The need for crude oil – and other fossil fuels – is not going away anytime soon, and investors should be holding some assets that benefit from higher oil prices.
That’s the contrarian contention from Tamim Asset Management, which has a near-term 18–24 months target on oil of US$50 a barrel; and, longer–term, does not rule out oil seeing a triple-digit price, which it has not seen since 2014.
Tamim concedes that the economic slowdown on the back of COVID-19 has slammed oil demand – and says demand “isn’t likely to come back in a hurry.” Nor does the manager believe in the notion of a “V-shaped” recovery. Since 2016, every single upward move in oil prices has been driven primarily by production cuts from OPEC (the Organisation of Petroleum-Exporting Countries).
So, what takes oil higher – let alone back toward US$100 a barrel?
The answer, says Sid Ruttala, investment specialist at Tamim Asset Management, lies in the supply-side.
“Pre-COVID, the US had actually become the largest oil producer, at 13 million barrels a day. The problem with this is that most US production, primarily of the Permian Basin, is one, high-cost (above US$27 a barrel for even the most efficient producers, like Exxon); and two, close to half of production is tight oil (unconventional wells that require a higher amount of resources to produce). Low prices have caused a great deal of this to be shut-in,” says Ruttala.
The major problem with this, he says, is that once companies go offline, bringing things back online isn’t as simple as switching the lights back on. “It’s like leaving a car in the garage for a long period of time, the longer this goes on for the more likely it is that one would require a new battery to get it up and running again,” Ruttala says.
And financially, the shale part of the US oil and gas industry is in trouble. “Fitch Ratings is suggesting that more than US$43 billion ($62.3 billion) of high-yield junk bonds from oil and gas companies are likely to default, including some high-profile ones like Chesapeake, Whiting Petroleum and Diamond Offshore,” he says.
This is the inevitable downside of the US shale oil explosion, which brought about the much-vaunted US self-sufficiency. “The only reason we had this global glut was not because of advances in technology, it was low interest rates – for US companies in the Permian Basin, all of a sudden it was viable to just pop some debt on your balance sheet and start drilling, even though your cost of production is exorbitant. A lot of that production is not coming back,” he says.
And in a self-reinforcing loop of decline, prolonged low oil prices (and the effects of the COVID-19 pandemic) are slashing drilling and exploration investment, which means a slumping rig count. ‘The number of active rigs across the US has fallen below 200 for the first time since 2009, with upstream close to standstill. Why does this matter? Even when things are at business as usual, because of the lower quality and the nature of US production, there is a 30% a year depletion of wells, which constantly requires new investments to be made in order to sustain the production levels. As one could imagine, building new rigs and infrastructure has a long lead-time, and high capital spending, that becomes ever more unsustainable the longer the price of oil stays at these levels.”
And then there is the fact that increased use of renewable energy is cutting into the requirement for oil.
But this is a more nuanced situation than most people understand, says Ruttala. “The likely long-term secular decline for oil demand is very much a valid point. But does anyone think that the oil and gas producers are unaware of this problem? Most of the big oil players have either diversified their asset base or looked to move into materials production – they all have renewables divisions now.”
The most viable – and logical trend – for producers is transformation of fossil fuels into materials, he says. “Most investors tend to forget that oil can not only be transformed into plastics and petrochemicals, such as naphtha and diesel, but also polymers as well as being a crucial element of the making of everything from steel to fibreglass. So, while the cars might be electric, oil is still going to be needed as an input. For example, wind turbines, for example, take a tremendous amount of oil product to produce, from the cargo that transports them to the steel and fibreglass they are made up of.”
In addition, Ruttala is sceptical of renewable energy’s ability to power the massive energy requirements of the likes of China and India – seeing an unavoidable long-term role for hydrocarbons, at the very least as the back-up that renewable energy requires.
“Logically we will see fossil-fuel demand decrease, but we’re not going to get to a point where all of a sudden, we just give up on fossil fuels altogether. That’s not going to happen, at least, not in my lifetime,” Ruttala says. “Even if there were to be further longer-term trends that damage the future use and sustainability of oil – and this in itself is a question mark since it relies on policy makers keeping to their commitments (we all know how the Paris Accords have played out) – there is still going to be marked demand for oil. The logic (of higher prices) is, what decreases first? Supply, or demand? I’m betting on supply decreasing first.”
That is where the scope emerges for oil to find an equilibrium that can countenance US$100 a barrel again. “Whether we see triple digit prices for oil is going to be contingent upon the magnitude of supply cuts across the Permian and the capacity for the OPEC countries to diversify their base and move towards fuel transformation, not only into petrochemical-related products but materials,” Ruttala says. “Putting aside this recent ‘dead-cat bounce,’ we think this represents a rather bullish scenario over the long-term.”
Tamim’s preferred listed plays to benefit might surprise some: perhaps not LNG giant Woodside Petroleum, but sub-$100 million junior producer Horizon Oil, which has made more headlines this year over a bribery probe relating to its Papua New Guinea assets, an investigation that saw chief executive Michael Sheridan fired in February.
“We like Woodside’s asset and revenue base. If people say we’re heading out of coal, renewables can’t do it all, so gas becomes crucial. Woodside has temporarily shelved its major LNG expansion projects, Browse and Scarborough, but longer-term, we believe these will go ahead; and the Sangomar offshore oil project in Senegal (Woodside 35%) is going ahead (Woodside is targeting production in 2023). As we go through this period of lower oil prices, Woodside is very well-capitalised – it can keep the show running for an extended period of time,” says Ruttala.
Broker Credit Suisse argues that Woodside can withstand oil prices as low as US$10 a barrel for FY20 and US$15 a barrel throughout 2021, without risking debt covenants.
“Over the long run we are likely to see an increased demand and monetisation of Woodside’s existing infrastructure assets (i.e. Pluto) which include the processing of LNG. Most recently Chevron has also indicated its sale of its stake in the NWS (North West Shelf Project, Australia’s largest LNG project), of which it currently owns a sixth. This brings up the prospect of either Woodside or Shell (the other shareholders) increasing their respective stakes. The potential synergies from this prospect, especially given their Pluto LNG infrastructure, could be stellar since it brings in the prospect of vertical integration, both upstream and downstream,” says Ruttala.
Tamim’s valuation on Woodside – assuming an oil price that reaches US$50 a barrel over the next 24 months – is $36, compared to a market price of $20.94 (down from $35.56 in early 2020).
The firm’s other oil play, Horizon Oil, is producing at both the Beibu Gulf (offshore China) and Maari/Manaia (offshore New Zealand) fields, and progressing the development of its licences in Papua New Guinea. “Horizon has been absolutely trashed – it is down from 16 cents in October to 6.3 cents – and it’s now very cheap. Its cost of production is what’s attractive,” says Ruttala.
Its Beibu Gulf fields produce 8,000 barrels a day, and that is likely to go up in the future, Ruttala believes. The cost of production in this particular region is below SU$15 a barrel (HZN reported US$8.25 a barrel in the March 2020 quarter) and breakeven for Horizon is an attractive US$20 a barrel. We think it is a reasonable buy.”
Against a current HZN share price of 6.3 cents, Tamim’s target price is 25 cents – again, assuming an oil price that reaches US$50 a barrel over the next 24 months.
Keeping in mind that Tamim’s bullish oil case is over a much longer time horizon, Ruttala says WPL and HZN are reasonable buys at present levels.