Margin of Safety in Hydrocarbons
Factors putting a floor under hydrocarbons and ways to get exposure
First and foremost, thank you very much for reading Andermatt! If you like the work and would like to see constant improvement as Andermatt keeps publishing more content at higher rates, please be sure to subscribe and share the word!
1.) Margin of Safety | Factors Putting A Floor In Hydrocarbons
Global Energy Demand
WTI Crude Oil Curve
Financing Standards
Emission Scenarios - Demand Divergence
Lack of Demand Destruction
Demand (In)Elasticity
2.) 2 Plays To Get Exposure | Midstream & Deepwater Drilling
Energy Transfer (ET)
Transocean (RIG)
When it comes to investing in hydrocarbons, there is a very obvious bear case that is often used to tout all oil & gas companies as un-investable. Fears around stranded assets, ESG mandates, and green bonds are front and center when investors choose to divest capital from the space. Frankly, they may or may not be right on this after all, but we want to assess things on a probabilistic basis and reflect on why this could lead to highly reflexive moves. Some of these concerns are very justified and they are covered in Andermatt’s 1st research post.
If investing is the practice of optimizing returns for investors, though, then the first thing one ought to ask: what is the downside?
In this article, I will evaluate the various factors that provide a margin of safety for investors and which investments - with different features attached to them, - may lead to asymmetry in the space.
Margin of Safety | Factor Evaluation
Margin of Safety, Factor I | Global Energy Demand
When we think about the ways in which human civilization has evolved over the course of history, one fundamental aspect is energy. As western living standards have increased tremendously on the back of WWII, energy consumption quadrupled from the 1950 - 2000 (from ~102 million terajoules in 1950 to ~420 million terajoules in 2000)1.
Figure 1, Energy Usage/GDP | Global Primary Energy Demand | GDP Per Capita
Worldwide, this calculation still leaves 759 million people devoid of electricity and 2.6 billion people without access to clean cooking (WorldBank Data as of 2019)2. Furthermore, we have a global populous that’s 55% urbanized (as of 2018) and will be 68% urbanized by 20503. Living standards are only going to increase if energy production can follow.
While access to more efficient and renewable power sources is evolving simultaneously, this is the 1st tailwind behind investing in hydrocarbons; in order to increase participation in the economy, people will have to consume more hydrocarbons. The degree to which that is going to affect various sources of energy is also illustrated by the EIA’s OECD vs. non-OECD country comparison by source.
Figure 2, Primary Energy Consumption By Source [Oct. 2021]
This is the 1st and fairly high-level tailwind that provides a Margin of Safety when investing in hydrocarbons. Fossil fuels are more likely than not going to play a lesser role as a percentage of the overall energy mix, but they are 1.) part of the solution and 2.) likely staying around for longer than some may have thought.
In of itself, the terminal value calculation changes under that scenario (stranded asset discussion covered in Andermatt’s #1 writing.)
Margin of Safety, Factor II | WTI Crude Oil Curve
The WTI Crude Oil Curve is nothing more than an aggregate price expectation for a barrel of oil at different points in time in the future. As is illustrated in the graph below, near-term deliveries are valued at a much higher price than barrels that are scheduled further out (known as backwardation.)
This phenomenon occurs during a time where geopolitical tensions are as high as they’ve been in quite some time and the potential for a bifurcation between the world’s two largest economies is real (this is not a forecast, but merely an observation of current events.) Bifurcation, or at least a tendency towards it, comes with allies on both sides, which may be more beholden to one than they are to the other.
To return to the Crude Curve discussion, though, a backwardation has meaningful implications for producers that need to plan and serve demand in the years to come:
Long lead-time CAPEX projects are less likely to occur in an environment that’s coined by massive volatility
CAPEX budgeting happens under the assumption of what price is currently available upon completion of the project — those prices are substantially lower than spot
Producers with existing reservoirs that have remained unhedged are able to capitalize on high front-month prices
Figure 3, WTI Crude Oil Futures Curve [03-22-2022]
With oil trading at $110/bbl on the front-end of the curve, the first intuition would be that CAPEX becomes rampant and demand-supply imbalances are resolved quickly. That is not so. Oil executives across the industry have to look out on the curve and do the math with prices that are $30-$40 below front-month prices. Why? Capital projects take time to complete. In fact, using John B Hess’ , CEO of Hess, recent commentary at a Scotia Bank conference, we see that companies are budgeting $60-$65 per barrel oil.
If you believe that market prices of securities are a reflection of the forward assumptions managements provide, in and of itself, the current carry trade across the oil price curve provides a margin of safety. Under the scenario of finding a new equilibrium in prices - therefore leading to an upward shift across the curve, - cash flow expectations could increase substantially. On the contrary, a shift downward on the front end is going to have a lesser impact on the back-end contracts.
Unsurprisingly so, transitioning to a new form of energy on which a $80 trillion global GDP runs on turns out to be very tricky. More importantly, though, real commodities are characterized by supply-demand mismatches that lead to underlying price swings; unlike software, atoms aren’t re-programmed with an overnight fix. It is precisely because of the attributes we find with real commodities that re-pricing for longer is more likely.
Margin of Safety, Factor III | Financing Standards
Pressured by stakeholders, producers of hydrocarbons appear to be ahead of an economy that is simply not able to move to renewables at the pace we’d like to see. Logically so, hydrocarbon suppliers started to focus on returning value to shareholders and managing a world in which they will play a lesser role in the energy mix. As illuded to in Factor II, supply-demand mismatches have far wider implications in real commodities than they do in the world of bits (digital economy). Decisions can’t be reversed as easily as it takes time to explore, develop, and distribute fossil fuels to the end consumer. As decisions to be more financially disciplined occurred in the face of oil gluts in the past, the knock-on effects will inevitably become clear when demand outstrips supply — accompanied by an inability to turn on the spigots.
This week’s SEC reporting regulations announcement along with Swiss Re’s and ING Bank’s opposition to the fossil fuel space show that the possibility for a mismatch between growing demand and stagnating supply is increasing.
Now, one might turn to NOC (National Oil Companies) and private companies that aren’t under the same sort of scrutiny and therefore can turn to volume growth rather than purely focus on financial discipline. The problem: financing constraints that are increasingly relevant in this industry impact businesses across the board wanting to drill and distribute fossil fuels. Just at the end of last week, reinsurer Swiss RE’s annual report stated:
Swiss Re’s Asset Management is pursuing a 35% reduction in carbon intensity of its listed equity and corporate bond portfolio by 2025 and has achieved a decrease of 34% since 2018. On the underwriting side, tightened policies for providing re/insurance support to businesses with thermal coal, oil and gas exposure corroborate the firm’s push for making a real-world impact in driving sustainable business practices. The Group pushed ahead towards reaching net-zero emissions from own operations by 2030 and from investment and underwriting portfolios by 2050.
On March 23, 2022 Dutch bank ING followed with a statement on its new steps towards Net-Zero by 2050:
ING has worked hard over the years to build a power generation lending book that’s 60% renewables, outperforming by far the most ambitious climate goal of the Paris Agreement. Today we go a step further and announce that we aim to grow new financing of renewable energy by 50% by year-end 2025 and will no longer provide dedicated finance to new oil & gas fields. We’ll continue to support that, while increasing investments in renewables and gradually reducing funding to upstream oil & gas by 12% by 2025 and 19% by 2030. This puts us on track for minus 53% by 2040, in line with the IEA’s net-zero by 2050 roadmap.
Figure 4, ING Total Power Generation Lending [03-23-2022]
The dispersion between what stakeholders demand from banks and what oil companies see as a realistic assessment of the industry’s financing needs is substantial. For reference, oil company Hess on various CAPEX needs under different climate trajectories.
Figure 5, HESS Global Energy Demand
The bottom line around financing and its spillover effects into a lack of drilling:
Divergence between what stakeholders demand vs. what economic demand is going to look like.
Western banks continue to constitute the main pool of liquidity/lending. Almost irrespective of where drilling happens, a lack of access to financing retards the ability to serve rapidly growing energy needs outside the developed world.
Whoever has access to existing oil reserves and can explore new hydrocarbon reserves at low cost has a strategic advantage as its unlikely to see another oil rush (with that being said, higher prices are eventually the cure for high prices; Private oil and gas companies set to take center stage in North American upstream industry - IHS Markit)
Consolidated sub-industries within oil & gas that are willing and able to deleverage balance sheets can provide highly asymmetric outcomes for investors.
Margin of Safety, Factor IV | Emission Scenarios - Demand Divergence
The same dispersion between a normative world and what is actually happening is not only striking when it comes to CAPEX projections and the potential for underinvestment, but also when we turn to emission scenarios.
It is important to keep in mind that while policies are laid out for a Net-Zero/1.5°C pathway, energy consumption does not agree. In fact, CO₂ emission projections are off by up to 90%. McKinsey notes:
In the Accelerated Transition scenario, emissions by 2050 are 20 percent lower than in the Reference Case, reflecting a more rapid shift to renewable sources for power generation as well as an accelerated uptake of new, lower-carbon technologies in end-use segments, such as road transport and industry. However, Reference Case CO2 emissions, and even Accelerated Transition emissions, remain far from the 1.5ºC Pathway. CO2 emissions by 2050 need to drop by 90 and 85 percent versus projected levels, respectively, to comply with the requirements for the 1.5ºC Pathway. In fact, CO2 emissions need to show an annual decrease similar to the drop in 2020 for the next 30 years to reach the target by 2050.
Figure 6, McKinsey on CO₂ Emissions
The gap in emissions ultimately affects the degree to which E&D investment from the corporate side - as a result of new “contracts” with shareholders as well as a lack of lending, - is misaligned with future energy needs.
Whether we like it or not, the world runs on hydrocarbons and global energy demand will continue to increase one way or another. In order to cover demand in a world that is increasingly driven by the energy consumption of developing economies, fossil fuels will have to be a part of the solution. As was noted in Andermatt’s #1 article, it was natural gas that halved U.S. emissions amidst a transition from coal to nat. gas. Similarly, the world as a whole will need to integrate hydrocarbon reserves in order to decrease emissions over the long term.
Figure 7, McKinsey Primary Energy Demand Per Fossil Fuel
Similar to prior factors, the goal to decrease emissions is more likely than not only realistic when viewed from a “fossil-integration perspective”. This becomes extremely obvious when we turn to Europe’s energy security crisis and the ways in which past decisions are now constraining economy and industry.
If the world wants to agree and set common standards for emissions that work for most, we will have to integrate natural gas into the solutions framework for lower emissions. Emission scenarios are therefore the 4th factor providing a margin of safety and a much longer runway for oil & gas than many would have thought.
Margin of Safety, Factor V | Demand Destruction (Or Lack Thereof)
What usually permeates around when energy prices go up is: the cure for high prices is high prices (the quiet part out load: if producers are willing & able to fill the gap.)
Indeed, only if producers can step in prices can correct. That may be much more complex this time around. 1.) We do not have a stable swing producer and 2.) As outlined in factors I - IV, hydrocarbon suppliers are not viewed as part of the solution yet.
As supplies remain subdued and below pre-Covid levels - turn to the lag between investment and developed acreage in research post #1 - prices rise and global economies ask themselves: what can we do to alleviate price pressures from the consumer?
The answer from a variety of policy makers seems to revolve around demand subsidies, which are going to spur demand and prolong the process of demand destruction despite high prices.
EU ETS Distribution | BNEF
Under the EU Emissions Trading System (EU ETS) Directive, member states can use revenues from the sale of carbon allowances to shield electricity-intensive industries from indirect emission costs that pass through power prices. The indirect cost compensation program was designed to help ensure that industrial companies operation in the EU are not penalized by higher carbon costs than their international rivals.
Competition between countries for ever increasing energy prices can lead to an acceleration in the price discovery on the upside and leave many economically impaired from allocating more $s to energy.
Despite efforts to cut back on energy consumption - A 10-Point Plan to Cut Oil Use - tax reductions on energy are well underway.
Combined with the years it takes to bring back production, we may be in for a cycle of outbidding between countries and a realization that hydrocarbons will need to be part of the energy mix for much longer.
Only when the realization around the importance of oil & gas kicks in to a full extent are we likely going to see similar announcements to the one Saudi Aramco just made.
Figure 8, Saudi Aramco CAPEX/Production [March 21,2022]
With that in mind, oil projects are not easy to restart and it again goes back to the argument around the world of atoms vs. bits.
Until then, we are likely going to see major competition amongst geographics as they try to secure fossil fuel supplies.
Margin of Safety, Factor VI | Demand Inelasticity
Unlike luxury goods, demand for fossil fuels is inelastic. That means that even in the face of high prices, demand destruction may be ways away. If the economy wants to stay alive, truckers will continue to use gasoline, jets will proceed with jet fuel, and electricity will continue to come from nat. gas power plants.
A study done by the IEA in 2006 shines light on the degree to which demand is price inelastic.
Figure9, IEA Price and Income Elasticity of Oil Demand
Possibly, even more relevant is the demographic dynamic pointed to in Factor I. As income increases outside OECD countries, so does demand for oil.
Another important piece of evidence comes from a study conducted by the EIA that looks at the impact of demand on supply.
Figure 10, EIA Elasticity Study
Bottom line:
Global demand cannot shift oil supply curve
Supply shocks have economically modest effects on global activity
This is not to say that the findings translate 1:1 to the current situation, but they do make clear that a lack of supply may not have the same demand destruction affect many are hoping for.
2 Plays To Get Exposure | Midstream & Deepwater Drilling
Now that the factors that introduce a great degree of margin of safety to investing in hydrocarbons are laid out, let’s turn to two specific examples that may give you various degrees of asymmetry when investing in the space. This is the first post on introducing specific energy investments (announcements to follow.)
Energy Transfer (ET; Bloomberg Description)
Energy Transfer LP owns and operates a portfolio of energy assets. The Company engages in the operations such as transportation, storage and terminalling, crude oil, NGLs, refined products, and liquid natural gas.
Energy Transfer LP transfers natural gas and other energy resources through its massive network of US-based pipelines. The primary activities in which the company is engaged, which are in the US and Canada, and the operating subsidiaries through which it conducts those activities are natural gas midstream and intrastate transportation and storage, crude oil, NGL and refined products transportation, terminalling services and acquisition and market activities, as well as NGL storage and fractionation services.
Transocean (RIG, Bloomberg Description)
Transocean Ltd. is an offshore drilling contractor. The company owns and operates mobile drilling units, inland drilling barges, and other assets utilized in the support of offshore drilling activities worldwide. Transocean specializes in technically demanding segments of the offshore drilling business, including deepwater and harsh environment drilling services.
It operates in the world’s major offshore oil-producing regions, including Africa, Asia, Brazil, Canada, India, the Middle East, the Gulf of Mexico, and the North Sea. The company has a fleet of 138 mobile offshore drilling units (72 semisubmersibles and drillships, 63 jackup rigs, and three other rigs). Transocean’s other operations include management of third-party drilling services. Major customers include BP and Chevron.
Energy Transfer | The Pipeline Fee Business
As a midstream operator, Energy Transfer runs on predominantly fee-based contracts that allow for re-negotiation after contract expiry. That doesn’t only make the company less prone to inflation/input-cost pressures, but also gives ET pricing power in areas it has unique access to.
Figure 11, Energy Transfer Fee-Based Contracts
In addition to its fee structure, Energy Transfer is rapidly expanding its exposure to natural gas, which is a commodity of geo-strategic importance in the face of geopolitical realignment across the globe. In short: ET has a massive tailwind behind its back that doesn’t only make its cash flows highly predictable but also more sustainable in the decades to come.
Figure 12, Energy Transfer Natural Gas Exposure | Revenue Breakdown
After a time of drought for oil & gas at large, Energy Transfer’s free cash flow as well as ROIC/WACC ratio are increasing rapidly. As the business model becomes part of the global energy transformation solution, expect that trend to continue.
Figure 13, Energy Transfer Free Cash Flow, ROIC, WACC
An additional factor not talked about as often is the fact that the barriers to entry are substantial. Given midstream’s asset intensity, Energy Transfer’s existing projects are positioned with a substantial moat embedded in them.
Transocean | An Oligopoly Industry
Anyone who takes a look at Transocean’s stock price over the past decade and beyond realizes that deepwater drilling has been an extremely troubled industry. Levered balance sheets forced most offshore drillers into bankruptcy and left the ones still standing highly levered. On a bumpy path to increased capital discipline, we note 1.) our Margin of Safety factors and 2.) the relative friendliness of the CDS market towards Transocean’s bankruptcy risk in the recent past.
This is not to say that Transocean is out of the woods, yet, but when and if they are able to manage a recovery from extreme stress, the asymmetric outcome will have been substantial.
Figure 14, Transocean CDS
An overly levered balance sheet is a blessing and a curse at the same time in this case. Investors do have the opportunity to bet on what may result in a highly asymmetric outcome if the company is able to refinance its debt amidst rising hydrocarbon prices.
Figure 15, Transocean Debt Structure
Transocean’s metrics are recovering from a very low base; it is precisely because consensus prices in past metrics that substantially favorable outcomes are possible.
Figure 16, Transocean FCF, ROIC, WACC
The last factor to mention is the vast degree of consolidation in the offshore drilling industry. The probabilities are clearly in favor of policy makers addressing what could become a much worse energy crisis globally; it is a question of how able Transocean will prove to re-finance its debt before the company can take advantage of oligopoly market characteristics.
Figure 17, Offshore Drilling Quarterly Industry Revenue | Industry/Company Rev. Breakdown
Figure 18, Transocean Path Towards De-Leveraging The Balance Sheet
Conclusion
These are two different investments with very different characteristics. This is NOT INVESTMENT ADVICE.
In the next writing, we will explore some of the opportunities in more detail and look at opportunities to play this market from an asymmetric perspective. Despite the massive run that energy markets have had over the recent past, companies like Transocean make it clear that there are still businesses that are on the path towards recovery and face major hurdles that consensus isn’t comfortable with. Only if we are able to identify opportunities that come with those characteristics does consensus have room to catch up with the economic realities that are bound to set in amidst a global energy security emergency.
Please don’t hesitate to reach out (andermatt.research@gmail.com) and please be sure to subscribe to this newsletter — I appreciate every singe one of you!
More announcements about future research articles are going to follow in the coming days.
Until next time,
Andermatt Research
Eddy, James, et al. “Five Key Questions Clients Ask about Our Energy Demand Outlook to 2050.” McKinsey & Company, McKinsey & Company, 27 Mar. 2019, https://www.mckinsey.com/industries/oil-and-gas/our-insights/five-key-questions-clients-ask-about-our-energy-demand-outlook-to-2050.
World Bank Group. “Report: Universal Access to Sustainable Energy Will Remain Elusive without Addressing Inequalities.” World Bank, World Bank Group, 4 June 2021, https://www.worldbank.org/en/news/press-release/2021/06/07/report-universal-access-to-sustainable-energy-will-remain-elusive-without-addressing-inequalities.
“68% Of the World Population Projected to Live in Urban Areas by 2050, Says Un | UN Desa Department of Economic and Social Affairs.” United Nations, United Nations, https://www.un.org/development/desa/en/news/population/2018-revision-of-world-urbanization-prospects.html.