When I look back on 2016, what were the Big Themes? For me, the #1 theme was the same as 2015–Nobody Knows where the oil price was going. We all guessed how much US production would drop (Market was about right), how tight credit would be (much looser than expected), how and when OPEC might cut production (it took a whole year but they did it) etc etc etc..
Had OPEC not come to an agreement in November, oil would be mid-40s now and everybody’s energy portfolio would not be looking so good. The depth of global inventory draw down before this OPEC cut was painfully slow.
The lesson—Be Flexible. There is lots of economic hydrocarbons in the world. We will likely never be short energy in the near to medium term…so be on the lookout for the lowest cost producers (generally the companies with the fastest well payouts).
Another theme was that management teams continued to drill marginal wells that lose money–which to me is anything under 75% but certainly under 60% IRR. Junior producers for sure cannot grow production within cash flow under 60% IRRs, and even the intermediate producers were willing to put growth ahead of returns on capital. It just kills me to see producers bragging about a huge inventory of 50% IRR wells. Those are dilutive, value-destroying wells. It means more debt or more equity is coming.
In one sense, who can blame them? I mean, they did find investors to fund that craziness. But in the long run, drilling wells under 60-75% IRRs is a Ponzi Scheme, and destroys shareholder value.
Looking back, another theme was that trading technically worked really well–The Energy Charts were actually pretty good this year. What I mean by that is, you could have invested in energy stocks based on the charts—the charts of US and Canadian energy ETFs–XLE and XEG–both said energy was a safe place to invest from the February trough onwards. And they were right. If I would have just put my brain in Park and stopped agonizing about where oil was going and just bought the charts–I would have made a lot more money a lot more peacefully.
The Trends I Called Right
Ethanol—that margins and valuations would continually increase. And that happened. Margins improved steadily through the year, as low oil prices spurred domestic demand for gasoline. The real kicker was exports to China, which helped absorb some extra capacity. Even though ethanol production steadily rose through the year, inventories declined as China increased their US ethanol imports dramatically. US ethanol is the cheapest octane on the planet. We all thought President-elect Trump would be bad for the ethanol market, but once he saw that all the ethanol counties voted for him…I think ethanol will be ok
The Permian Bubble—the Permian was the last major oil play in North America to go horizontal—but once it did, WOW. Everything came together for the Permian this year–producers figured out they could get oil from as many as 11 zones. Parsley Energy said they thought they could spud 96 horizontals in one square mile through those 11 zones!!
The trend toward using more sand, and finer sand, in their completions (fracking) continually increased production per thousand feet of lateral. Then laterals got longer—7500 – 10,000 feet is now normal where land positions allow it. I saw flow rates as high as 400 boepd per 1000 feet in the Permian (Resolute Energy’s latest). 2016 was a perfect storm for the Permian.
As the Permian went horizontal, it became very clear—with regular results over 3000 boepd from companies—that this play could pay out wells in just 7-9 months at $45 oil. The Permian was a smoldering fire and the Resolute results were the oxygen to make it explode into investor consciousness as The Place To Be, and the Saviour of Energy Services in the US.
The Big Trend I Called Wrong
Canadian Natgas stocks would be under real pressure all year with low AECO (the Canadian benchmark pricing, the Cdn equivalent of NYMEX) pricing.
But the Canadian natgas stocks traded more off of US natgas stocks (and therefore NYMEX Henry Hub pricing) than AECO. AECO had bearish fundamentals all year—really high storage levels, increasing production, producers in a fight with TransCanada on their mainline tolls to ship natgas back east…so I didn’t buy the junior leaders, the strong growth stories–like Painted Pony. It only went from $3-$11 without me.
That also meant I ignored the leading Montney stocks–like Paramount (POU-TSX), Seven Generations (VII-TSX) which had fantastic years–POU was up 500% off the bottom at year end. But for the most part, all energy stocks rebounded strongly out of the February low through to June and then treaded water until the OPEC cuts.
Natgas stocks were not about natgas pricing in 2016; they were about lowering costs through higher production from better fracking (longer wells, (LOTS) more sand, tighter spacing).
The service sector had much choppier charts, and only started getting some sustained love early-mid Q4.
The other point for me to make is that I don’t add much to these mainstream stocks unless I see something compelling, as the sector is so well covered; it really is over-analyzed. I like shining my flashlight in the dark corners of the energy market to find different kinds of stocks.
Where Did I Get (Abnormally) Lucky
Approach Resources—anytime I invest far down market in quality (which is really saying they’re higher up the cost curve), you are counting on rising commodity prices. On this trade I had two other things going for me—fast rising excitement in the Permian—The Permian Bubble was just getting underway; and a Big Short Position.
My #1 reason for buying the stock was getting in front of the Permian Bubble that I saw coming—and understanding that once The Street saw it, they would rush in and buy every old, high-cost producer that once traded at much higher levels.
Once that rush started…well, there was a massive short position against the stock…it all combined to make this high-cost producer double in just over a month. And I sold it there. Luckily I bought $60,000 worth!
Possible 2017 Themes
Service Companies Operating in the Permian—The Trump election win moved the balance of power, IMHO, from the producer to the service company. What I mean by that is—investors don’t know if OPEC cuts hold, or what the price of oil will be. But investors do know that all these producers will use all the liquidity they can to drill baby drill.
Natgas Volatility—it’s all about winter weather. Natgas moves 10% now on whatever the latest far ranging weather forecast is. Demand has already been 25 bcf/d more in early winter than it was last year. Structurally, US natgas production is down 3-4 bcf/d, but has a big cushion in high inventories.
Before shale gas really started growing in 2009, there was a real possibility that North America could be short gas. That is not the case anymore. Whatever demand is, shales from the Montney to the Marcellus can meet it—once infrastructure is approved. And even then–for only an undetermined period of time.
But certainly in the short to medium term, any supply shortage will be very short lived—especially under a Trump administration that also has a Republican House, Senate, and most of the States’ governors.
After winter ends, higher gas prices are all about demand, especially Mexican and LNG export demand. RBN Energy made this point in their #1 Prognostication for 2017:
“And the #1 Prognostication for 2017 is…….
- Natural gas, particularly wet natural gas, will be a more attractive market than crude oil. If you buy our Prognostications about crude, gas and NGLs, this is where you land. The crude market will muddle along at prices that average somewhat higher than 2016, but no big recovery. The forward curve for natural gas is mispriced—too low given the coming surge in demand from LNG and Mexico exports. And NGL prices will be increasing more than both oil and gas, due to the ramp-up in ethane petrochemical demand and ethane exports. Put all that together and you get a rosier outlook for gas than crude, and an even rosier forward view for wet gas that will be the source for all those NGLs.”
CEO Rusty Braziel and his team have a great track record and are not to be underestimated. I’m a little less bullish than Rusty; I expect increasing supply should come on quickly now that the gas rig count is at 135, up from 81 off the bottom. Technology and understanding logistics better (more sand, longer laterals, downspacing) means that each new rig brings on a lot more natgas than ever before.
And there is another 4+ bcf/d of new pipelines coming out of the Marcellus and into service in 2017. That’s a lot of low cost gas; the differentials in the Marcellus have already dropped a lot (lower diffs=higher prices; closer to Louisiana pricing).
I don’t see natgas being a disaster in 2017, but I see oil stocks making me more money than natgas stocks in 2017.
OIL in 2017
Fundamentally, the 2017 oil price is all about OPEC cuts. Without significant cutbacks, global inventories come down VERY slowly–I think oil would be capped in the low $50s/barrel, and realistically lower. But optimism is high and the Gulf States are making sure the world knows they are already cutting production…so I think high 50s are realistic with a spike or two into the 60s this year.
There is precious little spare capacity in the world today, so I think any Black Swan event for oil will be bullish–some MidEast tension or terrorism in an oil field. The good news for shale producers is that the Saudis are really hurting; I think they will be willing to cut more than anyone thinks…and then maybe pull the rug out again for a month or two maybe to keep the funders of NOPEC (the Shale Lenders) honest.
Technically, the charts of oil and oil stocks say–own as much oil as you can stomach.
The only other thing I would say for 2017 is that service costs MUST come up, potentially a lot in 2017 and 2018. Not only did service companies not make any money the last two years, but so much of the technical labour has gone. Roughnecks aren’t just dumb hulky men; most of these rigs require highly technical people on the job 24/7. Tens of thousands of those people are GONE, and who knows if they come back to this volatile sector–and at what price.
LNG in 2017
The Asian LNG price is back up to $8-$9/mmbtu. If oil can stay in the $50s, that will help LNG a lot. I see an increasing number of FSRUs—floating import terminals—in 2017, but FLNGs—Floating Export Terminals—won’t be a Big Story for at least a couple years, and realistically 2020 before there is a critical mass of them to convince investors to pay up for 25 years of cash flow.
In Canada, I think you see Petronas NOT be the first big project to go ahead, but that first group won’t say yes until mid-late 2018. LNG is completely dead in Canada if the NDP (the leftist party in Canada) wins the BC election in May, but that is highly unlikely.
LASTLY…a couple things keep me a bit nervous…
- The first year of the presidential cycle is rarely a good one for stocks
- The market is already extended since the election
- Interest rates will come up… I just don’t know how quickly
Regardless, in 2017, I will continue to look for
a) low-float stocks with
b) a business edge that’s
c) underfollowed or
d) has a large or under-appreciated catalyst looming.
That’s what I do.
EDITORS NOTE: Want to know an underfollowed Oilfield Services play in the Permian–one with the most leverage of any company I see there? They have at least major FOUR catalysts to announce in 2017, and I expect the Market to reward this stock for each one. CLICK HERE for the name and symbol for this Permian winner!