Mixed U.S. Energy Earnings Reinforce Credit Views and Outlook for Range‑Bound Oil Prices
U.S. exploration and production (E&P) companies delivered mixed second-quarter earnings results and guidance, with evidence of operational missteps by certain Permian Basin producers. One particular large producer’s report of drilling delays, higher planned well costs and higher gas-to-oil ratios sparked broader concerns about whether Permian producers can maintain efficiencies and execute on plans to drill larger wells.
During the 25 July – 9 August earnings period, the largest passive ETF tracking the S&P Oil & Gas Exploration & Production index declined by 5.5%, while West Texas Intermediate (WTI) crude prices increased by 3.5%. This short-term divergence contrasts with the roughly 50% correlation between the ETF and WTI crude over one- and three-year timeframes. While the majority of E&Ps maintained their 2017 production targets, with slightly lower capex budgets – a net positive – we began to see some signs that activity would decline at sub-$50 oil prices.
Overall, we believe second-quarter earnings support our underweight to energy-related credits in general and our macro view that Brent crude will likely remain range-bound at $45–$55 per barrel (bbl) in the short to medium term.
Oil prices: key supports and risks
Factors supporting oil prices include heightened uncertainty about whether U.S. shale (particularly in the Permian Basin) can deliver on lofty growth expectations given execution risks in a tight oilfield services environment. Global inventories have also been drawing down on both an absolute basis and relative to normal, reflecting strong demand in both emerging and developed markets and the impact of OPEC production discipline (see chart). And while geopolitical risks can cut both ways, we believe current risks for key suppliers are higher than they have been in some time, lending support to prices.
Downside risks to oil prices remain, however, including uncertainties about OPEC’s continued compliance with its production quotas (and its eventual exit strategy from the agreement) and the risk of a global demand shock or a re-acceleration of U.S. shale investment should prices remain in the $50–$55/bbl range. While the emergence of electric vehicles and more efficient internal combustion engines pose headwinds to longer-term demand, we don’t view this as an immediate concern, particularly with growth in global demand exceeding trend growth for the third year running.
Investment and credit implications
Given our view of range-bound oil prices, PIMCO remains underweight energy-related credits in general, particularly oilfield services companies, drillers and higher-risk E&Ps, which require significantly higher commodity prices to be cash flow positive. However, based on our rigorous proprietary stress test analysis, we are finding investment opportunities with select master limited partnerships (MLPs) and higher-quality E&Ps, which are better insulated to withstand an environment where crude oil prices remain range-bound. Specifically, we favor E&Ps with low-cost acreage positions, strong balance sheets and access to liquidity, and conservative management teams.
See PIMCO’s Asset Allocation Outlook Midyear Update for more of our views on real assets.
Ronald Jin is a credit analyst focused on the E&P and waste services industries. John Devir is a portfolio manager for long/short equity strategies and a contributor to the PIMCO Blog.
Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Investing in MLPs involves risks that differ from equities, including limited control and limited rights to vote on matters affecting the partnership. MLPs are a partnership organised in the US and are subject to certain tax risks. Conflicts of interest may arise amongst common unit holders, subordinated unit holders and the general partner or managing member. MLPs may be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial condition, or unfavorable or unanticipated poor performance of a particular issuer. MLP cash distributions are not guaranteed and depend on each partnership’s ability to generate adequate cash flow. Energy exploration and production (E&P) companies are subject to government regulation, which may impact costs and earnings and may be the subject of civil liability risk from claims. Companies in this industry may be adversely affected by volatility of energy prices, commodity prices, exchange rates, interest rates, imposition of import controls, competition, capital expenditures, depletion of resources, development of alternative energy sources, energy conservation efforts, technological developments and labor relations. All investments contain risk and may lose value. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.