Description

This write-up is likely more targeted towards SMA managers or those with older clients who would prefer to get exposure to offshore oil without having to own a bunch of separate volatile O&G stocks in their client accounts and instead want a simpler and less volatile way to get exposure to the sector.

SPDR S&P Oil & Gas Equip & Services ETF (XES) has a ~$390m market cap and trades an average of $18M of volume. Currently, there are 41 holdings in the fund. Looking through revenue breakdowns it appears the fund is weighted to ~56% Onshore Services and ~44% Offshore Services. Unlike OIH (which has ~33% between SLB and HAL), the concentration risk is much lower in XES with its largest position (PUMP) at 3.7%.

Biffins’ write-up on ESV sent us down an offshore rabbit hole that has been fantastic. So many thanks to him/her. We like XES here for a couple of reasons (i) it provides exposure to an area of the energy market that has significantly lagged oil prices and E&Ps, (ii) it provides exposure to the offshore plays that we like through one security, (iii) it has less volatility than a pure play basket of offshore names (ESV, NE, RIG, RDC, etc.).

The bullish stance on oil has been made by others on VIC that are way smarter than we are oil. We’ll just summarize this here:

•         The nearly 45% drop in global E&P capital expenditures has led new conventional oil developments to plummet and global oil inventories to continue to drop.  
•         Many Non-OPEC international operators have focused on cash flow by running their best fields full-tilt and not managing for the long run.  These short-term actions have resulted in accelerating decline rates in many countries around the world. 
•       The dearth of new mega-projects and deferred maintenance capital on existing fields has also resulted in declining conventional oil production.  Conventional oil production declines will likely more than offset any continued gains coming from shales plays like the Permian. North American production, which makes up 20% of global supply, has absorbed ~70% of global demand growth since 2010.  Even with the tremendous growth out the Eagle Ford, Bakken and more recently the Permian two out of every three non-OPEC barrels still come from convention oil sources. 
•         Oil demand remains positive despite trade war worries.  YoY demand growth looks to exceed 1.5 million barrels per day in 2019.  Even if demand growth was to come in 20% lower than 1.5mm, we would still see consistent draws in global oil inventories throughout next year.  This all circles back to the need for much higher E&P investments. 
•         Global surplus capacity has dwindled to 1.5%.  That is not a big cushion for any further disruption out of Iran, Venezuela, and Libya.
•         Over the last 16 months, OECD inventories have been drawn by 635k barrels per day relative to seasonal average.  This appears to be the fastest recorded drawdown since inventory data began. For the rest of 2018, IEA projects global demand will average 99.6mm barrels per day, while total non-OPEC production will reach 67.7mm. OPEC spare capacity is unlikely to be able to fill the gap with sanctions on Iran and Venezuelan economic woes. Continued deficits would take inventories down to levels not seen since 2008.
•         International E&P spend in the first half of 2018 was up only a few percent YoY.  The growth rate in the 2H spend is looking to already strengthen.  YTD average Brent Crude prices is currently $72.21 with a low price of $62.08 and high price of $80.35.   This compares to the average price in 2017 of $54.70 with a low price of $45.6 and high price of $66.65.  As many oil majors use TTM oil price averages to make FIDs, we should enter 2019 with oil companies looking to increase budget spending given improved E&P cash flow and the higher TTM energy prices.

Bigger picture, the well-established market consensus that the Permian can continue to provide 1.5 million barrels per day of annual production growth for the foreseeable future is now starting to be called into question.  This was brought up by SLB’s CEO at the Barclays Energy conference in early September.  It is unclear how the Permian production and productivity will change as companies inject billions of pounds of proppant and water into the ground each year.  Well performance is dropping in the Eagle Ford as the percentage of child wells continues to increase.  Child wells in the Eagle Ford have already hit 70%.  In the Midland Wolfcamp of the Permian, the percentage of child wells has just hit 50%.  SLB noted that we are already starting to see a similar reduction in unit well productivity similar to the Eagle Ford.  This suggests the Permian growth potential could be lower than expected. To offset the decline even more investment is needed to overcome the growing reservoir challenges.

Further confirming this thesis, we’ve seen RIG go on the offensive and acquire ORIG because they believe day rates and utilization rates have bottomed. At recent conferences other CEOs have mentioned there will likely be more consolidation in the space for those with smaller fleet sizes. The sell-side always lags here, pretty substantially, but we have seen a number of upgrades in the last two weeks where the sell-side is just beginning to buy into the thesis.

Why XES?

Despite the howls of protest this will induce, many managers do have to actually take into account volatility because a painful path to profits can threaten one’s business in the interim. Therefore, for some taking a substantial naked position in pure offshore drillers might be too much. Investors who want to own offshore but can’t take the volatility can use XES is one of two ways:

•         Go long instead of pure offshore: It does have meaningful exposure to a lot of the pure-play offshore drillers, so you will likely do well if the thesis plays out (probably not 4x your money like ESV but XES would more than double if these stocks go back to where they were last time oil was trading at these prices)
  
  
•        Go long a basket of offshore / short XES: This is not scientific but looking back at a number of the rallies and pullbacks in the last year, we have found that XES has tended to capture roughly half of the upside of ESV and NE while capturing roughly 2/3 of any decline. Therefore, given that it is liquid and easy to borrow, this could be a good security to short against a basket of the top offshore plays in order to hedge out some of the oil price risk and onshore exposure risk.

The downside to going long XES instead of a naked basket of offshore is that we are taking on ~44% “onshore” exposure which could continue to be challenged in the near term before pipeline capacity comes online. However, we feel comfortable taking on that exposure at these prices because if oil prices take off, we think the pressures from Wall Street to “spend wisely” will once again flip to pressure companies to drill, drill, drill. Stocks like HAL are down over 25% since the spring and have largely adjusted for the dampered outlook for onshore.

In conclusion, if you can’t take the full exposure of offshore, this is a wonderful vehicle.

Here’s a breakdown of some of the (mainly) offshore components that are in the ETF and what they do (we can get into more depth in comments if anyone is interested).

Risks:

Oil price – this is the primary risk. As we’ve discussed above, we think there is a higher probability oil prices are headed higher, but we could be wrong.

Onshore exposure – as discussed, with a little less than half of this ETF exposed to onshore, if onshore servicers don’t participate in the recovery, upside could be muted.

US dollar – if the US dollar continues to soar, it could continue to hurt emerging market economies which could lead to demand destruction

Recession – a US recession would likely lead to demand destruction

Catalyst

• Higher oil prices
• Increased day rates
• Increased utilization