Shift to positive stock-bond correlation could increase risk, reduce returns
Noah Weisberger, Managing Director, PGIM IAS and Amanda White, director of institutional content at Conexus Financial talk returns in a volatile market.
The world is experiencing the results of an underinvestment in traditional oil/gas energy infrastructure which was compounded by Covid- 19, when some companies believed that peak oil demand had arrived pulling back even more on investment, then came the Russian invasion of Ukraine, and the disruption is overlaid with the longer-term focus on energy transition. We look at both sides of the demand and supply puzzle.
>> Welcome to Insights for Outcomes. I'm Julia Newbould, Managing Editor at Conexus Financial, owner of Investment Magazine. Today, it's my pleasure to be talking about navigating the disruption in energy markets. I'm joined by David Winans, who is a Principal and Credit Analyst for PGIM Fixed Income', US investment grade credit research teams. Specifically, David covers the US and non-US energy sectors for PGIM and is an energy sector specialist, having covered the sector since 2003. This year has probably been more affected by disruption than anyone had anticipated, and we're not sure where this will end, so I'm sure you will all agree that it's a fascinating time to be looking at the energy sector, and I'm thrilled to be joined by David today. Welcome, David, how are things for you?
>> Thank you so much. It's great to be here. Hopefully, I can visit Australia someday.
>> We hope so.
>> Yeah.
>> So David, we've got a lot of things converging to create the complexity we're seeing in the global energy markets, oil markets recovering from COVID-related meltdown, the impacts of Russia's invasion of Ukraine on the global energy industry, and the longer term focus of the energy transition, so let's look at them piece by piece, and both sides also of the demand and supply puzzle. Firstly, with regards to COVID in the supply side of the equation, can you please talk us through the impact on energy markets over the past couple of years and how you see that playing out, regardless of where we are with the geopolitical impacts of Russia?
>> Okay. Well, I mean, we kind of got to step back and take a little bit of a history lesson here. All right? So, you know, everyone should kind of realize, you know, what happened here in the United States, you know, starting, I guess, maybe about 2006 and then onward for the next decade, the so called shale revolution, where, you know, US oil production, just basically, you know, skyrocketed, went hockey stick and to the right, okay? That went on for, you know, good, you know, 8 to 10 years, and during that period of time, the energy industry in the United States was aces. They were awesome at finding and producing, you know, oil, out of these type shale formations, companies like EOG and, you, what used to be XTO energy, you know, Devon Energy, a lot of these independents. I mean, finding -- you know, getting oil was not a problem, but during that whole period of time that I covered the industry, you know, most of these companies, they didn't trend a lot of free cash flow. There wasn't a lot of great returns. Right? So it was kind of explained to me, like, you know, the investment thesis for that period of time, I had one company management team tell me. I'm like -- and you ask him, like, where's the cash returns here? Where, you know, where's the payback for the shareholders? And it was explained to me, you know, we're following a commodity-plus model. That's the investment thesis. And what that meant, was, rather than go out and buy a barrel of oil, just speculate on one barrel of oil, if I bought an upstream EMP company, if I bought this company, I could get the oil they had, plus the prospect that they could produce more oil, so I get next year, one and a quarter barrel of oil, one and a half barrel of oil, okay, so it was a commodity-plus type investment thesis. Okay? The problem with that was these companies are all trying to grow at, you know, 8%, 10%, 15%, oil production growth. They're all trying to generate all this growth. At the same time, you know, oil demand globally was growing, but it's growing like 2% or 3% a year, so it was inevitable that you end up in a situation where you get into some kind of an oversupply, all right? And, you know, that's what happened back in, you know, at the end of 2014. Finally, you got into kind of a glut situation where there -- you know, the shell guys just basically drilled themselves, you know, just -- they just -- any kind of rally in the price, they just drilled into it. And returns for the sector, if you were an investor in the sector during that period of time, the returns were not good. Okay? So fast forward now. You get into about, you know, 2016, 2017, 2018. You know, investors in the United States, they were frustrated, you know? The returns hadn't been there. If I'd went out and bought a, you know, a tech stock, I'd have done way, way, way better, right, way better than buying one of these oil companies, all right? So they finally started to get the joke that commodity-plus, especially in a world where you think that, you know, oil demand is going to be less in 20 years or 10 years, why do I need to keep drilling production at, you know, double digits, okay? They finally got the joke that, "Hey, we need to focus on cash returns to investors. We need to focus on metrics where we can comp and, you know, show people money like every other company in the Standard & Poor's 500. Okay? So they became much more disciplined, much more disciplined, and you didn't see like, in 2018 2019, companies weren't going out anymore, putting out like, "Hey, we're going to grow 15%," you know? The new mantra was, okay, we're going to grow 0% to 5%. We're not emphasizing growth. It's all going to be -- you know, any dollar we get, it's going to go to the balance sheet, we're going to go to shareholders, we're going to be disciplined. So what you saw in 2019 is a market -- before COVID even hit, the market, oil market gradually started to tighten up. Okay? Things were kind of starting to get tight. You know, oil, Brent, was higher than 60 bucks a barrel all through 2019. Okay? And, you know, by December 2019, things are starting to feel pretty good in, you know, in the oil patch. Companies were being disciplined. You know, the returns were starting to come through. You were starting to see free cash flow. You know, I put 60 bucks into my model. Hey, this looks okay, you know? Maybe we're finally starting to get somewhere. Then COVID hit and, you know, everything just gets completely whammy. Now, these companies that are already being disciplined, they went out, negative $23-a-barrel WTI. I said at the time, this was like oil passing a kidney stone. All right? It was obviously a temporary thing, you know? It was, you know, it was negative 20. It was negative, you know, [inaudible] Cushing, Oklahoma, because of, you know, finance. That was a financial anomaly, but still, that scared the crap out of a lot of management teams, right? That's really scary. So what did they do? They went out and they cap x to the pole. Right? Any kind of -- anything they could cut, any rig they could drop, it was -- I mean, they just cut it. And these wells, the shale wells, if I don't keep drilling, they decline, you know, some of them 80% a year, just roughly. Okay? So what happened was US oil production went from, you know, almost 13 million barrels a day to like 11 million barrels a day, like a 2 million barrel a day hit, okay? -- in a matter of, you know, two or three months, right? It just collapsed, okay? So and then at the same time, you had the OPEC crowd, they came in and they had their little price war, I think that lasted about three weeks, and then they came in and made an agreement and decided they were going to, you know, take [inaudible] barrels of oil off market, so you had a market that been going into 2019 that was already starting to feel a little tight. COVID comes, and boom, everybody just stops, all right? Then let's layer on the whole, you know, the whole ESG situation. You had guys like the head of the IEA. GP famously came out and said the funding dirty energy was going to be a loser, and anybody who funded energy, you know, you risk losing all your investment. Right? You had the BP, their 2020 outlook [inaudible] oil demand had finally hit a ceiling, that we'd finally reached peak oil demand, not, you know, not five years from now, not 10 years from now, but immediately, okay? All of these pressures and, you know, [inaudible] there was the -- you know, they're going into, you know, the COP meeting in Scotland and such. There was a lot of pressure from -- in equity investors too, not just to show me the returns anymore, but, you know, just don't invest any more dollars into this entirely, okay? So like I said, you had a market going into COVID that was already starting to feel tight. Okay? Everybody drops rigs because the price collapsed. OPEC becomes, you know, they put in quotas. You know, you layer on the ESG, all the pressures from investors to show returns. Now, COVID, demand come back, almost completely back to what it was, and now lo and behold, you know, we're in a market that's desperately, you know, very, very, very, very short energy. So you put yourself on a diet of capital in 2019 even before COVID started, okay? And then you'd starved yourself for two years, and you wake up in 2022 and it's like, hey, it's time to eat some oil, it's time to eat some gas. You know, nobody's cooked it, you know? It's just not on your plate. So then, you know, February of this year, the Ukraine, you know, the Russian invasion exacerbates it even more, so that is really how we ended -- I mean, how we ended up situation. You know, it didn't happen. It wasn't one single, like, oh, my gosh, it was the OPEC cuts or oh my gosh, it was ESG or oh my gosh, it was Russia. It was all these things, you know, like coming together, and you've created a situation where the market is just really short energy, and if it wasn't for, you know, locked downs in China, probably be -- probably have oil $20 a barrel higher right now, at least that. So that was a long, long history lesson, but that's how we got here. That's what's happened.
>> So David, can you tell us a little bit more about, you know, where you just ended talking about the Ukraine invasion and Russia? How did the European situation affect everything?
>> Well, the European situation, you've got a gas crunch obviously, going on in Europe right now. You know, they're -- supposedly their storage is back up to a 2021-type of level, but I mean, if you go into winter, and you lose the flows, how many days of cover is that storage really going to last you? And where is the storage at is the big question. You've seen gas prices spiral up to, you know, 60, 70, 80 bucks an [inaudible] in Europe, and unlike, you know, 10 years ago, where Europe was one gas market and the United States was another gas market, now you've got, you know, roughly 12%, maybe 13% of US gas production, it's going to your Europe in the form of LNG. So it's pulling US gas price higher, too, and there's a limit, okay? This is producer discipline in the United States, is partially limiting like the US supply response, there's gas and prices appear in the United States. That being said, even if the United States could, you know, put out another 10 BCF a day in gas tomorrow, you know, you couldn't get it to Europe because the LNG facilities are bottlenecked. I mean, there's no more liquefaction capacity in the United States. Until Exxon's Golden Pass comes on in like I think 2024, just not getting any -- you're not going to get any more gas, but you could lower the gas prices here in the United States, but like I said, producers are being disciplined, and then second of all, building new infrastructure here in the United States, the pipelines have been a major challenge. There's a pipeline, you know, a six-point -- I think it's $6.6 billion price tag on this pipeline right now, the Mt. Valley pipeline. Okay? It's been hung up for years. I think they've got, you know, less than 20 miles less to complete [inaudible] and they've been waiting on that for what is it three years now? You know? It's been a long time, and it's just been hung up in the courts. I mean you've got the biggest 200-mile -- 200 miles to the west of me, you know, is the second largest gas field world, and you can't get the gas out. Right? It doesn't make any sense. So, I mean, there's solutions for Europe's gas issues, but they're years away, and they require investment now, so, you know. And then the oil situation in Europe, I have to say, I'm surprised how well they've been able to redirect oil flows to keep the oil situation from spiraling out of control, but I have talked to a lot of people in the industry, both services companies and oil majors. You know, I don't want to name drop, but a lot of people are worried that, you know, Russia longer term, it could be Venezuela 2.0 where, you know, these guys pulled out. They've lost a lot of technical expertise. Can they really keep production up going forward? You know, what happens when that part that they need breaks and they just can't order it from Houston anymore, you know? It's -- I'm not sure Russia's productive capacity is going to be the same a year or two from now.
>> Yeah, very interesting.
>> Yeah, so it's a mess. It's a -- I never thought I'd see him mess like this. It's a mess.
>> So David, what do you see as the geopolitical energy policy alternatives for different countries, you know, and for Europe in particular?
>> In the near term, there's no physical solution, in the near term. In the near term, there has to be some kind of political solution, because there's just not going to be the amount of gas they need this winter, you know, if Russia cuts off flows, right? And I think it's anybody's guess, if they will or not. But, you know, the Europeans, and the Americans too, I mean, you're seeing the beginnings of them trying to explore alternative solution. There's one major I talked to last week, and their CEO was in Egypt, thinking about, you know, more ways to get LNG. You know, the Germans and the Canadians, the Canadian Prime Minister Trudeau, Trudeau made a promise last week he would get more LNG to Germany, he'd supply Germany with LNG, which is, you know, very interesting considering there's no LNG export facilities in Canada. That being said, there's plenty of gas in Canada. Now, there were some technical problems with this but the gas price in Alberta, natural gas price in Alberta a couple of weeks ago, was almost zero. Okay? So there's gas in Alberta. Now, some of that was mechanical [inaudible], but even today, I think the price is like, like, 2.50. Okay? There's gas in Canada, but once again, can you get it to the place you need it to be? This should have been done like years ago, but, you know, these politicians are talking now for the first time in a long time like, you know, maybe something needs to happen here.
>> So when you're talking about, you know, LNG as an alternative energy source, the challenge is mainly the actual getting it to where it needs to be. Is that what -- ?
>> Yeah, you have to liquefy it, and these facilities, they take, you know, at least two years to build and they're billions of dollars, and it's, you know, it's not going to -- it's too late to do anything about it by, you know, this winter. It's not going to make a difference but something's -- you know, you need to start putting these in. [inaudible] I mean, as an alternative to LNG, I mean, there's imports from Africa too. There's pipelines, you know, that flow into Italy and such from Africa. Those pipelines, my understanding is they're not full, so maybe if you invested in some of these African countries too, maybe that could be an alternative, so I mean, once again, these are long-term solutions, and the crisis is now, so I don't know what the answer is going to be, but there's going to have to be a political solution to this, and you can't come and tell me, it's like, okay, we're going to do renewables, right? -- because renewables, they're not going to -- here's the thing with renewables. 60% of the time, they work every time. All right? So and renewables are not going to satisfy like things like aviation demand, trucking, shipping, industrial uses. You know, they're not that great for heating your home. They have their place but, you know, that's not the renew -- you know, investing in renewables, that's not going to get you through the winter now at this point. It's too late for that. I mean, the grid-level storage, it's just it's not ready for primetime, so.
>> When we talk about the high prices, what's been the response of US oil and gas producers to higher prices? Is producer discipline likely to continue? [inaudible]
>> It is likely to continue for the independents because one, you can't get the crews, you can't get the equipment. All right? That's part of the issue, and like, you know, the Permian Basin, I mean, cost inflation is already a concern. How many more people and frack spreads and rigs can I shove into the Permian? And if I move -- if I start to move, you know, assets to other places like Oklahoma or the Bakken, like I said, can I get the crews? It's going to cost, right? And these companies, like I said, they were beat up for over a decade saying, okay, every time we got a price rally, you guys drilled into it, you know? Why do they want to go out and subject themselves to 20% inflation on a well, when their investors are going to freak, okay? And then on the other -- the only guys who are really ramping up production in the United States are privates. They probably -- you know, they have a different, you know, set of considerations, and you have seen Exxon and Chevron ramping up as well too, but I think some of that was already kind of preplanned. They already had something, a well drilled and ready to go but, you know, it's going to be tough to really to get back to, you know, to get -- I mean, you could probably -- you know, you could get back to 13 million barrels a day. I mean, you'd get back to pre-COVID level of production, but to get past that, you know, it's not going to be, you know, it's not going to be like, you know, 2008 to 2014, where the US was adding, you know, a million barrels a day every year like clockwork, you know?
>> When we go to investors, what role do they play here in the energy transition? Is there a friction between making returns and being good global citizens here?
>> No, we're bondholders here at Prudential, so I don't get a vote. Okay? So it's not my place when I meet with management teams to go and tell them like, you know, you need to be a better citizen and such. I just want them to, you know, pay me back my principal, primarily. Okay? But it's an interesting question, because in the short-term, you know, you have a fiduciary duty, you know, to go out and chase, you know, to get returns for your clients. We had one client ask us, so what was my top pick, my top, you know, top bond pick for ESG concerns? And that bond performed very well. So how do you justify that, as a fiduciary to your investors, when you had the price signal was saying, gee, I can make a lot of money here, but on the other hand, I've got, you know, am I contributing to global warming if I give these people capital? Well, you know, you're contributing to, you know, people freezing, if you don't give them capital, maybe, so it puts -- the problem with -- the problem I personally, just thinking of me personally, the problem I have first with ESG is if it puts me in a situation to make these judgment calls, right? And, you know, to me, making these value decisions should be the job of politicians, not, you know, not securities analysts, right? So that's -- it's just -- I don't know. It makes life a lot more difficult, that's for sure.
>> So Dave, from your point of view, from a purely returns perspective, oil and gas still look like good investments?
>> In the short term, these guys are money good. And, you know, some of it is the move up in rates, but there are still, you know, there are still oil and gas companies out there with bonds that are trading below par. Okay? Meanwhile, some of these guys could be net cash. If you're an equity investor, I know a gas company I was looking at, you know, even if you really discount US gas prices next year, it's still trading at like four times cash flow. So I mean, if you think these prices persist, or even if they come down some, I mean, you're making, you're making a lot of money.
>> Yeah.
>> You know?
>> So that --
>> You're making good money.
>> -- [inaudible] that longer-term conversation and the movement behind the energy transition with many institutional investment -- investors making net-zero commitments and aligning portfolios with the Paris agreement, so how does it look in the long-term with regards to the energy transition?
>> You know, I mean, I wish I knew what oil demand was going to be like 10 years from now but, you know, all I can say is, you know, there's been a lot of pressure put on the supply side of the equation. Meanwhile, oil demand and gas demand, you know, it hasn't moved at all. If anything continues to increase, and for every person in California who's buying a Tesla, God bless them, you know, how many people in, you know, Vietnam, are buying their first car, right? I'm not convinced that we've seen the peak, you know, in demand for these, you know, for fossil fuels. And the energy transition, I'm going to say it's a little overhyped. It's a little overhyped. I, you know, I wish I could say otherwise but, you know, I don't see demand rolling over anytime soon.
>> So what is your view on the transition pathway and how investors should be considering this in the light of the shorter-term potential returns in oil and gas?
>> You know, in the short term, you know, the money's there in oil and gas. A lot of these transitional, you know, transitional technologies, hydrogen and such, I haven't seen any demonstrable economics [inaudible], so I feel if you're an investor and you want to get involved in the energy transition, you know, do I want to invest my capital in someone and, you know, at these prices, maybe I, you know, I drill a oil well, I'm getting, you know, 40%, 50% return, okay? If I, you know, put my money in a wind farm or a solar plant, solar, you know, I'm going to probably get a utility-like return, 8% to 11%, maybe. If I invest in some of these, you know, more far out the road technologies like hydrogen or something, who knows what my return will be? So I think, you know, your risk tolerance, I think if you're an investor, if you really want to get on the cutting edge of this stuff, I think it's more -- it's not for me as a fixed income person, my clients, God forbid. I think it's more, you know, a venture capital or, you know, private equity is more, you know, suited to take some of these risks that are further out in the stream of, you know, the energy transition. Right?
>> So, David, for our investors that are listening to this conversation, what is your advice in terms of navigating both the short-term and long-term outlook for energy markets?
>> You know, in the short-term, you know, it's really all a question of demand. Okay? What -- you know, you got the COVID lock downs in China and, you know, there's worries about a recession here in the United States, although, you know, the US oil inventories have continued to, you know, draw very, you know, very, you know, really draw down this whole summer, right? So I think, you know, if you want to make money in the short-term, it's a demand call. Now the longer term, you know, the supply side of the equation, it looks compelling. US producer demand is in place. You've got big questions about the supply, you know, the supplies coming from Russia. You know, we've seen disruptions in the energy patch before from Iran, from Venezuela. You know, you saw, you know, there's, you know, Iraq. You know, there was wars there. Seeing, you know, various disruptions but, you know, Russia is one of the big three. If you can -- in the oil and gas, you know, the demand side of the equation is always hard part. Now, the supply side, if I wanted to come up with like, my supply number, I just add up, I would just add up every -- all the guidance from the US guys, and I knew I could pretty much count on that. In fact, I could probably build in a little bit because they'd always sandbag. Okay? Then the Saudis, you could count on -- you can kind of -- you can believe what the Saudis are going to do. They -- I mean, Saudi Aramco, I mean, they -- I mean, say what you will, but they're reliable. Okay? And you can generally count on Russia too, okay? -- give or take. So figuring out the supply was not the problem. It was figuring out the demand. Now, I've got to constantly look at the supply because Russia has become a big question mark, and that's one of the big three, and this isn't Libya or Venezuela. It's bigger than all of those countries. You know, it's bigger than those put together. Okay? This is a huge issue. So if they lose 20%, 30% of their capacity, you're -- it's -- you know, now you're really in a pinch, okay? So, you know, there needs -- you know, an oil price of $90 a barrel is telling you we need more supply investment now. Okay? But the funny thing is, you know, the ESG considerations and such have got many companies, like maybe some of these European oil majors saying, we don't want to make those investments anymore because we're under pressure, so we're going to go to, you know, wind farms or artisanal coffee, or solar farms or whatever, right? -- and take the 9% or 11% returns, because that's what our investors want. They don't want the 40%, 50% returns from the oil and gas project [inaudible] price 90. So, you know, that's a bit of a head scratcher. Okay? So there has to be some kind of supply response at some point if you think the demand is going to be there, and like I said, despite this energy transition, I haven't seen any clear evidence that demand is really rolling over anywhere aside from, you know, European natural gas, which is going to definitely get some demand destruction pretty, you know [inaudible] globally, you know, it's still strong. People want this stuff, you know? And it's hard. You can't replace all of it that easy. I don't -- people equate oil as, okay, that's the gas that goes in my car. There's so much more than that. So much oil goes into petrochemical, aviation, shipping, trucking. You know, it's -- even if you do electrify a lot of these cars, where do I get the copper? Where do I get the -- you know, they weigh more, they're 2,000 pounds heavier. Where do I get the, you know, the cobalt, all right, you know, the lithium, okay? A lot of questions, I mean, where do I get the electricity to generate this to begin with? So I think, you know, the answers to this, you know, longer term are very uncertain. I don't know the answers, but in the short-term, you know, I'm seeing like, a lot of cheap paper out there, you know, a lot of cheap paper, so I feel like, you know, I feel like my number one job is to make money for my clients today, so, you know, that's what I'm going to do.
>> Thank you, David, so much for the conversation today. It's been really interesting and there is so much that we've got to learn.
>> Yeah, it was great talking to you.
Noah Weisberger, Managing Director, PGIM IAS and Amanda White, director of institutional content at Conexus Financial talk returns in a volatile market.
Michelle Teng discusses how climate change and early release schemes can affect super funds and the global economy.
Junying Shen discusses the implications of differing cash flow characteristics and performance among infrastructure asset sectors.