Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
Energy – Being Forced to Get Lean and Mean?
It’s been another choppy and volatile week in the markets. They have a lot to digest: the ever-changing news around China trade and its implications for the global economy, early earnings news post-third quarter, impeachment inquiries, and the utter collapse of the unicorn IPO market. Resources in particular were underperformers, and defensive stocks, particularly in some of our watchlist real estate ideas, continue to march higher.
We continue to watch the energy markets with fascination. Energy stocks are completely unloved, and investors have exited the space en masse. However, we have reason to believe that 2020 will be a much better year. One dynamic in particular that we are watching is the fall borrowing-base redeterminations process. Around this time of the year, banks revisit their lines of credit with energy producers and make the decision whether to maintain, increase, or decrease the borrowing base for each one. We believe that in a $50-55 WTI pricing environment, lenders are likely to choose to reduce the borrowing availability for independent E&P companies at the margin. In apparent confirmation of our analysis, we are hearing that banks are lowering their price deck assumptions in order to reduce their exposure to the sector. Most banks use price decks in the high $40 area, as they tend to be quite conservative in their lending practices. We know of one large bank that is using $45 WTI/$2 Henry Hub natural gas.
This dynamic poses a tremendous challenge to any company that has a significant portion of its revolver (revolving credit line) drawn and is not generating free cash. Therefore, in company specific situations this could appear to be bad news – and this is very much on a case-by-case basis, as not all companies outspend cash flow. Lower capital availability will lead to declining production and reserves going forward, and the process is iterative – lower reserves lead to even less capital availability in the future.
Fundamentally, however, this is good for the long-term health of the energy sector. It forces the issue of capital discipline, particularly in an environment where the equity markets are also closed as a source of funding. In the fall of 2016, there were companies that saw their borrowing bases reduced by 30 to 60 percent. Some companies have suggested that asset sales are one source of capital for them, however, those sales have dried up almost completely. Energy private equity that chased acreage in the Permian during the heyday has no exit, as there is no appetite in the capital markets for energy IPOs.
Somewhat paradoxically, we believe this is a significant silver lining for the energy sector. As they say in the commodities world, the cure for low prices is low prices. Although painful in the short term, this forced capital discipline on the sector will slow the rate of US production growth, which has shown staggering growth from 8.4 million barrels a day in mid-2016 to 12.6 million as of October 4th (Department of Energy). Meanwhile, returns on capital for the sector in aggregate have been anemic, and there is much shareholder dissatisfaction. However, falling US supply growth should help the overall global inventory situation begin to show signs of balance, and this should be good news for oil prices and energy stocks – assuming the global economy does not go into a tailspin. We take a decidedly non-consensus, cautiously optimistic view on the group going into 2020.
As always, we thank you for your continued interest and support.
Best Regards,
David McAlvany
Chief Executive Officer
MWM LLC
