European oil majors bottomed on March 18, whereas Brent oil prices kept making lower and lower lows until April 1. As the rest of the energy sector got smashed, including leveraged U.S. shale and larger cap U.S. oil majors, European oil majors like Royal Dutch Shell (RDS.B) , Total (TOT) , Equinor (EQNR) , and ENI (E) kept getting bid higher and higher for two weeks consistently.
Something did not add up, as these stocks viciously rallied 60%-80% when Brent oil was down 50%+. Not only were the fundamentals not making sense, but cross asset arbitrage was also out of sync. After years of being in perennial decline, oil majors have just never been able to see higher earnings or stock prices regardless of higher oil prices given their lack of leverage and declining profit margins. Other than their fixed income properties yielding them 5% dividend yield, they have had zero appeal to anyone in the energy universe as the real bang for your buck was always in oil services or selective shale plays, refiners and other proper profitable businesses. The oil majors never even outperformed the market. But what has changed today?
Today, according to the Wall Street Journal, the Saudi Sovereign Wealth Fund just announced that they have acquired $1 billion worth of shares in the above-mentioned European oil majors. BOOM! That explains the massive outperformance.
Ironically (or shall I say coincidentally) enough, all this talk of a potential oil cut started exactly last Friday April 3, when President Trump tweets out of the blue that he had a call with Saudi Arabia and that they will cut about 10-15 million barrels. Trump did not even get the units right as the world wondered if he meant 10-15 million barrels per day or just million barrels. The former represented about 50% combined production between both Saudi and Russia, and a number very hard to fathom by themselves.
Low and behold, they announced an emergency meeting over the weekend and they are trying to engineer a cut of 10 million barrels per day mpbd as we speak. The oil price is now up 40% in the last week and Sovereign Wealth Fund is sitting on profits close to $500 million. Slam and dunk people! Now that is a job well done.
Over the past two decades, strategies have emerged to “beat” the market, provide “alpha” to clients, concocting super smart and technically driven price calculations to find where the discrepancies are and to offer that product to investors to help manage their money. It seems the best hedge fund in the world is actually investing in government entities.
Since the Global Financial Crisis of 2008 and the Fed’s rampant Quantitative Easing, it was always known that the system is rigged. At times of stress, the government comes in to bail their favourite entities, like U.S. banks and companies, but invests in them beforehand to capture the upside as well as being part of the regulation that can change the law.
As part of the Fed-assisted coronavirus stimulus measures, the banks are being offered money at risk-free 0%, but allowed to lend it out at 1%-1.5%, which makes it a no brainer to put collateral of their Treasuries with the Fed only to use that cash and lend it back out — reverse repos. One wonders whether it is right for a government and its entities be allowed to invest (directly or indirectly) in the same thing when the former controls the price and latter the investment?
In the case of oil, it is a mystery. Let’s outlines facts. On March 6, Saudi Arabia decides to break off the old OPEC + alliance and flood the market with 3 mbpd of extra oil, causing the oil price to collapse a further 50%. This was after the oil price was already down 25% after the coronavirus demand shock starting from China. Asset prices and oil price collapsed 60% in March. On March 18, European oil majors started defying their sector trends and rallied close to 70% on average (we now know Saudi Sovereign Wealth Fund was buying). On April 3, two weeks later, Saudi Arabia announce that the oil price war is over and that they are close to announcing a 14% cut to global supply to “support” the price, causing the oil price to rally 40%. At the risk of sounding a conspiracy theorist, it seems way beyond my pay grade to understand or legitimize, but can only offer facts.
We are now about to enter Q1 2020 earnings for all companies, including the oil majors. Given marked-to-market commodity prices, refining margins cratered, collapsing gas prices, it is no rocket science that these oil stocks will be reporting in excess of 30%-40% earnings declines. Most of the oil majors have higher oil breakeven costs closer to $55/bbl Brent to balance their spending, cash and dividends.
With the sudden collapse in oil prices and oil demand grounding to an almost halt as 25-30 mbpd of oil demand is lost during this lockdown, it is only fair to see these same companies announce budget capex cuts of 20%-30% to protect their balance sheets. The same was seen in 2014 and the same is being seen now. Companies will put a hold on their generous share buyback plans and dividends util the situation in oil settles down, which may even cause them to lose their fixed income appeal.
As OPEC convenes later this afternoon to announce the infamous oil cut of around 10 mbpd, the point in contention is the level at which to start off that calculation — the recent production level or the average of Q1 2020. That changes a lot of things, as clearly Saudi Arabia only flooded the market with an extra 3 mbpd in March, so their starting point is higher. Even if a deal is announced, global oil markets have in excess of 15-20 mbpd for the next two months as global economies remain in lockdown.
There is a lot of optimism about what will happen after the lockdown, as most expect demand to come screaming back like in Jan 2020, but the world and its behaviour has changed. Until and unless a vaccine is developed, demand will not fully return as governments and businesses have a lot of damage to repair and will think twice about starting too soon. But what if the virus is not contained, and lockdown lasts for longer?
Commodity markets are dictated by demand and supply. We all know the physical market and curve dynamics suggest there is just too much oil and not enough storage capacity, hence the involuntary shut-ins. But for the prices to recover fully, we need to see a period of lower prices and well shut-ins to clean off all that excess inventory until demand can fully catch up. The price may have rallied from $23/bbl to $34/bbl, but its fate is far from clear.
An oil major is priced off its commodity, its top-line revenue driver. No matter what games governments and central banks play, at the end of the day, earnings will be coming down for these oil majors. And when they do, are you really willing to pay a 20x-plus P/E multiple for these European oil majors that just do not and cannot grow?
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