The Energy industry limps into Q1 earnings season with crude prices at 18-year lows despite a big OPEC/Russia crude production cut. What could it take for Energy to get back on its feet?
It came like a bolt out of the blue, a sudden gusher that spiked beaten-down crude prices nearly 25% in a single day and put Energy stocks into greener pastures for the first time in weeks.
The oil shock was a tweet from President Trump on the morning of April 2. He said he’d spoken to the leaders of Russia and Saudi Arabia and they’d agreed to cut crude production by 10 million barrels a day or more. This, Trump said, would be “great news for the oil and gas sector.” Sure enough, over the Easter weekend, OPEC and Russia signed onto a deal that will reduce output starting May 1.
But apparently the Energy sector needed a lot more great news to get out of the hole it’s in. Few think it can recover much anytime soon, even with massive production cuts. The Q1 earnings season approaches with the sector down more than 40% for the year. The U.S. Energy sector continues to bleed, and earnings might offer more proof of how deep the wound is.
Though Trump’s announcement sent U.S. crude prices to $26 a barrel from $22 in just minutes, keep in mind that even $26 was the low point in the 2015–2016 economic downturn, and it’s well below crude’s 2009 lows during the Great Recession. Also, crude companies weren’t included in the fiscal package passed by Congress last month.
The price of crude quickly fell back below $23 again on April 13 after the deal announcement, and within a couple days crude had eclipsed the $20 (see chart below). The problem is, such agreements sound wonderful in theory, but history shows that what seems awesome on paper for oil isn’t always that way in the execution. Getting everyone to play by the rules is the challenge, and that’s really the question everyone has.
Also, an output cut that starts in May does nothing for Q1 earnings that ended March 31. Crude averaged 17% lower in Q1 2020 than in Q1 2019, so that’s the challenge Energy companies already were dealing with long before the virus made things even worse.
Three of the Energy sector’s six sub-sectors could report worse than 50% earnings declines from a year ago in Q1, according to research firm FactSet, with the sector as a whole taking a 51.5% hit. The worst sub-sectors are expected to be Oil and Gas Drilling (-92%), Oil and Gas Exploration and Production (-69%), and Integrated Oil and Gas (-67%).
On the other hand, FactSet forecasts the other three sub-industries in the sector to report double-digit growth in earnings for the quarter. The gains are expected to come in Oil & Gas Refining & Marketing (+25%), Oil & Gas Equipment & Services (+23%), and Oil & Gas Storage & Transportation (+12%).
The virus that’s devastating global economic growth was just the latest in a long string of ugly blows for the U.S. oil patch. Energy companies were already getting hammered long before this happened, and the virus was just the final blow that put them over the barrel, so to speak.
Some of the challenges they’d already faced included booming crude production worldwide, growing competition from alternative sources of energy, long periods of tepid economic growth in key economies like Japan and Europe, and an industry that had built up heavy debt loads that made some analysts question their long-term financial viability.
In Q4, long before the pandemic began, Energy sector earnings fell more than 42% from a year earlier, according to research firm CFRA. For the full year 2019, they fell about 31%, the worst of any sector. The pain came as energy firms faced tough comparisons to 2018, a year when crude prices had been higher and a big corporate tax cut had helped grease the skids.
The Energy sector is arguably a victim of its own success. U.S. daily crude production hit a record 13 million barrels a day last year, up from around 5 million barrels a day a decade earlier. OPEC tightened its production over the last two years in an attempt to support prices, but that was having a limited impact up until coronavirus, with U.S. crude prices generally staying around the $50 to $60 a barrel range. That’s near the lowest levels of profitability for most U.S. producers.
Then the virus emerged right as Russia decided not to go along with more cuts. To punish Russia and maybe put more pressure on U.S. producers as well, Saudi Arabia loosened up the taps in March and threatened to pump oil at record high levels even as Russia added production. This one-two punch of unprecedented output right into the teeth of an economic collapse sent crude prices down below $20 by early this month, the lowest level since early 2002. On an inflation-adjusted basis, that put crude prices down near all-time lows.
It wasn’t too surprising to see Energy sector stocks get absolutely rocked in February and March, even after being the worst-performing sector of 2019. Just about all the major production, oil field service, and pipeline companies tanked in March and early April, though refineries did a bit better because low crude prices can help their margins. The problem is, few people need lots of gasoline right now—with usage back to 1968 levels. Having said that, we’re all still depending on trucks to get supplies to grocery stores as we hole up in our homes.
Earnings season arrives with arguably no end in sight to the coronavirus situation and some airlines are flying planes with no passengers. The cruise industry—another heavy energy user—is at a standstill and questionable how quickly it can recover even after the virus subsides. How many will want to celebrate the end of the coronavirus scare—when it comes—by booking a cruise? That industry, like energy, had also been struggling from highly publicized problems even before the virus.
Transportation might have more trouble cycling back up even when the economy starts to re-open. How long is it going to be before people feel comfortable in the middle seat of a plane, for instance?
At some point, you have to think crude can come back, because people will eventually drive to work again. Many will likely relish the day they can go back to the office, and that could push up demand. There’s also travel in terms of planes and ships, though some analysts say for the airline industry this is like Sept. 11 in terms of long-term impact. They reminded us that the airlines didn’t really get back to normal for a full year after the attacks.
You just have to wonder how many of the smaller energy firms will still be around to take advantage if and when things get back to normal. Shale producer Whiting Petroleum (WLL) filed for Chapter 11 bankruptcy earlier this month. Its stock had fallen from $30 a share to 31 cents a share over the last year.
Dallas Fed President Robert Kaplan, speaking on CNBC the day Trump made his tweet, cheered the Saudi Arabia/Russia news but also noted there’s still a massive supply weighing down the market, and that the U.S. oil patch could continue to struggle.
For what it’s worth, though spot crude oil fell below $20 in mid-April, the curve of futures prices shows a fairly steep contango, with prices for deferred delivery a good bit higher. For example, as of April 16, the December 2020 futures contract (/CLZ20) was trading above $34. That’s still a far cry from the mid-$50s—where prices were trading a couple months ago—but if the futures curve is a guide, the market is pricing in at least a partial recovery in short order.
Kaplan, whose Fed district includes the shale-rich Permian Basin of the southwestern U.S., said production there won’t be easy to turn back on if and when additional supplies are needed. It’s not the type of operation where you can flip a switch and have it immediately back at full steam.
Another element to keep in mind here is that with the 10 million barrels a day reduction, that basically cuts the anticipated daily oversupply to around 10 million barrels, from 20 million. This kind of overstock situation has never been seen, and it’s likely to overwhelm storage capacity. Tanker rates have been soaring as oil companies scurry to find places to put the excess crude, because it’s not possible to simply push a button and stop production on a dime.
U.S. production is expected to drop pretty fast, as the U.S is part of the agreement between OPEC and Russia. However, the U.S. oil industry isn’t state-controlled, so it’s hard to say how much and by when production will come down.
When it does, that could be a problem for oil service companies like Schlumberger (SLB) and Halliburton (HAL) because they’ll have less demand for their business. Baker Hughes (BKR) has reported several weeks of falling U.S. rig counts, and by early April the number of active oil drilling rigs was down to 504, from 833 a year earlier and the lowest in more than three years. It’s likely to move lower in weeks to come. Less drilling means less revenue, meaning Q2 could bring even worse results for this battered industry.
Energy as a sector actually rose about 8% in 2019, compared with nearly 29% for the S&P 500 Index (SPX). Energy has now been the worst-performing S&P sector for two years in a row and four of the last six. It did lead all sectors in 2016, however.
The question we used to hear on these calls was always, “Where are you drilling?” Now, the question is likely to be, “How long can it take for demand to recover once the crisis ends?” Veteran executives in the industry at some of the largest multinationals hopefully can provide some perspective, but, like all of us, they don’t have a crystal ball into this unprecedented crisis.
Companies might also be asked how quickly they can scale down and then scale up, whether it’s oil production or refining. They could be asked how they plan to maintain unused or little-used pipelines over the long haul, and whether they’re going to stop exploration for new supplies.
Another question emerging as the crisis continues is whether the biggest oil companies can continue paying dividends at current levels, or at all. Exxon Mobil’s (XOM) dividend yield, for instance, approached 9% by early April. The dividend at Chevron (CVX) was nearly 7%. Some analysts say these firms might have to divest assets to bring costs down, but that has the potential to shrink revenue, perhaps hitting the dividends.
ConocoPhillips (COP) has a lower yield, and also has a lot of exposure to the upstream market. However, COP has a larger downstream and chemicals business that might help protect it a bit from some of the crude market volatility if the economy can recover relatively quickly from this emergency.
Companies face tough choices. They’re not getting much cash flow at this point, but if they cut or end dividends, that could mean seeing their market values fall even further as investors run away. For now, any investor looking for yield should probably be very careful about investing in Energy companies, because the situation remains so uncertain.
In Q1, Energy firms in the SPX are expected to report a 51.5% decline in sector earnings growth, compared with just a 10% overall decline for all sectors in the SPX, according to research firm Fact Set. Earnings fell 42% for the Energy sector in Q4 compared with a slight rise for the S&P 500 overall.
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