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Summary

  • J.P. Morgan believes Brent crude could hit $190/barrel by 2025.
  • We believe this figure to be incredibly optimistic but still strongly subscribe to the underlying premise: chronic underinvestment in upstream projects since 2014 will lead to a significant price shock.
  • Capex for 2020 has been reduced by over $120 billion in response to the latest price collapse, far exceeding cuts from other recent downturns.
  • We further note that the capital leaving the industry today may never return as large institutional investors and banks increasingly impose limits on fossil fuel lending.
  • We are therefore very bullish medium-term crude prices and have positioned our portfolio to reflect this by opening long positions on EOG Resources, Pioneer Natural Resources, Suncor Energy, ConocoPhillips and Cenovus Energy.

J.P. Morgan thinks crude oil could hit $190/barrel by 2025.

That stunning figure was buried in a detailed, 65-page report from its European equity research team, titled “Supercycle on the Horizon.” Due to the unfortunate timing of its release – March 3, 2020 – the report understandably received little-to-no media coverage as the COVID-19 pandemic gained momentum and global markets began to crash. The key paragraph can be seen below:

“The combination of the supply and demand side dynamics suggests that the global oil market could move into large and sustained deficits past 2022, reaching an extreme 1.7 mbd by 2025. Running this scenario through our pricing model suggests these balances would lead to Brent oil prices rising steadily from 2022 onwards, averaging around $80/bbl in 2023, $100/bbl in 2024 and $190/bbl in 2025.”

At Cattle Drive Capital, we believe this headline-grabbing forecast to be wildly optimistic, but nonetheless, strongly support the underlying premise: chronic underinvestment in new conventional supply over the last several years will cause a shortfall in a few years’ time, leading to a significant price spike. We expect this supply shortage will be further exacerbated by the hyperbolic decline profile of US shale, which has served as the primary growth engine for global production in recent years.

This bullish view is, of course, also predicated on the assumption that oil demand will continue to grow steadily even in a post-COVID-19, increasingly carbon-conscious world. We believe that it will (led by India and China), but acknowledge certain downside risks to growth emerging from the pandemic, such as a reduction in the frequency of air travel or an increase in remote working. For the time horizon in discussion (out to 2025), we do not expect any significant cannibalization of oil demand from alternative energy sources, electric vehicles, renewables, etc.

To reflect our price view, in April we initiated longs on several large, oil-weighted independent E&Ps with strong balance sheets, low leverage ratios and a history of capital discipline. Our largest position is on EOG Resources (EOG), and we are also long Pioneer Natural Resources (PXD) and ConocoPhillips (COP) as well as Canadian integrateds Suncor Energy (SU) and Cenovus Energy (CVE). We plan to hold these positions for the next several years.

It’s worth pointing out that J.P. Morgan is not alone in its bullish medium-term outlook. Goldman Sachs published a similar thesis in its “Top Projects 2020” report released in late May. The bears among us may point to Goldman Sachs’ now-infamous $200/bbl call in May 2008 to suggest that the latest “supply crunch” argument is likely to prove as absurd as the previous one.

There are indeed some parallels between the arguments presented by Goldman Sachs at the time, but this isn’t 2008 anymore. Credit, once so freely available to the shale patch, is rapidly dwindling after years of capital indiscipline and several price collapses since 2014. And more broadly, capital available to the global upstream industry is being reduced as institutional investors place increasing pressure on banks to cut or halt lending to fossil fuel companies.


Capital Gone Today… Is Gone Forever?

As seen in previous downturns, corporates have responded to the latest price collapse by aggressively slashing capex programs. The speed and magnitude of the reaction, however, was unprecedented. According to Energy Aspects, over $120 billion of 2020 capex has been stripped out of budgets, $44 billion of which comes from the US upstream. That is a monumental figure that exceeds the previous price collapses of 2014 and 2016.

Source: Energy Aspects

There is another key difference. The current down-cycle is set against a backdrop where major institutional investors and lenders are increasingly withholding capital from upstream companies in an effort to bolster their “green” credentials. ESG mania is on the rise, and its implications are profound: the capital that is leaving the industry today through organic means (a price downturn) may never return due to the adoption of (inorganic) policies driven not by returns, but by social activism on the part of investors.

This is not just needless fear-mongering. It is both qualitatively and quantitatively demonstrable that capital starvation of the upstream segment is a real and growing threat to supply security.

The below graph from Goldman Sachs clearly shows how steeply investment for newly sanctioned “Top Projects” has fallen in recent years:

Again, remember, oil is a cyclical business, and this outflow of capital from the industry today will inevitably result in sharply lower production down the road.

More qualitatively, French bank Natixis made the following announcement on May 18: “Natixis today announces two new pledges in its energy and climate transition policy. Natixis will no longer finance projects dedicated to shale oil and gas exploration and production or companies actively involved in these fields.” (Source: Natixis Announces withdrawal from shale oil)

This follows a similar announcement made by French peer BNP Paribas in October 2017: “The world must reduce its dependence on fossil fuels, starting with oil and gas from shale and oil from tar sands, whose extraction and production emits high levels of greenhouse gases and has harmful effects on the environment… These measures mean that BNP Paribas will gradually cease to finance a significant number of players who are not actively part of a transition to a lower-carbon economy.” (Source: BNP takes further measures to accelerate support of the energy transition)

There are countless other examples of this sort of corporate social activism.

Another graph from Goldman Sachs shows that new lending to the upstream space in Europe fell from over $14 billion in 2014 to less than $2 billion in 2018:

Source: Goldman Sachs Equity Research: The end of non-OPEC growth

The bank projects that the lack of investment and credit availability in recent years will result in materially lower global production by 2025:

“Tightening financial conditions for new oil & gas developments have led to delays in many projects’ Final Investment Decisions since 2014, translating into 7 mb/d of lost oil production from long-cycle developments by 2025 vs. our Top Projects estimates back in 2014.”

And that’s just for long-cycle (i.e., conventional) projects. Shale presents a whole other problem…

The Shale Type Curve Quandary

As we’ve already stated in a few of our previous articles, horizontal shale wells have hyperbolic decline profiles and often experience production drops of as high as 75% in year 1 of production and a further 50% in year 2. This much steeper decline can be seen in the green line below (for the Permian Basin), versus conventional production seen in the other lines:

Source: Goldman Sachs Equity Research: Top Projects 2020

Therefore, as the shale production base grows, companies need to drill more every year just to keep overall output flat in a phenomenon widely referred to as the “shale treadmill.”

Consider the following stunning statistic as evidence: 55% of US shale oil output is only 14 months old, despite the fact that we are 10 years into the “revolution.” It is equally remarkable to consider that 75% of all Eagle Ford wells now produce less than 45 bbls/d. HFI Research has already written a good piece on the shale treadmill here: “Oil – The Shale Treadmill Is Going To Be A Thing Of Beauty.

Why is this a problem? Because the vast majority of the world’s oil production growth in recent years has come from the US shale patch. There has been serious underinvestment in conventional, long lead-time projects. So, with $44 billion in capex stripped out of the US upstream space in 2020, you can expect base declines to quickly accelerate and domestic production to start tailing off rapidly.

We are therefore rapidly positioning ourselves for a massive price spike in the not-too-distant future. $190? Probably not. But a price with a 3-digit handle wouldn’t surprise us. We therefore recommend investors find E&P companies with strong balance sheets, capital discipline and a history of FCF generation to capitalize on this significant opportunity.

Author: Cattle Drive Capital

Source: Seeking Alpha: $190 Oil? J.P. Morgan Thinks It’s Possible

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