Returning Contango Kills Short Term Upside

Friday, July 15, 2016

In the latest edition of the Numbers Report, we'll take a look at some of the most interesting figures put out this week in the energy sector. Each week we'll dig into some data and provide a bit of explanation on what drives the numbers.

Let's take a look.

1. New equity issued as lifeline for oil and gas companies

- U.S. E&P companies are issuing new equity at "record speed," Bloomberg reported.
- New debt issuance has collapsed as creditors lock out much of the industry, so oil drillers are using equity for cash infusions.
- U.S. companies have raised $16 billion in new shares this year, more than half of the $29 billion that has been raised, Bloomberg says. Over the past five years, new equity only represented about a quarter of capital raised.
- But equity offers better cash positions without new debt. Normally, companies worry about dilution, but several firms have issued equity this year without too much of a hit to their share price. Pioneer Natural Resources (NYSE: PXD) is a good example of this, issuing new shares and using the cash to buy up assets and finance drilling.

2. New hiring?

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- The oil industry has laid off more than 350,000 people around the world. In the U.S., payrolls in the "mining and logging" sector, which in government data includes oil and gas, dropped below 400,000 in May for the first time since 2011.
- As Bloomberg Gadfly notes, year-on-year percentage declines in May looked slightly better.
- But the bad news for workers is that productivity is sharply up from the past. Shale drillers no longer need as many people to drill an average shale well.
- Nevertheless, companies may need to raise wages if they are going to attract workers to come back. Anecdotal evidence from Texas and North Dakota suggest that some oilfield service companies could struggle to attract talent once drilling picks up. Some workers have moved on to other industries.

3. Distressed oil and gas bonds pay off

- Defaults and bankruptcies have swept the oil and gas sector. With each passing default, the bond market for distressed oil and gas debt is rattled, shaking the stability of indebted companies.
- But the riskiest debt can also compensate risk-taking investors handsomely. Bloomberg Intelligence found that the value of at least a dozen bonds from distressed E&P companies more than doubled over the past few months as oil prices shot up.
- Ultra Petroluem Corp's 2024 bonds offered the most staggering of returns - more than 600 percent in the second quarter and a 1,400 percent gain since February.
- Many companies have gone bankrupt from the oil price downturn, making this investment strategy extraordinarily risky. But for the companies that survive, the payoff is large.

4. Contango returns

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- The market contango, in which front-month oil contracts trade at a discount to futures one-year out, has widened again recently.
- The contango for September 2016 contracts versus September 2017 contracts opened up to $5.64 per barrel earlier this week, the largest gap since March. That is also twice as high as the contango in June.
- The contango points to worries about near-term oversupply. A glut of refined products is leading to more floating storage and the demand picture suddenly looks weaker than expected.
- A contango indicates a short-term supply glut, which suggests oil prices have little room on the upside…at least for the next few weeks until countervailing data proves otherwise.

5. China worsens the glut with more exports

- China's flagging economy is leading to lower-than-expected oil and refined product demand. Lower domestic demand means more oil, gasoline and diesel are left over for export.
- China's exports of refined fuels surpassed 1 million barrels per day in June, an increase of 38 percent year-on-year.
- As mentioned above, this is worsening the glut for gasoline and diesel, creating storage and unloading problems in certain parts of the world.
- This, of course, is causing refining margins to narrow - margins have declined by one third to just $4 per barrel in Asia, according to JP Morgan.
- Refiners could be forced to scale back, which should be positive for product prices, but negative for crude oil prices.

6. U.S. shale cheapest option moving forward

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- A new report from Wood Mackenzie found that U.S. shale is increasingly the most competitive source of new oil production. The FT charted some breakeven prices of different regions (above) using the Wood Mackenzie data.
- Having cut costs by 40 percent over the past two years, many shale basins can now breakeven at today's prices. The Wolfcamp in the Permian Basin breaks even at $39 per barrel, and the Eagle Ford can break even at $48 per barrel, the report says.
- That compares very favorably to deepwater projects, most of which are not profitable even at $60 per barrel.
- Wood Mackenzie concludes that in the future, the marginal investment dollar will increasingly migrate to the U.S. shale patch, at the expense of places like the North Sea, West Africa, or other deepwater drilling areas.

7. Drilling permits show some life

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- Not surprisingly, the collapse of oil prices led to a sharp decline in the number of drilling permits issued to E&P firms.
- But, drilling is showing little glimmers of life, if Texas is anything to go by. The Houston Chronicle reports that drilling permits in Texas ticked up in June compared to May, rising to 656 new permits issued.
- That is dramatically lower than the 2,200 permits issued in June 2014, but it does offer some signs that drilling could pick up, especially after several months of smaller declines.
- But permits point to future drilling - completions were still down from May to June, from 1,030 to 900, respectively. For the year-to-date, completions stood at 6,429 in Texas in 2016, half of the levels seen in 2015 for the same period.
- Nevertheless, as permits start to rise, completions will lag only just behind.

That's it for this week's Numbers Report. Thanks for reading, and we'll see you next week.