Some Bad News That’s Not All Bad – August 2, 2019

Some Bad News That’s Not All Bad – August 2, 2019
Morgan Lewis Posted on August 2, 2019

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

Some Bad News That’sNot All Bad

It has been an incredibly eventful week in the markets, as well as within the hard assets strategies. There is a great deal to unpack on both a macro and a micro level. In addition to being in the thick of corporate earnings season, with lots of company-specific developments, we have had a 25 basis point cut to the Fed Funds rate by the FOMC, a $300 billion-dollar additional tariff placed on goods from China, and a material unwind in the energy, base metals, and other resource equity categories. Even gold stocks struggled relative to the yellow metal.

Energy has become particularly topical as we saw wholesale liquidation across the sector yesterday. We spend a great deal of our time on conference calls during earnings season, as we have mentioned previously. Yesterday, a major top-tier pure-play Permian exploration and production company announced a significant production shortfall. We believe there is a great deal of read-through for the stocks, as well as implications for the commodity going forward.

In order to put this in context, we need to take a step back and review the last few years in the energy patch, and what is unfolding today as a result of this history. The US shale boom renaissance centered deep in the heart of West Texas. It had been thought that energy production in the United States peaked in the 1970s, but fracking technology was a game changer for “tight oil” – resource we always knew was there but couldn’t extract until technological advances in fracking and horizontal drilling occurred, with ever longer laterals, higher sand loadings, and closer well spacing allowed.

The industry raised billions of dollars chasing production growth at the expense of returns, and US oil production doubled. Because the decline rates are so high in US shale, in many cases up to 70 percent in the first year, enormous amounts of capital were required in order to keep the growth machine chugging along. Accordingly, the industry sowed the seeds of its own demise, and we are still experiencing the hangover of this period of malinvestment. Over the last couple of years, we have seen a “bust” in the stocks. Investors have had enough of watching their portfolio companies chase growth for growth’s sake, and independent E&P companies have zero access to the capital markets via either debt or equity. This has forced them to largely live within budget constraints dictated by operating cash flows. Companies, in response to this as well as low commodity prices over the last few years, have had no choice but to drill their most prime, highest-return-on-investment inventory.

Back to the present and our call yesterday: What the company said was that in essence it has reached the technical limitations for well down spacing, and further densification of drilling was leading to poorer well performance. To us, it seems like a watershed moment worthy of discussion. The technological rate of change has reached its limitations, which will translate to lower capital efficiency going forward. Costs will begin to tick higher, and production growth may have to slow further. So, in effect, instead of “peak oil” what we have reached is “peak productivity.” Bringing production forward doesn’t change the amount of recoverable resource, it just creates a dynamic where, going forward, companies will have to spend more money to generate the same amount of production.

This may all sound like horrible news, but, as we say, the cure for low oil prices is low oil prices. Producer spending will remain tight, and the rate of change in supply growth is likely to slow. Therefore, absent a major global economic slowdown, we believe that this tightening US supply dynamic will ultimately prove to be a tailwind for the commodity price.

We thank you for your continued interest and support.

Best Regards,

David McAlvany
Chief Executive Officer

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