Super vol vs super cycle, a subtle but important mindset difference

Navigating the Energy Transition: Transient versus sustainable cash flow

A key feature of the 2020s energy transition era is likely to be regular but ultimately transient commodity price spikes. Spikes will be driven by the mixture of (1) normal, cyclical fundamental factors (2) traditional geopolitical turmoil and (3) the new commodity drivers that stem from the energy transition via "self-inflicted" geopolitical turmoil risk (e.g., Europe) and ESG "virtue signaling" (Europe and US). For both investors and oil and gas companies, the ability to precisely disentangle substantive cycle strength from traditional geopolitics and the new commodity drivers is unlikely to be possible or necessary.

My ROCE Deep Dive series discussed (here), (here), (here) and (here) is the underlying foundation for how I view the profitability cycle for the oil & gas sector, the ultimate driver of fundamental value. My ESG 2.0 and Energy Transition Resilience (ETR) framework I detailed (here), (here), (here), and (here) speaks to how I think the oil and gas industry should think about setting up for long-term value creation in the energy transition era. I have also commented on the interplay of Geopolitics and energy transition (here), (here) and (here). With all of that as a backdrop, I will now turn to the topic of Navigating the Energy Transition during what is sure to be an anything but smooth path in what I am calling a "super vol" commodity price environment during the energy transition era.

I offer a few suggestions to managements and investors:

• Most importantly, recognize that high degrees of commodity volatility are likely to persist for many years, and that the volatility will work in both directions; it's less about a "normalized" price deck than understanding and navigating the extreme ends of the cycle, which can turn suddenly and shockingly.

• Use periods of particularly high commodity prices to prioritize balance sheet improvement (see Fortress Balance Sheet) as the over-arching short-term objective. I don’t believe there is any such thing as “too strong” a balance sheet, which has both defensive and offensive benefits.

• As long-term capital market access cannot be taken as a given, certainly not for all oil & gas companies in all regions, I believe investors will place a greater premium on those with a fortress balance sheet in conjunction with superior returns on capital.

• Stop waiting for investors to give you the green light to grow again; thriving in a long-term transition is about sustainable business models, not the historic ramp-up/ramp-downs that happen, slightly lagged to the commodity price cycle (worst way to do it).

• Figure out how to get both your company and broader industry to Net Zero Scopes 1 and 2 along with (near) “zero” methane. If you can combine a credible NZO plan with a fortress balance sheet and superior returns on capital, you will have cracked the code to a premium valuation and the potential for sustained outperformance. And it should surprise no one that there is no change to my view that Scope 3, as currently defined, is dumb (discussed here).

Super vol macro backdrop

Ill-advised energy and climate policy choices are likely to exacerbate oil and gas price cycles in both directions, as opposed to merely on the upside. Through the ups and downs, I suspect commodity prices inclusive of the extra volatility will on average be higher than what they otherwise would have been ex-transition.

Within this super vol commodity backdrop, I believe we are in a return on capital super cycle for the oil and gas sector which benefits from "substantive" ESG, and aided by the commodity price benefits of virtue signaling and self-inflicted geopolitical turmoil. However, I prefer to characterize the commodity price environment as "high and volatile"—super vol if you will—as opposed to using the super-cycle language, mainly to emphasize the volatility point. Is this just semantics? Perhaps, but the word "cycle" often implies a smoothness and "super" a durability driven by underlying supply/demand drivers.

The super-cycle terminology does not quite capture my expectations for the 2020s. Discontinuities driven by ill-advised, extreme policy choices are likely to increase volatility, especially during periods when inventories and spare capacity are low. But the world isn't short resource. Fortunately, we still have enough capitalism-like reaction functions in enough countries/regions that I don't believe we should simplistically assume it will only be sunshine and daydreams going forward. Furthermore, politicians responsible for poor policy choices can change their minds, create “exemptions” that suddenly change short-term dynamics, or be removed from office. The resulting policy volatility I believe will exacerbate underlying commodity volatility (again, in both directions).

Quick summary of my oil macro framework:

• There are potentially numerous "reasonable cost" oil and gas development projects that can generate competitive full-cycle returns on capital for oil and gas companies at $65-$75/bbl (or lower) Brent oil equivalent.

• Both traditional and ESG investors are strongly discouraging new CAPEX and mandating, at a minimum, oil and gas companies first show that returns on capital have indeed improved.

• Substantive uncertainty on long-term demand trends, in particular for crude oil, coupled with the fact that we are not searching for new oil basins to generate supply growth as we were in the 2000s, suggests we don't necessarily need the magnitude of sustained oil price re-rating we had in the 2000s (i.e., 5X increase from $20s/bbl to essentially $100s/bbl), at least not on a fundamental basis.

• But the policy and ESG mistakes being made are likely to contribute to higher oil and gas pricing than otherwise might be warranted solely on traditional supply/demand/cost fundamentals; Europe is the most obvious example of the type of upside volatility that can exist when climate religiosity trumps the basic human need and right to abundant, affordable, reliable, and secure energy.

Through cycle versus point in cycle

It's an obvious but oft forgotten point: investors place (or should place) significantly higher value on through-cycle profitability and earnings/cashflow/free cash flow than temporary metrics. Yet, as recently as one minute ago, we can see big debates from analysts about whether 2H2022 oil prices will fall back to $70/bbl or rise above $100/bbl. It's fun to debate, especially on Twitter. It's not totally irrelevant. But for long-term value creation, it is simply something to navigate.

The ultimate goal is to generate healthy, through-cycle returns on capital. For larger companies in a mature industry like oil & gas, competitive ROCE should result in sustainable free cash flow which can be used to strengthen balance sheets or returned back to shareholders. It is possible that smaller companies might be able to grow volumes at a higher rate and still generate acceptable profitability in the instances where the company is early into a new play with superior economics. This is rare, but not without precedent. Some of you will remember the good ole days of Ultra Petroleum in the Pinedale Anticline and Spinnaker Exploration in the Gulf of Mexico, two SMID-cap E&Ps that generated excellent ROCE with significant volume growth for a defined period of time.

Refiners: 2010s Brent-WTI blow-out

When shale oil first started ramping in the 2010s, US pipeline and storage infrastructure growth lagged shale oil production gains, resulting in a significant widening of the spread between Brent (North Sea) and WTI (onshore US) crude oil (see Exhibit 1). This was to the significant benefit of onshore US refiners, as refined product prices (i.e., gasoline, diesel, jet fuel) remained linked globally, such that the feedstock advantage fell directly to the bottom line. However, the market broadly recognized that building new pipelines and infrastructure simply required capital and time and the dislocations would ultimately prove temporary.

As an analyst at Goldman at the time, we used a model by which we gave companies "full" credit for what we thought would be the long-term Brent-WTI spread (about $2-$3/bbl as I recall) and then used a sensitivity model for magnitude and duration of the above-normal spreads. For example, as a base case we might have assumed $15/bbl spreads would last for 12 months followed by a 12 month stretch at $5/bbl, followed by a return to "normal" spreads; we would examine “what if” sensitivities in terms of magnitude of spreads and duration. We applied probabilities to different scenarios of spread normalization and ultimately credited companies for the one-time benefit of above-normal free cash flow by adding the increment to the long-term normalized valuations we calculated (if any of this isn’t clear to the non-energy, non-professional investors that read Super-Spiked, please ask in the Comments or hit reply to your email).

I would note that we gave more credit for the one-time free cash flow uplift to companies where we had confidence that the extra cash would be spent wisely via balance sheet improvement or returning cash to shareholders. I am simplifying here and in those days the major publicly-traded refiners were all committed to returning the bulk of excess cash to investors, such that I don't remember reinvestment risk or "wasting excess cash" as a major risk, though I am sure it did occur (see Exhibit 2).

Exhibit 1, Brent-WTI crude oil spread (Bloomberg)

Exhibit 2, ROCE for Refiners vs IOCs and Oily E&Ps (S&P Capital IQ, Arjun Murti)

Navigating the “super vol” transition macro: Recognizing transient cash flow booms as just that

The most straightforward and simple act a company can take with an unexpected surge in cash flows is to put it in the bank, pay down debt, build cash (reduce net debt), and strengthen the balance sheet. It’s an absolute no brainer. Just do it. Yes, shareholders will want (and deserve) to see a portion of the extra cash. But, as I discussed in Fortress Balance Sheet, there is no guarantee capital market access will persist long-term for oil and gas companies. When you look at the actions being taken by governments across Europe and parts of the United States and Canada, no one should assume sanity will prevail anywhere in the developed western world to the detriment of the citizens of Earth as well as the oil and gas sector.

The benefits of cash on hand are several-fold:

• Potential to make counter-cyclical acquisitions (best use of cash);

• Potential to repurchase stock at cycle troughs (as opposed to peaks as more often happens);

• Potential to maintain investment programs through commodity volatility (matters more for medium-/long-cycle projects).

How much is too much cash? Trick question. There is no such thing. Can a company be too profitable? Can an oilfield be too big? Is there a limit to how much a company should want to outperform? Can your favorite sports team win too many championships? As I noted in Fortress Balance Sheet, the Top 20 S&P companies ex-Financials and Energy have more cash than debt (see Exhibit 3).

Exhibit 3 (S&P Capital IQ, Arjun Murti)

E&Ps are not like other businesses, the "plant" is less stable

Unlike refining and most other industrial sectors, the E&P business is unique in that the asset base has an inherent uncertainty to it that you don't see in businesses with above-ground plants. No one can know with 100% confidence what the volume and cost characteristics of a barrel of oil (or Mcf of natural gas) are until it is produced. For example, in the Gulf of Mexico, a company might spend $1 billion on a 100 million barrel oil field only to discover that previously unseen "faulting" (a structural component of an underground reservoir) has cut the recoverable volume in half, doubling the per unit capital cost. Alternatively, a secondary zone could be found to have better production characteristics than initially perceived resulting in 200 million barrels of recoverable resources (my sincere apologies to all geologists/geoscientists that read Super-Spiked for the extreme lay person's explanation of reservoir analysis).

The tricky part for both oil and gas managements and investors is it is not always obvious, though sometimes it is, to know when the CAPEX and cost parameters for your oil and gas field have changed for the worse. Sometimes you get some early indications that field maturity is creeping into results. This is the max danger zone for investors as the communication and reaction function of managements is, lets just say, not always as ideal as one would like.

As a result of inevitable geologic maturity, there will always be an underlying need for oil and gas companies to add resource opportunities to a company's asset base. In a perfect world, companies remain patient and wait for down cycles to add project areas, especially if they come via corporate or property acquisitions. Sometimes that is not possible. However, it is hard to remember too many (or any?) acquisitions made at higher portions of the cycle that ultimately created significant shareholder value and didn't destroy shareholder value.

🚩Red flags to consider

Red flags that your oil and gas company might not be on-track to successfully navigate the energy transition include (not a complete list):

• Management has stated it is waiting for investors to give the signal that a return to growth mode is OK (i.e., the dreaded growth trigger).

• Net debt is not decreasing (excluding acquisitions) during periods of commodity price strength.

• Return on capital improvements lag the sector or the change in commodity prices (it’s not 1:1 on the latter, but it’s also not 0:1).

• Acquisitions are made in new areas from non-distressed buyers, without clear strategic or compelling underlying logic, especially during higher points of the commodity cycle.

• Companies talk up a good Net Zero and methane reduction game, but don’t follow through with concrete, verifiable actions. Delay and pretend I believe will fail as an approach (deny is not the correct term; it needs updating and I think pretend may be the more accurate descriptor). Getting to true net zero will be a challenge for all companies in all industries. Leading companies are working in good faith to crack the code.

The red flags are just that, red flags. There will be exceptions. On growth, the one exception I would make would be companies that have demonstrated they are capable of generating double digit full-cycle returns on capital. Realistically, that is not a very long list at this moment.

⚡️On a personal note...

Super-Spiked is a newsletter about the messy energy transition era that has arrived. There is zero intention to make it about my personal views on controversial "American culture war" topics outside of energy & climate policy. So why then did I bring up the recent controversy facing The Joe Rogan Experience last week? Freedom of speech and a willingness to discuss and debate "non-conforming" views espoused by the so-called mainstream media is critical, in my view, to constructive energy and climate policy discussion. Mainstream media views on how to address any number of important topics are not always correct, as we have seen so clearly with the pandemic.

It is not about whether I or anyone else like Mr. Rogan's unique comedic brand, or his equally unique podcast; I, for one, am not an avid listener. It is the attempt by some segments of society to silence unpopular, controversial, or what they consider to be “wrong” views that some (or many) find offensive that I stand firmly against. It is not up to me, the public mob, and certainly not leading tech sector executives, to decide right from wrong, good from evil, information from mis-information, or what is “acceptable” comedy in the case of Mr. Rogan. There are of course exceptions to this general point, but the cancel culture bar should be high; certainly higher than anything I have actually seen with The Joe Rogan Experience. The mob should not rule.

⚖️ Disclaimer

I certify that these are my personal, strongly held views at the time of this post. My views are my own and not attributable to any affiliation, past or present. This is not an investment newsletter and there is no financial advice explicitly or implicitly provided here. My views can and will change in the future as warranted by updated analyses and developments. Some of my comments are made in jest for entertainment purposes; I sincerely mean no offense to anyone that takes issue.

Regards,

Arjun

💿 Super-Spiked Energy Transition playlist update 📼

The seventh addition to the Super-Spiked Energy Transition playlist which you can follow directly on Spotify or YouTube comes from Black Sabbath's Ronnie James Dio era. "If you listen to fools, the mob rules" was written in 1981, clearly in anticipation of apocalyptic climate change religiosity that has materialized in the early 2020s. Mr. Dio, in particular, was apparently a visionary that went along with his booming vocals and otherwise medieval lyrical themes. I thought I saw a then independent Dio on The Last in Line tour but it must have actually been in 1986 on the Sacred Heart tour as the show was definitely at The Garden (I am relying on Wikipedia to help jog and confirm my memories). The attached video comes from his final appearance ever on August 29, 2009 at age 67 at the House of Blues in Atlantic City. Sadly, Ronnie James Dio passed away in 2010, may he forever Rest In Peace.

This week also features a second new addition and the eighth playlist song overall, Sugar Magnolia by The Grateful Dead, which includes the great "sunshine and daydreams" lyric. Unfortunately, a move to a 100% renewables future is neither advisable nor practical as is painfully obvious in the regions furthest along in the transition. Sugar Magnolia represents that dream; but just a dream it is; and a dream that is quickly turning into a nightmare. But Sugar Magnolia is a cross-over song in that it also symbolizes classic upcycle thinking that creeps into both oil & gas managements and investors. It is the rare song that clearly pokes fun at both the climate and fossil fuel crowds. Well done Robert Hunter and Bob Weir!

For those of you concerned by the inclusion of The Dead here, I know, the Super-Spiked Energy Transition playlist has been near 100% 1980s metal heretofore. My musical tastes post my teenage years expanded well beyond the hard rock genre. I am certainly not a Dead Head but am a big fan of their music. I saw the Dead twice, at Giants Stadium in 1987 and at McNichols Arena in Denver in 1990-ish.

Super-Spiked energy transition playlist

1. Concert for 2 Cellos in G Minor, RV 531: I. Allegro Moderato. Given Germany is at the center of energy transition policy controversy, it seemed appropriate to use this song from Wolf Hoffman, lead guitarist of Accept, as the intro/outro for Super-Spiked Videopods.

2. Whiplash. Energy transition is driving a new era of commodity price volatility.

3. Amazonia. All of us here at Super-Spiked (i.e, me) are on board with saving the Amazon Rain Forest and being more respectful of Indigenous Peoples.

4. Creeping Death. Signifies the risk of decreasing capital market access for companies that ignore substantive ESG principles.

5. I Can't Drive 55. A step change in fuel economy is the key for oil demand moderation this decade, but doesn't seem on-track to happen. Apparently no one outside of Europe and perhaps Japan can drive 55.

6. Bedlam in Belgium. In honor of the insanity otherwise known as European energy and climate policy.

7. The Mob Rules. A song ahead of its time in anticipating the apocalyptic climate change religiosity and cancel culture silencing that has come to dominate the early 2020s.

8. Sugar Magnolia. The rare cross over song that clearly pokes fun at the “sunshine and daydreams” attitude that 100% renewables represents a remotely sensible policy path or that oil & gas upcycles are only up and to the right.