Expert Opinions

A Renaissance and other Trends in Energy: A Few Minutes with Oil and Gas Equity Analyst Paul Sankey

Jim Gorman
Jim Gorman Director
December 11, 2019

In September 2019, the US exported more oil and petroleum products than it imported. This marked the first month ever that the US was a “net exporter” of oil, something that was perhaps unthinkable not long ago when our dependence on foreign oil was widely viewed as a national vulnerability. With a lot going on in the sector, we sat with Mizuho Americas Oil and Gas Equity Analyst Paul Sankey to get his take on the trends he is seeing.

1. You introduced the Renaissance thesis for US oil exploration & production in October 2017. How is that going now more than two years on?

We developed the Renaissance thesis directly from our clients. We all saw US exploration & production (E&P) companies with the best industrial opportunity of the past 50 years, namely unconventional oil production in the US, particularly in the Permian Basin – which is the world’s largest producing field, right in Texas – yet the E&P companies themselves were consistently under-performing the market in terms of stock price performance. We concluded that E&P corporate strategy was the problem.

We had seen the same issue of market dislike for a great industrial backdrop before – in oil refining companies. As a result, they affected change through a fairly uniform practice of CapEx discipline, no hedging, and cash return to shareholders. It is more complicated for E&P companies because of decline rates, but we do still believe some companies should “blow down” and allow declines in order to generate high cash return. Growth is misguided in a business this mature, yet the average E&P still pursues growth.

We argue that “Peak oil” and the idea of global resource constraint and declining US production has been debunked, and that the price of oil will trend lower in the future. This means that companies need to change their strategy away from growth, which was previously seen as returns-accretive, because with “peak oil,” growth was the challenge. Now, returns are the challenge and we want companies to make plans based on the assumption that oil prices will be LOWER in the future. That would represent capital constraint, lower growth, and higher cash return to shareholders. That is our “Renaissance.”

In 2018, in which the E&Ps started the year preaching capital discipline, as soon as the oil price rose beyond $60 a barrel, the companies increased capital expenditures. We were furious, and so was the market based on relative stock price performance, which was a disaster.

After that lesson was delivered, we believe we are beginning to see companies fully comprehend the revolution in US oil and its impact on their strategy. We see ourselves in the third inning. Some companies such as ConocoPhillips are completely on board. Most are getting there. And many are going bankrupt, as capital markets cannot see their investment case when assuming lower prices in the future.

2. What is IMO 2020, and what will its impact be to the oil sector? Who wins and who loses?

We call this “the biggest shift in global oil markets” since Churchill moved the Royal Navy from coal to oil (readers of The Prize will likely agree).

IMO 2020 refers to the International Maritime Organization’s ruling that starting January 1, 2020, marine sector emissions in international waters must be drastically cut. Essentially, it mandates a switch to lower sulphur fuels to reduce those emissions by over 80%. 

This is actually a massive regulatory shift for global oil markets. We believe the impact is very severe for the biggest marketers of bunker (high sulfur fuel that powers ships), namely Singapore and Fujairah, UAE. The US has long since met the standard, and will benefit from increased low sulphur distillate demand and the weakness of Asian refining margins led by Singapore.

Most see the effect as transient, as investment will correct the excess of high sulphur fuel oil in Singapore and East of Suez markets, but we believe this will take some time to play through. We remain bullish on US refiners.

3. What do you mean when you discuss the end of the oil age and the advent of what you call the “Tesla Effect”?

The core concept is that the 20th century was powered by oil, while the 21st century will be powered by electricity. It’s just like what happened to coal, which accounted for nearly 80% of US energy consumption at the start of the 20th century, but now accounts for less than 15% - which I believe is way too much given climate change.

I think we’re about ten years into a thirty-year transition from oil to electricity, and terminal value of oil has been severely affected by this potential of consumers to change behavior. Oil prices could play a role in accelerating or decelerating this transition. When prices go up, consumers are incentivized to switch away from oil where possible – say, by buying an electric car. This could hasten the transition overall. That affects terminal value for oil companies.

The over-arching concept is over-estimated by the market – hardly any electric cars are being sold and it’s been 10 years since we started talking about this – but it will remain an overhang, as it will always be 10 years away. The solution for companies is our Renaissance – bribe shareholders to own the risks of oil through high dividends and share buybacks. It worked for refiners. Despite the Tesla effect, which ostensibly affects refiners the most, we still have seen refiners outperform E&P on a sustained basis.

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