Oil And Gas Capex Renaissance

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IN THIS PUBLICATION:

Oil and gas capex fell by 20% since 2014, leading to the halving of resource life of top projects globally.
Total oil and gas capex is now expected to grow by almost 50% through 2027, reaching $150 billion, the highest level since the capex boom of 2004-14.
90% of S&P 500 companies currently trade above the 50-day moving average trend line, which has almost always coincided with positive returns over the next 12 months.

Oil And Gas Capex Renaissance

In the world of commodities, few sell-side publications have the reputation of the annual ‘Top Projects’ report that Goldman produces. This report was one of the few occasions when, as an entry-level analyst at Goldman, I had buy-side portfolio managers proactively reaching out for an intro to the lead analysts behind the report, rather than me having to incessantly chase them to showcase the ideas GS had to offer. This report was one of the few times I experienced having “leverage” as a sell-side analyst, and I have to be honest – it felt good.

This year, there are important takeaways from the report that reinforce the view of a tight oil market for many years to come unless prices move higher. Let’s dive in.

Where We Are:

Energy capex has fallen by almost 20% since 2014 for reasons that we all know, leading to c. 10 million barrels a day of lost oil production (c. 10% of global oil production) and 3 million barrels of oil equivalent of lost LNG production by 2024/25.
This has led to the resource life (i.e. the number of production years producers have in recoverable resources) of the largest projects around the world to fall more than 50%, from 50 years in 2014 to 23 years today (with half of those resources breaking even with oil at >$60/barrel). This is not a “we’re running out of oil” problem (we aren’t), but a clear indicator that capex needs to increase because, over the last decade, we have lost a significant amount of our recoverable reserves and to avoid a catastrophic rise in energy prices, increases in production (which require new capex spending) will be needed to match well depletion and increase in demand.

The report also confirms that non-OPEC production growth (mostly shale) is about to flatten out – this is a narrative we covered in our June Update. As per GS: “We estimate that the long-cycle developments will only add an average of c700 kbl/d pa over the next five years, which is barely sufficient to counter decline rates, but not to deliver net production growth, on our estimates”.
That’s no bueno if you think about it because if production from long-cycle developments will only be able to replace declining production, then oil demand growth (generally 1%-2% every year) will need to be met by higher production from somewhere else (probably OPEC’s spare capacity).

Whilst both are bullish on black gold, the difference between Goehring & Rozencwajg (which we frequently quote) and Goldman is the timing of when shale production growth will turn negative (2025 for Gorozen vs later than 2026 for GS).

Where We're Headed:

The decline in oil and gas capex is over. The world has started to realize the problem of idealistic green transition targets, and total oil and gas capex is now expected to grow by almost 50% through 2027, reaching $150 billion, the highest level since the capex boom of 2004-14.

This capex renaissance is happening at a period when the industry is much healthier: shale is more concentrated with a higher focus on cash generation, and 70% of undeveloped resources around the world (i.e. oil that is sitting beneath undrilled sites) are profitable with $70/barrel Brent oil price (compared to 25% in 2014).
As we highlighted in our June Update, OPEC+ has regained the role of swing producer (i.e. the player in the market that has control of the largest spare production capacity, which helps control production levels and gives it significant influence on the direction of oil prices). GS expects OPEC to have to commit to an additional 1.6 million barrels a day of production out of its spare capacity (which is assumed to be 4 million barrels a day) for production to meet demand in 2025.

Overall, this confirms the key point we made in June: the actions of Saudi Arabia will become increasingly more relevant in the years to come for understanding the direction of oil prices (increasing geopolitical risk, once again).
Goldman confirms the tailwinds for natural gas as well, with the market continuing to be tight until 2025-26, when production growth, driven by capacity growth from Qatar and North America, finally hits the market.

LNG Capacity Additions, Qatar, North America

Additionally, they believe that “the tightness in the gas market that was observed in 2022 dissipated in 2023 driven by warm winter, ample inventories and lagging China and European industrial demand, and while taking longer-than-expected, our economists expect sequential recovery in China activity and gas demand throughout the year driving balances tightly going into next winter”. The bullish setup for natural gas through year-end, which we covered in our latest Research report, continues to build.

What to Make of It:

We all know how cheap oil and gas companies currently trade, so there’s plenty of work to do in that sector if you want to find good companies to invest in.

S&P 500 sector valuation vs history dividends buybacks

The report has also laid out the cyclical bull case for Oil Services companies – those that are directly exposed to the increase in capex budgets. This is also an area we discussed with Harris Kuperman a few backs on our Ides of Macro podcast.

The OIH (US oil services) has lagged the XLE (US energy sector) and XOP (US E&P companies) since 2020, and that makes sense – the performance of oil services companies depends not on oil prices, but mostly on growth or reduction in capex budgets of oil and gas companies (which in turn depend on the future outlook for oil and gas, amongst other indicators).

XLE, XOP, OIH, Energy Capex, Oil Services

This means that the oil services sector should outperform not when the price of oil moves higher, but when the outlook for the price of oil is bullish enough, for a long enough period of time, to allow oil and gas companies to increase their capex budget – which, according to Goldman, is where we find ourselves now.

We’re not convinced that this is the right moment to jump into oil services, but in any case, doing proper research takes time, and if you believe Goldman is directionally correct, then the place to look is OIH, the US oil services ETF – components are listed below, sorted by market cap.

We’d look for low leverage, high FCF generation, and solid counterparties. But you do you.

Two Asset Allocation Strategies from Great Generalist Thinkers

Marko Papic:

“I think a global asset allocation should reflect the 2001-2007 period. That means you want to be short the US dollar, you want to be in European and Japanese equities, you want to be in industrials and materials relative to tech, and you want to be in emerging markets.
China is obviously part of the emerging markets universe, but you have to understand that China is in a different world. The country is in a deleveraging cycle and there are just too many risks. So with respect to stimulus, China is more like a trading opportunity than an investment opportunity.
That means from a long-term asset allocation perspective, emerging markets ex China should do very well since everything is in place for a capex driven commodity super-cycle.”

Lyn Alden:

“I tend to look at what’s going to do well over say, a three to five year period while still trying to be cyclically aware. And so I’m kind of going with the three pillar portfolio at the current time, which is basically, one pillar is profitable, reasonably priced equities. (…)
Then also, I add a significant commodity/ inflation protection part of the portfolio. And that’s still what I think is under owned in most portfolio. So if you think of a classic 60/40 portfolio, it’s very much geared towards disinflation, so it benefits from bond yields going down, that allows equity valuations to structurally go higher. And if we do enter a period of you know, waves of inflation or on average above target inflation, especially if it’s if it’s more energy driven, one of the ways to hedge all of your other otherwise disinflationary positions, is to have some of that direct exposure. So it could be commodity producers, it could be underlying commodities. It could be hard monies like gold or Bitcoin. That kind of assortment is how I think of that whole part of the portfolio.
And then lastly, I still think there’s a space for cash equivalents T-bills because, I think most of the signs still suggest that we’re not out of the woods yet, in terms of recession risk. (…) I still think that we’re kind of you do want to basically be prepared for that choppiness for the next 6 to 12 months. I think that basically, you want to have some disinflation protection in your portfolio, even if you’re otherwise structurally thinking inflation long term. And so I’ve been using those kinds of three portfolio, different kinds of sides of it, that I rebalance over time to kind of lean into whatever I think is under-owned at the at the moment.”

Momentum

According to Jeffries, 90% of SPX companies are currently trading above the 50-day moving average trend-line. Since the 1990s, this has almost always coincided with positive returns over the next 12 months. It seems we’re heading toward All-Time Highs again, and if you were one of the few investors that was pitching this contrarian view in December 2022, when the whole world was bearish, let me tell you “Bravo!”.

US Dollar

As we’ve said many times in this publication, the US Dollar is the most important asset in the world. In 2H, it will once again take center stage.
We’ve heard Michael Kao recently say that he believes most central banks around the world will start easing sooner than the US (usually, the US leads the way and the rest of the world follows in terms of hiking and cutting rates) because the US has the strongest consumer in the world, a luxury that other economies don’t have. If this idea is remotely right, then the EURUSD is mispriced and should move lower.