The Pursuit of Vikings: Embracing Oil Market Volatility

Super Vol Mindset, Part 3

Odin! Guide our ships, our axes, spears and swords

Guide us through storms that whip, and in brutal war

- Amon Amarth, The Pursuit of Vikings

This week I’d like to tie together three themes I have featured in Super-Spiked: (1) the oil price cycle; (2) the ROCE cycle; and (3) the volatility cycle. We do not need to pray to Odin to guide us through a volatility storm. We just need to study and incorporate volatility into our sector framework. A few points:

• As I have hopefully demonstrated in prior posts, the oil price cycle, which garners the overwhelming focus from most sector observers and participants, is not the be all and and all of what drives oil and gas companies, be it from an investor perspective or corporate strategy.

• The long-term ROCE cycle is what I focus on most in terms of understanding both individual companies and the broader sector, with trend direction at least as important as absolute numbers.

• Perhaps the most mis-understood factor is volatility, which has been the focus of my last two videopods (here and here) and will be the focus of this week’s post.

Volatility is disrespected, ignored, and mis-understood by most. This is not about scenario analysis (which is important). Nor is this about day-trading equities or commodities (which is possible but not my focus). It’s about understanding the implications of volatility regimes on the long-term outlook. Higher volatility is inevitably going to occur at cycle extremes. However, notably, the existence of high volatility is by definition more likely during bullish oil price environments when supply/demand balances are inherently tight and small changes in either variable can have an outsize impact on spot pricing.

While it is true and understandable that generalist investors will place a higher valuation for a given level of earnings/cash flow, business growth, ROCE, and balance sheet health for companies that exhibit lower volatility, low volatility is simply not a realistic aspiration for anyone in a commodity business. A stable marriage in your personal life is a worthy and realistic aspiration. A stable stream of oil and gas cash flows for your E&P company is not. Rather than fear, ignore, or pretend volatility doesn’t exist, it ought to be measured, understood, and used to your advantage.

A goal of Super-Spiked is to make it interesting and relevant to my most sophisticated former clients and energy sector executives while still remaining accessible to a broader audience. So I am going try to avoid long, boring technical paragraphs, something you often find in Street and academic research, and use the Q&A style that many of you seem to like. I'd also like to give an upfront thanks and recognition to all of my former Goldman Sachs & J. Aron colleagues that drove my education on this topic during the heart of my analyst career. To be clear, these are my views and any thing I get wrong or mis-state is solely on me.

How are you defining volatility?

In the last two videopods I defined volatility as the one standard deviation move in quarterly average oil prices relative to the previous 5-year average (for the period ending in the given quarter). In this post, I am adjusting the definition to the one standard deviation move in quarterly average oil prices relative to the previous 3-year average oil price (ending in the given 3-month period). I am also using rolling 3-month periods as "quarters" rather than simply the traditional calendar periods as I used in the two videopods. The slightly shorter time frame I think yields a bit more information without the excessive trading noise that would come from even shorter time frames. The rolling 3-month “quarters” eliminates the arbitrariness of strictly calendar-defined quarters.

At the end of the day, I am trying to get at a reasonable order-of-magnitude expression of my views; this post is not an in-depth quant analysis. I have picked quarters and three years as a time frames relevant to both corporates and investors.

While ultimately it is the $/bbl change in quarterly average oil prices that will matter to oil and gas companies, the % volatility helps normalize the $/bbl for different orders of magnitude in longer-term oil prices. As an example, if the one standard deviation move in quarterly oil prices is $12.50/bbl at a time the 3-year average oil price is $50/bbl, I have characterized this as 25% volatility. At $100 long-term oil, the $/bbl sensitivity at 25% vol is double at $25/bbl. Recognizing that the $/bbl sensitivity will grow as oil prices increase is a pretty basic but often forgotten point. Moreover, the world does not move in neat, one standard deviation increments; preparing for wider $/bbl swings properly calibrated for the absolute price regime are easy first steps to take.

Exhibit 1 shows the standard deviation in rolling 3 month average WTI oil prices divided by the rolling 3-year average WTI oil price, which is graphed as the blue line on the left axis. On the right axis graphed as grey bars is the # of standard deviation moves that occurred in the given rolling 3 month period (i.e., sigma).

Exhibit 1 (Bloomberg, EIA, Super-Spiked)

Exhibit 2 graphs the one standard deviation move for the rolling 3 month periods over the prior 3 years on a $/bbl basis on the left axis versus the rolling 3-year average WTI price on the right axis. Both axes use a log scale. As might be expected, the absolute standard deviation moves with the absolute price level.

Exhibit 2 (Bloomberg, EIA, Super-Spiked)

Exhibit 3 is similar to Exhibit 2 but graphs volatility on a % basis by dividing the standard deviation by the rolling 3-year average as I did in Exhibit 1. It is graphed against the rolling 3-month average WTI price level on a log scale, similar to Exhibit 2. In commodity markets, investors and corporates often react to $/bbl moves without recognizing the scaling that happens depending on the level of prices. In other words, whereas the $/bbl standard deviation would be expected to increase or decrease with the corresponding $/bbl 3-year average oil price, the actual volatility we are seeing and its characterization as “high” or “low” is better done looking at it on a % basis (i.e., adjusting for the absolute level of prices).

Exhibit 3 (Bloomberg, EIA, Super-Spiked)

What can we observe about how corporates and investors react to volatility?

Some observations:

• Investors and corporates tend to place a higher weight on downside risks, especially early in a new super-cycle.

• Investors and corporates tend to under-estimate what "normal" volatility looks like.

• Investors and corporates tend to under-estimate upside volatility, especially early in a new super-cycle.

• A one standard deviation move in oil prices should not be the full extent of a sensitivity analysis. Understanding 1.5, 2, and 3 standard deviations and the likely duration if you wind up on one end or the other is worthy of study.

• Geopolitics has always exacerbated volatility; we can now add public policy and virtue signaling ESG (substantive ESG is necessary and not the issue) to the list of meaningful volatility enhancers.

How does the current “Super Vol” era compare with the 2000’s Super-Spike period from a volatility standpoint?

I would expect the current period to exhibit higher volatility both to the upside and downside (yes, it’s redundant to say “to the upside and downside” but I have found it necessary to avoid being mis-interpreted as just to the upside); in contrast 2003-2008 exhibited high statistical volatility (as I defined it) but it was primarily a steady march higher. A few points here:

• An environment of booming global GDP growth, as we saw in the 2000s, is likely to be less volatile than one where we are continuously having spikes higher to ration consumption in the absence of sufficient supply growth.

• In the 2000s, we were still broadly within the 40-year era of low inflation and declining bond yields.

• Today, the inflation outlook is more uncertain with risk skewed to the upside (i.e., higher inflation). A structural change in the inflation paradigm, if true, is likely to exacerbate volatility.

• In the 2000s, companies aggressively pursued all forms of oil and gas projects, some successfully, some unsuccessfully; global policy was broadly supportive of these efforts (Venezuela was a notable exception).

• In the current period, global policy and “climate only” ideology is at best neutral and more often outright hostile to new oil and gas supply.

• A slower supply response in the current era points to a greater dependence on demand destruction pricing, which will add to volatility (and uncertainty).

Can you summarize how you differentiated the ROCE cycle from the oil price cycle? Doesn’t the sector simply move with oil prices?

As a reminder, structural ROCE cycles are related to but ultimately distinct from the oil price cycle. Prior examples cited include:

• Early 1990s when ROCE trended higher despite range-bound oil prices;

• During the 2002-2014 Super-Spike era, ROCE actually peaked in 2006, two years prior to the 2008 oil price peak and well before the late 2014 price collapse;

• ROCE in the $100 oil period of 2011-2014 was about the same as the 1990s despite nominal WTI being about 5X higher (let that sink in: a 5X increase in oil price but ROCE was broadly unchanged!).

When the 2000s-era super-cycle first kicked in during 2003-2006, ROCE exploded to the upside consistent with sharply higher oil prices. However, a strong CAPEX upcycle quickly led to a normalization lower in ROCE, ultimately resulting a 14-year ROCE downcycle era (2006-2020).

There is no need to repeat all that I have previously written. You can find links to the full ROCE Deep Dive series on the right sidebar of the Super-Spiked website or here, here, here, here, and here.

Exhibit 4 (Bloomberg, S&P CapitalIQ, Super-Spiked)

What is the connection between the oil vol environment and structural ROCE cycle?

Volatility math is simple and straightforward. The human emotion, both by investors and corporates, is not. When oil prices fall $20/bbl, people freak out, as we have seen in the most recent episode. Downward moves, in particular, tend to get greater weight placed on them, especially early in a new structural upcycle.

This is where the ROCE analysis comes into play. The interpretation of volatility makes a difference depending on where one is in the structural ROCE cycle. If we are near the start of a boom period or at the end of the bust period, a rise in volatility can signal a favorable inflection in the cycle is at hand.

I would also note the reduction in volatility toward the end of the Super-Spike era over 2011-2014. Oil market volatility was at a low point just ahead of the ignominious end to the era post the infamous OPEC “Thanksgiving” meeting in November 2014. There was absolutely nothing good about the low vol, $100/bbl 2011-2014 period.

What is meant by the phrase “volatility trap”?

When volatility is high, uncertainty, by definition, is also high. It is natural for investors and corporates to hunker down when uncertainty is high. In my view, it is highly relevant to have a view on whether we are early, in the middle, or late in a boom or bust period for ROCE. Risk/reward of volatility outcomes skew very differently depending on cycle position.

Right now, high volatility is contributing to delaying a much-needed CAPEX ramp (in order for supply growth to keep pace with demand growth without having to resort to demand destruction). It is keeping investors and corporates on the sidelines. It is creating opportunities for companies and investors that can look through what is a very natural and normal part of energy commodity businesses.

How can a company protect against inevitable volatility?

The question really needs to be rephrased to: How can a company ensure it is well positioned to take advantage of inevitable volatility? Hopefully some (many?) of you now know the answer:

• Fortress balance sheet

• Mid-teens (or better) through-cycle ROCE

• Profitable (or break-even at worst) at normal cycle troughs (i.e., it is not advisable to forever worry about the next COVID-equivalent calamity).

• Assets at the low end of the future industry cost curve

The goal is not to avoid volatility or even guard against it. It is to be positioned to act on a large scale when fear is high.

Is hedging a way to reduce volatility?

Not really. I get why one might want to use it for asset acquisition specific hedging at the time of purchase following a spike in the forward curve and to protect early period cash flows. Hedging, I'd argue is not an avenue to sustainable value creation for most companies most of the time. To truly reduce volatility, one would need to hedge significant production over many years; most hedging programs are next 12 months or so in duration. These are not really hedges of anything since no one is investing in oil fields that have only 12 months of production. In addition, you essentially cannot hedge capital and operating costs which are often pro-cyclical to the oil price. Downside protection strategies via put options might have more merit.

To be clear, there may be other scenarios where hedging might make sense. My bigger point is that I wouldn’t equate a conventional hedging strategy as the way to address systemic commodity price volatility.

Why does everyone want to reduce volatility?

I have no idea why there is so much craving for boring stability.

How do you price volatility?

The options market are an obvious place to start, with a deeper discussion beyond the scope of this post.

How did you learn to embrace oil market volatility?

I made a bold call early in my career at Goldman Sachs that recognized upside volatility in oil was not being sufficiently considered, stuck with it while fighting the haters (in the Wall Street sense), became a partner, retired at a relatively young age, became a work-from-home advisor/director well before COVID made it de rigueur, and started Super-Spiked. The greatest gift of having embraced volatility early in my Goldman career was the opportunity to be at home before my children escaped to college.

How can others learn to embrace volatility?

Oil and gas companies are now promising to return a significant portion of upside cash flows back to investors. The guessing game is over. A significant portion—and a greater portion than historically would have been allocated—is and will be going back to investors. The expected value from upside oil price risk is not zero; it's a number greater than zero. How are you pricing that into equity valuations?

What is a more practical example of how to embrace volatility?

A 3 standard deviation move in oil prices I think will approach $75/bbl in coming years. What are the odds of 3 months of $100+$75/bbl=$175/bbl oil? It's not zero. Is it a <1% chance? Or more like a 30% chance? What probability is the market currently pricing in?

We are in a world where there is no spare capacity, there are no inventories, there are fewer government stocks, everyone is fearful of oil demand rolling over despite the fact that there are many billions of people currently energy poor and those that are energy rich do not want to move backward to the energy not-so-rich category. Very few companies are talking about meaningful new CAPEX plans. Geopolitical risk are high and rising. There is war in Europe. Europe!!! “Climate only” ideology continues to plague many of our traditional institutions and has spread to large segments of the financial community.

So, I'll ask again, what is the probability of 3-months of $175/bbl oil? Or 12 months of $150/bbl? Or the odds of a continuation of $75-$125/bbl for five years?

What is the probability of 12 months of <$40 WTI in the next 12 months? 1% or 30%? How about in the next 5 years? What are the odds of 6 months of $60 WTI in the next 6 months for 12 months?

How does your view of the probability of those conditions occurring compare to what is being priced in now?

Is vol analysis just another phrasing for scenario analysis?

No, not in the sense that I am using the terms. These concepts have some similarities but express different ideas. I would attribute vol as more of a recognition of trading volatility in commodity markets that can impact cash flows for a defined period of time including those relevant to longer-term investors and corporates; as is hopefully clear by now, this is not an attempt at a trading analysis measured in days, weeks, or other shorter points in time.

A scenario analysis I think of more as a set of factors, conditions, or viewpoints that could transpire. For example, one could have a scenario that examined the possibility of public policy that embraced a “fortress North America” approach to US, Canada, and Mexico oilfield development including a streamlining of project permitting, the encouragement of foreign investment in Mexico, pushing back on environmental obstructionism for inter-state and inter-country pipelines in the US and Canada, and similar measures. This might then translate into a view on oil prices, ROCE, and volatility. I would guess the volatility analysis would suggest an initial spike potentially followed by a period of lower ROCE, lower oil prices, and lower volatility. The volatility view is a component of the scenario analysis. This is just one example of a scenario.

Is “Super Vol” just a fancy way to say you don’t have a specific price view?

The problem with looking at probabilities when publicly discussing oil markets is it will often feel to readers or listeners that you don’t have a specific view and are simply trying to cover all bases. For example, when we first made our Super-Spike call at Goldman Sachs, we actually discussed the odds of being between $50-$105/bbl over the subsequent 5 years, with a recessionary downside risk of $30/bbl. Some interpreted this as a shocking call that oil WOULD rise to $105/bbl (mainstream media). Others chided me for having a de facto range of $30-$105/bbl over 5 years and sarcastically commenting that I was simply missing the $0-$30 possibility. Neither version was the intention.

The world doesn’t want nuance. It wants definitive, strongly stated, click-bait statements. I’d argue that specific price views are unhelpful for both corporate planning and investor perspectives and ultimately inaccurate.

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⚡️On a personal note…

In prior posts and on Twitter, I have exhibited extreme skepticism that the world can or should even want to move to a “renewables only” kind of world. But I then visited Iceland this summer, which generates essentially all of its electricity from renewable sources including hydroelectric and geothermal. Clearly, there are some reasons unique to Iceland’s geography (volcanic environment) and demography (1% of USA population) that help. And the black beach ATVs, glacier snow mobile tour, and Super Jeep vehicle travel were not exactly net zero friendly endeavors. Still, the beer was good, the sun never really set, and the people of Iceland were even nicer than Oklahoma TSA. I am now a Vikings fan and recognize that a “renewables only” future may be possible for other areas that share Iceland’s demography and geography.

Geothermal in particular, in certain locations, seems interesting or at least worthy of further study. To that end, I will be participating on a panel at the PIVOT 2022 conference (register here) next week that is geared toward the geothermal sector.

Some Iceland pics and a group of Swedish Vikings performing their classic The Pursuit of Vikings, the latest addition to the Super-Spiked Energy Transition playlist.

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Specacular waterfalls

Glacier snow mobile tour

Iceland is expanding as the continental plates are moving apart in the location above…I think in 1 million years, Iceland will be unrecognizable to anyone that visited in 2022

⚖️ 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