West Texas Intermediate and Brent Market (the key global benchmark). The total net position of these speculators is currently the lowest it's been since early 2016.

• Elliot believes that there has been an overreaction to recession fears among investors, leading to excessive short positions on oil.

Understanding Speculators' Positions

Elliot explains how he uses Commitment of Traders data to understand speculators' positions.

• The Commodity Futures Trading Commission reports on different classes of traders every week. Hedgers use futures markets directly or indirectly to hedge their production or exposure to price changes. Speculators use futures markets to speculate on price changes.

• Elliot focuses on managed money (mainly hedge funds), who use futures markets to speculate on the price of oil going up or down.

• Elliot explains that speculators have been betting heavily on recession, which typically leads to declining demand for oil worldwide and pushes down prices. However, he believes that the situation has gotten excessive.

Net Speculative Position in Oil

Elliot discusses the net speculative position in oil and how it relates to current market conditions.

• Elliot looks at the total net position of speculators in both West Texas Intermediate and Brent Market. He notes that this is currently the lowest it's been since early 2016.

• Elliot points out that during early 2016, there was a major supply issue in the oil market, leading to a huge short position among investors. However, when speculators lean too far in one direction or another, it opens up the possibility for a move in the opposite direction.

• Elliot believes that current supply and demand conditions do not justify prices under $65-$70 per barrel.

Delayed Release of Data

Elliot discusses why there was a delay in releasing Commitment of Traders data.

• The CFTC and ICE delayed release of data due to a computer hack of ION, a company that processes derivatives data.

• As they played catch-up on missed reports, Elliot noted that there has been an overreaction to recession fears among investors.

The Shale Oil Boom and Saudi Arabia's Response

This section discusses the shale oil boom in the US and how it led to a supply glut. It also talks about Saudi Arabia's response to this situation.

The Shale Oil Boom

• The shale oil boom in the US was fueled by cheap capital and low-interest rates.

• US shale oil producers focused on growth rather than profit margins, free cash flow, or dividends.

• This led to a supply glut of shale oil in the market.

Saudi Arabia's Response

• From 2014 to 2016, Saudi Arabia tried to bankrupt many shale oil producers.

• Ali al-Naemi, the former Saudi oil minister, had experienced a similar situation during the mid-1980s when non-OPEC production growth caused downward pressure on prices.

• In December 1986, Saudi Arabia increased production overnight to crack the market and squeeze out higher-cost producers.

OPEC Production Cuts and Non-OPEC Supply Growth

This section discusses OPEC's attempts to cut production and support oil prices in response to non-OPEC supply growth.

Non-OPEC Supply Growth

• In the early 1980s, non-OPEC supply growth caused downward pressure on oil prices.

• Despite OPEC's attempts to cut production and support prices, non-OPEC supply continued to increase due to investment in new reserves.

OPEC Production Cuts

• To support prices, OPEC started cutting production and pushing its partners to do so as well.

• However, this only propped up prices temporarily as non-OPEC supply continued to increase.

• In 1986, Saudi Arabia increased production overnight to crack the market and squeeze out higher-cost producers.

US Shale Oil Production Growth

This section discusses the growth of US shale oil production and its impact on the industry.

Shale Oil Production Growth

• The growth of US shale oil production was driven by hydraulic fracturing technology that opened up new areas for oil production.

• Companies focused on drilling a large number of wells despite not generating enough money to cover costs.

• Investors were primarily interested in volume and growth rather than profit margins or free cash flow.

The Evolution of the Oil Industry

This section discusses how the oil industry has evolved over time, from a focus on growth to a focus on generating free cash flow.

The Old Strategy

• Companies focused on easy access to capital markets and assumed that commodity prices would remain high.

• Saudi Arabia managed the price of oil to keep it around $100 per barrel.

• Saudi accommodated new production by cutting their own production, but eventually realized they were financing oversupply in the market.

The New Strategy

• Companies are now focused on generating free cash flow.

• They set drilling budgets based on free cash flow targets rather than trying to target growth rates in volume.

• US shale producers are talking about zero to five percent year-over-year growth in oil production this year compared to 25 and 30 percent during the boom years.

Future of Permian Basin Oil Production

This section discusses whether or not the Permian Basin will continue to grow its oil production or if it will peak and decline soon.

Conventional Oil Field vs. Shale

• Conventional oil fields have specific curves for rapid production growth followed by plateauing and eventual base decline.

• Shale is more like a manufacturing business where producing more is all about drilling more.

Permian Basin Growth

• Capex will be put into the Permian Basin, but not enough capex to continuously grow oil production enormously.

• Petroleum geologists predict that we'll see either flattening out or peaking and declining soon.

Understanding the Permian Basin and Production Growth

This section discusses how horizontal wells are drilled in the Permian Basin, how well spacing affects production rates, and the importance of drilling more wells to offset decline in production from existing wells.

Drilling Wells in the Permian Basin

• Horizontal wells are drilled like an octopus in all different directions under the Earth.

• If wells are located too close together, production from one well will interfere with neighboring wells and reduce overall production rate.

• Companies can only space wells so close or far apart without affecting their existing production base.

Importance of Drilling More Wells

• To grow production over time, companies must drill more wells to offset decline in production from existing wells.

• Pioneer CEO Scott Sheffield looks at their acreage that they've amassed over the last 10 plus years in the Permian Basin. They have many drilling locations on this space.

• If they drill a certain number of wells per year, they can grow production at a shallow rate for 15 or 20 years.

• However, as companies run out of primary drilling locations, they will have to drill more marginal acreage which is not as productive. This will limit overall U.S. production growth.

Low Cost Producers in the Permian Basin

This section discusses low cost producers in the Permian Basin and how Exxon Mobil plans to grow its Permian production.

Lowest Cost Producers

• The Midland Basin is going to be your lowest cost dollars per barrel oil coming out of the ground.

• Pioneer (PXD) is one of the lowest cost producers if not the lowest cost producer in the US. They are primarily focused on the Midland Basin of the Permian.

• The Delaware Basin is also a very low cost play, but you're going to tend to see more natural gas production from there.

Exxon Mobil's Growth Plan

• Exxon Mobil has a lot of acreage in the Permian and it's one of their growth areas for the next five years.

• They have a five-year plan out to 2027 and they updated it last year. They're looking to grow Permian production by a lot over the next few years.

• In fact, just last year they grew Permian production by 90,000 barrels a day.

• They are competitive with the lowest cost plays Exxon Mobil has anywhere in the world.

Overview of Oil Production in Guyana and Permian Basin

This section discusses the oil production in Guyana and Permian Basin, including the expected production levels, costs, and competition with other global producers.

Oil Production in Guyana

• Guyana is located in South America.

• By 2027, they are expecting over 850,000 barrels a day of oil from Guyana with a cost down around $30 to $35 a barrel all-in.

• Exxon is heavily invested in Guyana's oil production.

Oil Production in Permian Basin

• Permian Basin is competitive with anything anywhere in the world.

• Exxon Mobil Chevron Occidental are heavily invested there as well as some of the US Shale players Pioneer being one name that's very well known for investment.

• Permian Basin has similar costs right somewhere between that $35 to $40 dollars a barrel all-in.

• Permian Basin would be the lowest cost play in the United States outside the U.S there are some plays that can compete with that.

Competition with Other Global Producers

• Exxon and Guyana have low-cost productions.

• OPEC Middle East producers have a very low cost of production as well.

• OPEC is controlling more of the world supply than they did back when they started that sort of price war in 2014.

Profit Margins for Oil Producers

This section discusses profit margins for oil producers, including Saudi Aramco and Pioneer.

Profit Margins for Saudi Aramco

• Saudi Aramco has a good amount of oil natural gas production from Guar.

• Their costs are still probably $40 to $50 dollars a barrel.

• Most of your Middle Eastern producers have break-even rates still today estimated at less than $15 a barrel.

Profit Margins for Pioneer

• Pioneer generates more than $3 billion in free cash flow at $60 WTI prices.

• At 80 WTI, they generate approximately $6 billion a year in free cash flow.

• They can pay somewhere north of twenty dollars per share in annual dividends at steady WTI prices.

Global Oil Demand and Supply

The demand for oil is expected to grow globally over the next five years, but the supply side is facing challenges due to a decline in production from traditional oil-exporting countries. The Permian Basin and Saudi Arabia have been carrying most of the global oil production growth for the last 10 years.

Factors Affecting Oil Supply

• Mexico's Cannery field is becoming a net importer of oil, which is contributing to a decline in global oil exports.

• If the Permian Basin starts to sputter out, there will be significant supply problems.

• When prices go up, it generally encourages more spending on new supply. However, there has been a big fall in global capex recently.

Potential Areas for New Investment

• Deep water could see growth if prices rise to around $80-$90 per barrel over two or three years.

• Canadian oil sands companies like Suncor and Canadian Natural Resources are paying dividends and have been involved in big acquisitions recently.

• At $80-$90 per barrel, many US producers will be throwing off impressive free cash flow and dividends.

Exxon Mobil's Growth Prospects

Exxon Mobil has been high-grading its portfolio by selling off slower-growing older fields and investing in new projects with lower breakeven costs that generate more cash flow. This year marks a turning point for Exxon as their production is set to take off next year and beyond.

Debt Reduction and Dividend Growth

• Exxon has paid off almost all of its debt (around $17 billion net) and has a very highly rated company.

• They will be growing their dividend and buying back stock.

• Their production is set to take off next year, and their cash flow will increase as well.

Future Growth Projections

• Exxon's projections are based on a $60 Brent price, but they could see even more growth if prices rise to around $80-$90 per barrel.

• They have been investing in new projects like Giana that have lower breakeven costs and generate more cash flow.

Business Model of International Oil Companies

The section discusses the business model of big international oil companies, such as Exxon, and how they generate profits from internal business diversification.

Internal Business Diversification

• Big international oil companies have internal business diversification.

• Exxon generates about 65% of their profits from oil and gas production (upstream), while the remaining 35-40% comes from other businesses such as chemicals and refining.

• Refining could be one of the best performing sub-sectors in energy this year.

• Refining provides stability to cash flows because when oil prices are low, refining margins are actually quite attractive.

Natural Gas in Refining Margins

• Natural gas is a crucial component of refining margins because refineries use it to produce heat required for heating up oil to separate different components within a barrel of crude oil.

• Even though gas prices in both the US and Europe have come down, the US still has a massive cost advantage due to cheap natural gas costs.

Advantages for US Companies

• US companies have more refining capacity than other countries around the world that have been shutting down refining capacity.

• Refineries owned by US companies like Exxon or Valero Energy are located on the U.S Gulf Coast ideally positioned to export refined products.

• International oil companies have scale and balance sheets to invest in energy projects when prices are low. BP and Shell invested in renewable energy when oil prices were low.

BP and Shell's Investment in Renewable Energy

The section discusses BP and Shell's investment in renewable energy when oil prices were low.

Investment in Renewable Energy

• When oil prices were low, BP and Shell upped their investment in renewable energy and cut their investment in fossil fuels.

• They talked about not developing any new fossil fuel projects after 2025 or 2026.

Refining Capacity in the US and Europe

The section discusses refining capacity in the US and Europe.

Refining Capacity

• In the US, we've lost about a million barrels a day of refining capacity since 2018/2019.

• In Europe, refining capacity has been going down since 1980. From something by 2003 till 2017 they lost around 3 million barrels a day of refining capacity since then at least another million.

• European Union countries have more Draconian policies in place for ESG and green energy which could lead to opportunities for American companies to export stuff there.

Investing in Oil and Gas

The speaker discusses the investment opportunities in oil and gas during a downturn, particularly in Guyana. He explains that investing during a downturn allows for lower costs and better deals with local governments. He also notes that only a few companies have the scale to invest heavily in countries like Guyana.

Investment Opportunities in Guyana

• Hess Oil is an alternative investment opportunity for the Guiana play.

• Other major companies would love to buy a stake in Guyana, but it's not available.

• Exxon has the scale to pump large amounts of investment into countries like Guyana due to their capital spending budget of 20-25 billion dollars per year.

• Complicated offshore wells require expensive and technically complex handling, which Exxon has the technology and know-how to do.

Cost of Developing Fields in Guyana

• For full cycle development, Exxon estimates around $30-$35 per barrel as their cost.

• Conventional oil projects usually have high upfront capital commitments but low ongoing costs.

• Efficiency improvements may bring down costs even further.

Benefits of Investing Counter-Cyclically

• Investing counter-cyclically during a downturn can lead to paying less for everything else, including hiring workers and cutting deals with local governments.

• Exxon invested heavily when times were bad for the industry, allowing them to benefit from supply-side problems on oil prices later on.

• Shareholders will benefit from Exxon's huge tie to free cash flow coming.

Income Opportunities for Oil Producers

• Many people are looking for income opportunities but are hesitant about money market funds or U.S treasuries due to hidden risks.

• Pipeline companies offer good income opportunities due to their steady cash flows.

Investing in Energy Companies vs Traditional Income Sources

This section discusses the risks and benefits of investing in energy companies compared to traditional income sources like money market funds or U.S. Treasury bonds.

Interest Rate Risk with Treasuries

• Long-term treasuries have interest rate risk if the Fed increases interest rates to bring down inflation.

• Short-term treasury bills have less interest rate risk.

Risks with Money Market Funds

• Money market funds are uninsured deposits that may be secretly bailed out during a crisis.

• In 2019, money market funds were bailed out during the repo crisis when borrowers couldn't pay back their loans.

Benefits of Investing in Energy Companies

• Pioneer has a formulaic approach to dividends based on free cash flow and netting out capital spending.

• Pioneer pays out roughly 75% of incremental free cash flow as a variable dividend every quarter.

• The tie between Pioneer's free cash flow, oil prices, and dividends makes for a straightforward investment opportunity.

• There is relatively low risk that the price of oil will sustainably fall below $60/barrel, making Pioneer's yield relatively safe at 5%-10%.

Comparing Energy Producers to Pipeline Companies

This section compares the risks and benefits of investing in energy producers versus pipeline companies.

Risks with Energy Producers

• Investing in energy producers involves more commodity risk due to fluctuations in oil prices.

• If the price of oil falls below expectations, dividends may also decrease.

Benefits of Pipeline Companies

• Pipeline companies are traditionally seen as toll takers and have minimum volume commitments.

• MLPs own pipelines and handle other services for energy companies like Pioneer.

Investing in Pipeline Companies

This section discusses the risks associated with investing in pipeline companies and how to mitigate them.

Risks of Pipeline Companies

• The two main risks for pipeline companies are volumetric risk and balance sheet risk.

• Volumetric risk is the risk that the amount of volume of oil and natural gas going through the pipeline falls, which can happen if oil and natural gas prices fall or if drilling activity declines in a particular region.

• To mitigate volumetric risk, it's important to invest in companies with widely dispersed pipelines in different parts of the country with different commodities.

• Gathering pipelines are very sensitive to volume growth, so it's important to avoid companies that have a lot of gathering in an area that's not going to see as much growth. Processing contracts also involve some downside risk if the net value of Natural Gas Liquids falls.

Selecting Pipeline Companies

• Enterprise is a good example of a company with widely dispersed pipelines across different regions and commodities.

• Axon is a fee-based operator, making it less exposed to commodity price risk than smaller potentially faster-growing names.

• It's important to be selective when investing in MLPs since some have come under real trouble due to too much exposure to areas of declining volume or contracts linking them to commodity price risk.

Dividend Growth Potential

• Solid pipeline companies like those discussed here have paid reliable dividends for many years and will likely continue growing them at an annualized pace range between 3% and 5%.