I’ve received a few questions offline from people noting they have seen headlines of energy producers reducing their capital expenditures (capex) or cutting them entirely in response to the lower prices, and wondering whether or not that is sufficient to balance the market, and if so, wondering if that means the coast is clear.
Oil markets are complex, and we’d need need pages to properly answer this good question. But we’re not making an oil call here. What we’re saying is A) cuts thus far have been insufficient for a decline in oil production; B) companies losing money and facing ballooning debt with breakeven economics well above current levels will not necessarily proactively cut their production as that would ensure their demise; they will act as options and hope for a turn, which when not achieved, may force them to shutter; we have not seen that; (C) When that happens, the market will rebalance, and that does not mean things are okay; what it means is that supply finally fell in response to a 30% demand decline (supply and demand rebalanced the hard way). We will then start to see the knock-on implications for other companies indirectly linked to oil, and it will likely not be benign. That’s the main point.
Oh, and along the way, we will not likely face a storage shortage because there will be a (painful) response. But that’s a distraction – the main point from the previous post, is that oil drives a significant portion of the US and without an active consumer, there is no offset to this massive pressure.
Observations and details
- Capex cuts are misleading: Headlines abound of energy companies slashing capex. This is misleading for a few reasons: (A) Energy companies have cut capex for years while growing production (capex fell 21% from 2010 to 2018 while production doubled). This is possible due to movement to new formations and horizontal drilling. Beyond our scope, see here for more info. (B) Energy companies already had a decline of 13% at the beginning of the year in 2020 capex vs. 2019; we are now at 22%, so it’s a 9 percentage point increase in the cut, not a fresh 22% cut; (C) There is sustaining capex and growth capex; sustaining capex is the capex to sustain the existing production; growth is investment to expand it. Much of the incremental cuts have been to growth projects, not existing production (perhaps I’ll break this out in a separate post); (D) The big boys, who are better positioned, have cut less than the small players; for the average company, 2020 guided capex is 29% lower than 2019; in total, it’s 22%. See Exhibit 1 showing capex declining with production rising, Exhibit 2 for a rundown of cuts by company, and Exhibit 3 showing a scatter of cuts by size of company with cuts skewed in direction of smaller players
- Small players are cutting where they can, but with breakeven economics at least $30/barrel no matter what oil play, they are reluctant to cut existing production. Exhibit 4 shows breakeven by play; Exhibit 5 shows continued oil output still flat at prior year levels (we have cuts in growth, not a decline in production).
- Small players may fold. Cash flows are negative. Debt is at all-time highs. Capital markets will be reluctant to issue debt (even at a high yield) to fund distressed oil companies. As they hemorrhage, eventually they may run out of options and option value. Exhibit 6 shows the median debt for high yield companies is up 300% since 2008 and for investment grade companies, it’s up 91%. I’m not bothering to show it vs. cash flow as cash flows are largely negative.
- We will likely not run out of storage capacity. According to the Energy Information Associate (EIA) the US has about 653mn barrels total storage capacity, with 372mn barrels already occupying those refineries and tank farms, or 57% of the storage capacity. That leaves about 280mn barrels of remaining capacity. Over the past three weeks, inventories have been rising by about 16mn barrels per week. At that rate, with no supply response, we run out of capacity in 17.5 weeks, a math exercise that has sent off alarm bells. However, we produce about 13mbpd (millions of barrels per day), or 84mn barrels a week. You only need to see a 17.5% reduction in output to stop growing the inventory. Even if it’s just a 5% reduction, that extends the window to 24 weeks; a 10% cut would push this to 40.5 weeks. Exhibit 7 illustrates this.
- The point is eventually supply-demand dynamics in oil will rebalance. And that does not mean everything is peachy. It means production fell in response to weak demand, and this is when you will the knock-on effects of reduced oil production on other industries. That’s the point of this post and the original post on caution for market positions. Exhibit 8 is a reminder.