Eric Nuttall: Fear grips energy markets, but facts suggest oil fundamentals are still going strong

Despite the growing talk of a recession, there are no signs of weak demand globally.

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Fear can be an investor’s worst enemy. It can induce inaction, cloud judgment, degrade conviction and, at worst, lead to panic and capitulation. Over the past two weeks, energy stocks have fallen sharply, some as much as 30% or more, resulting in the worst price drop since March 2020, when WTI oil plunged by more than half to $20. due to the COVID-19 outbreak. .

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Today, WTI oil is trading comfortably above $100. So why the panic? Soaring global inflation and rising interest rates to combat it have significantly increased fears of an impending recession and subsequent weakness in oil demand. Do recessions necessarily mean falling demand, and if so, what does it mean for the price of oil and energy stocks?

To start with, let’s be clear: today, we categorically see no signs of weakness in demand globally. There are two real-time measures we use to assess demand: time spreads (the premium paid for barrels today versus a later date) and global oil inventory levels relative to average levels. If oil demand were weakening, we would see it in both indicators, and instead of weakness, the premium paid for immediate barrels has been rising since May, while the global inventory shortfall at normal levels continues to widen to record levels. .

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Interestingly, as panic mounts, both of these signs suggest that oil fundamentals are strengthening further and therefore any fears of weak oil demand should be related not to what is, but rather to what. What can be.

FEAR can sometimes appropriately mean “false evidence that looks real” and I think this is the case today. A modest pullback in oil and the outright drop in energy stocks have reinforced the belief that oil demand is collapsing or will collapse soon, and price weakness has spawned further price weakness, with equities caught in a negative feedback loop. We saw a very similar pattern in March 2020 when uncertainty was at its highest and despite oil still trading above $100 WTI, to me the panic in the market last week was close to what it felt like in the early days of the COVID outbreak. What is the best antidote against panic and FEAR? Facts.

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Historically, periods of global oil demand contraction are very rare and correspond only to the most severe economic contractions, namely the 2020 COVID demand shock and the 2008/09 global financial crisis. In other times, when certain countries or continents entered a recession, such as the United States in the 1980s and 1990s, while the growth rate of oil demand slowed down, it still remained positive. The recency bias, then, may be inflaming demand fears, obfuscating the fact that the price of oil is not only dictated by demand, but also by supply. With the impending depletion of OPEC’s spare capacity, projected output growth stagnating by the global super-majors through the end of the decade, short-cycle U.S. shale growth constrained by shareholder returns demands and continued shortages of labor and steel, and the potential decline of the Russia due to sanctions and exodus of E&P and service companies, we believe that any moderation in demand growth will be more than offset by the challenges of production growth.

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We are not alone in that opinion. Energy Aspects, a globally respected energy research firm, despite forecasting a recession in both the United States and Europe next year, estimates that global inventories will fall by 300,000 barrels per day in 2023, due to the challenges supply mentioned above. Cornerstone Analytics, another company whose work we highly respect, similarly forecasts that inventories will continue to fall sharply even if demand weakens due to a recession.

What if we are wrong and indeed the demand falls more than expected? With current inventories so low relative to normal, even a delta of one million barrels per day would have to persist for almost a year for OECD inventories to reach normal levels.

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Another insurance policy is that OPEC now has a proven playbook to use at a time when the market is significantly out of balance, and with oil prices just now back at levels that allow most OPEC members to remain concerned, if demand weakens, we would. he expects OPEC to be highly responsive to supply cuts.

What about energy stocks? We estimate that most Canadian energy stocks, especially the smaller ones, are pricing in a WTI oil price of about $50-$55. Cutting nearly a third from the current price to $70 would mean energy stocks remain profoundly underpriced, trading on average at a free cash flow return of 17 percent, with most companies promising 75 percent. or more of the free cash flow to go. for shareholder returns, this bodes well for a 12 percent dividend yield, even in a very bearish oil price scenario.

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What if we’re right and $100 WTI serves as the bottom line for the next four to six years or more? With WTI at $100, we estimate that the average Canadian energy stock trades with a free cash flow yield of 31 percent, can be taken private and debt-free with just 3.1 years of free cash flow, and has a enterprise value to cash flow ratio of 2.1x: a two-thirds discount to historical averages.

With the sector approaching “debt-free” status by the first quarter of next year and firmly committed to returning most of the excess free cash flow to shareholders, investors should take comfort in knowing that while equities have been painfully corrected in recent weeks, the only thing that hasn’t diminished is the massive amount of free cash flow pouring into the bank accounts of energy companies on a daily basis, which will soon become more visible with the reports second trimester in several weeks.

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As in 2020, this too shall pass. It’s mind boggling for me to have to talk about panic and fear with oil trading comfortably above $100, corporate balance sheets in stellar shape and what I think are imminent returns for investors, but here we are.

Don’t succumb to the fear of the moment. Tune out the noise and focus on what matters: Supply growth will be structurally challenged in the coming years and, in our view, will outweigh any temporary weakness in demand resulting from a recession. We remain bullish.

Eric Nuttall is a Partner and Senior Portfolio Manager at Ninepoint Partners LP.
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