What’s Really Killing Crude
As this year comes to a close and the new year arrives, I will cover several familiar topics over the next few issues. In next week’s issue I will cover the top energy stories of 2015. Following that, I will grade my 2015 predictions. Then in early January I will lay out my predictions for 2016.
But today I need to play catch up. Last week my colleague Igor Greenwald and I participated in the final monthly web chat of 2015 for subscribers of The Energy Strategist and MLP Profits. We hold these chats on the second Tuesday of each month.
This most recent session was one of the busiest on record. That’s not surprising given the current volatility in the energy markets. While we were able to address most of the questions during the chat, at the end of the allotted time there were still plenty remaining. I indicated to readers that I would provide answers for some of these in this week’s Energy Letter and others in the MLP Investing Insider.
Q: How much is the dollar killing oil and if it ever weakens could we see a double benefit for oil pricing?
Historically, because oil is denominated in U.S. dollars, a rising dollar indeed tends to correlate with falling oil prices. However, that’s not what is going on this time. Over the past year and a half, the price of West Texas Intermediate (WTI) has fallen from over $100/bbl to the present level around $35/bbl. The dollar has strengthened over that time, but not nearly enough to account for the huge drop in oil prices.
If it were a stronger dollar impacting oil prices, I would expect to see weaker demand. In fact, the International Energy Agency reported that oil demand for the first half of 2015 grew at the fastest rate in the past five years. Further, the growth rate was broad-based, with developing countries that one might expect to be hardest hit by a strengthening dollar reporting some of the strongest growth rates.
This oil price collapse is a function of two interrelated factors. The shale oil boom that began six years ago in the U.S. has added nearly 5 million barrels per day (bpd) of additional capacity to the market. This created an oversupply situation (more on that below), but perhaps more importantly prompted OPEC to defend market share rather than price (which would have helped shale oil producers continue to gain market share). The result was more oil than the market currently needs. The only silver lining in this energy investing cloud is the old adage that will continue to be true while there is no adequate substitute for oil: the cure for low oil prices is low oil prices.
Q: I know leased land has drill by dates on it, how will that affect our current supply and drilling projections going forward? And will it cause some companies to be able to reset lease pricing contracts?
The terms for oil and gas leases can vary greatly from one landowner to another, but in general it is true that there will be a “use it or lose it” provision that requires a company to drill within a specified period of time. Because producers are anticipating better prices in the future, many have begun to drill wells so they don’t lose their leases, but then they don’t complete them (i.e., they don’t hydraulically fracture them).
But even in cases where there isn’t a risk of losing a lease, many of these wells produce most of their oil and gas in the first year or two of operation. Thus, it may make sense for a producer to sit tight and wait until prices improve. Wells that have been drilled but not completed in order to store the oil in situ until the market improves have spawned a new term — fracklog.
I have seen estimates of as much as 3 million bpd in deferred output from such uncompleted wells, but that’s probably on the high side. In any case, this backlog will provide some headwinds for oil prices in a recovery. A significant number of these wells will likely be completed as oil prices reach $60/bbl.
As far as lease pricing, when I was in North Dakota in September the mood and the market had certainly changed from two years earlier. Oil and gas companies are in a much stronger negotiating position relative to landowners than they have been in years, so lease prices will come down.
Q: Where is a good resource for your average Joe to monitor global oil inventories?
I answered this question in the chat, but I want to provide more information and some additional context. The reason to monitor global oil inventories is that it is an early indicator for the direction of crude oil prices. At present, millions of barrels per day of crude oil are produced at a loss with prices where they are. So one would expect some of this production to be shut in, eventually balancing the market.
Changes in crude oil inventories should indicate whether the market remains oversupplied, and to what degree. For now, even though producers have been cutting back, crude inventories are still growing. That means something has to give. When storage levels are elevated and rising, that something is going to be the price.
There are at least a couple of good places to find global crude oil inventories. The first is the U.S. Energy Information Administration (EIA). Each month this government agency issues a Short Term Energy Outlook (STEO), which shows the current global supply and demand picture:
Note that inventories have been steadily increasing since Q1 2014, and while demand is growing supply has grown at a faster pace. So global inventories are at a very high level and projected to continue to grow in 2016. That is the impact of OPEC’s price war and the so far slow decline in U.S. shale oil production, and it is putting severe downward pressure on oil prices despite the fact that they are already below a sustainable level.
The other place to look for information on the global crude picture is the International Energy Agency (IEA), which publishes a monthly global Oil Market Report. This report provides a lot of data complementary to the EIA’s. In addition to tallying global crude oil inventories, the EIA reports on global demand (with projections) by region:
Source: IEA Oil Market Report
Note that global demand is forecast to rise another 1.2 million bpd in 2016. That, combined with falling shale oil production in the U.S., is what will bring the crude markets back into balance.
Capital Punishment Unwarranted
If the only thing you know about an investment is that it involves ships and has a yield then the drastic distribution cuts announced yesterday by Teekay LNG Partners (NYSE: TGP), Teekay Offshore (NYSE: TOO) and their sponsor Teekay (NYSE: TK) might sound like a worrisome indication that Capital Products Partners (NYSE: CPLP) might be next.
That’s the probable cause of Thursday’s 12% slump in CPLP’s price, to levels consistent with an annual yield of 19% based on the current distribution. It apparently matters little to the sellers that CPLP is primarily an operator of fuel product and crude tankers enjoying longtime highs in charter rates amid strong demand, with only a modicum of exposure to the less robust containership market via long-term leases.
In contrast, Teekay Offshore serves offshore oil producers in the North Sea while Teekay LNG transports liquefied natural gas, representing two energy sectors that have fallen on hard times amid the slump in crude prices. (Teekay’s dividend, in turn, was underpinned by its incentive distribution rights in its affiliates.)
Teekay used Kinder Morgan’s blueprint in justifying its MLPs’ distribution cuts, citing “upcoming capital requirements for…committed growth projects” and their now impractically high cost of equity capital.
But Capital Products Partners doesn’t have any “committed growth projects” it hasn’t already financed. It’s already paid for the four ships it added toward the end of the third quarter and has cash on hand for the fifth — vessels that are already committed to long-term charters and should boost its cash flow from here on out.
Even without that boost, CPLP had 1.04x coverage on its third-quarter payout, and more like 1.10 proforma for the new additions to its fleet. Charter coverage for 2016 stood at 79% at the end of October, and most of the expirations were for the product and crude tankers likely to earn more on new charters.
No shipping dividend can ever be called safe, especially not one yielding almost 20%. But CPLP’s sponsor maintained its payouts throughout the deep slump that followed the global financial crisis, and had been adamant about increasing it 2% to 3% annually starting this year.
CPLP’s debt/EBITDA ratio — including the financing for the latest ship but not their earnings — stands at about 4. In contrast, Teekay LNG’s was in the neighborhood of 7.
We’re designating CPLP our top-ranked Best Buy. Buy below $7. Bumped from the list is UGI (NYSE: UGI), a utility stock that has held up relatively well and as a result lacks the near-term upside of the other top recommendations.
— Igor Greenwald