Sale Of The Season
How to dodge risk in a low-price environment without sacrificing opportunities when the upswing returns
WHILE MANY INVESTORS ARE BALKING
at allocating more capital to the Canadian energy sector right now, there are many others who are thinking this might be the chance of a lifetime to buy oil and gas equities at historic lows. It’s a contrarian stance, for sure. But how much more bad news can be out there? Some might sense a move toward capitulation when even the most bullish analysts have thrown in the towel. But capitulation can often mark the turning point in these volatile markets. It’s a matter of stomaching the what-ifs.
What if global oil demand fails to live up to expectations and the Iranians are able to bring another 500,000 barrels per day to the market? Oil supply outside of OPEC should be falling, but what about Pioneer Natural Resources’ recent $1.5-billion equity issue? It’s largely going to fund an expansive U.S. capex program with the expectation that Pioneer’s production growth will exceed 15 per cent per year for the next three years. If that kind of big capital is still out there being deployed, how are we supposed to get a rebound in price? Goldman Sachs talks about the risk of a global oil storage problem this year, which could cause a further sell-off potentially down to $20 per barrel. And on the natural gas side, if the winter stays warm and we don’t experience a hot summer to drive air conditioning loads and increase demand, storage congestion and very low prices will become a real risk in this market as well.
The accompanying chart shows the consensus view in the oil market around the prospective average price for WTI in U.S. dollars in 2016. Most investors are aware of where the spot WTI futures contract is trading, and some are aware of where the forward strip price is trading for 2016 – and beyond. But not many are aware of the expected distribution around the price. This is not a subjective view of the distribution – it is based on objectively observed market prices in the oil futures and options markets in the first week of January. The chart illustrates the probability that the average WTI price will fall below the price levels indicated on the x-axis. For example, based on early January pricing, the market is saying that it believes there is a 36 per cent probability that the WTI price this year will average below $35.
As an investor, one doesn’t want to miss the impact of a sudden cyclical upturn in the market, but one can’t ignore the risks that most producers will face in an extended low-price environment. The key is sustainability over the next 12 to 18 months, meaning determining which producers are in the best position to weather a low-price environment. Investors will wisely examine balance sheets and management team strength. But don’t forget one other very important factor: the magnitude of existing hedge positions. Companies with a significant component of their production hedged for the balance of 2016 and into 2017 will have an edge on their peers with respect to sustaining cash flow in a difficult price landscape. And often these hedged producers will have better access to capital markets. Case in point: The aforementioned Pioneer Natural Resources had 85 per cent of its oil and 70 per cent of its gas production hedged for 2016 at the time of its recent equity issue. One major geopolitically based supply disruption is all it takes to turn the corner on this thing in a hurry, but the opportunistic investors will also want to ensure that their producer equity investment will survive any further commodity price weakness.