Longer-term investors should focus on an energy company’s structural advantages in terms of asset-base quality, operational efficiency and financial discipline, not the price of oil and gas.

Thanks to growing U.S. shale oil and gas output, tectonic shifts were already dramatically changing the energy landscape even before the weekend attack on Saudi Arabia’s main oil facilities knocked an unprecedented 5.7 million barrels a day of supply, or about 5% of daily global production, offline, and sparked a record 20% jump in oil prices. Half of Saudi gas production was also taken out.

But, barring further strikes against oil infrastructure in the region, the immediate oil price reaction may be too extreme, given ample global crude inventories, initial estimates of the pace at which Saudi Arabia can bring downed production back online and the steady growth in U.S. shale output.

Ironically, the attack may become a lifeline to many U.S. exploration and production (E&P) companies, which have turned the U.S. into the world’s largest oil producer. Before the attack, their stocks and bonds had been battered this year amid bearish views that they were driving global supply growth faster than demand growth, without delivering good financial returns.

From October last year to the end of last month, the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) had lost more than 50%, hitting its lowest level since its June 2006 inception. But thanks to the attack and the associated geopolitical risk premium, many oil companies are now seeing a significant bid from investors, as the market strives to determine how much spare global capacity can be quickly brought online; how long global oil inventories can cover the shortfall and, just as importantly, how quickly they can be distributed; and, most importantly, how fast Saudi Arabia can repair the damage and restore its production.

Yet none of these questions should really form the basis for more than a tactical trade in energy, which many short-term investors and speculators appear to be putting on.

A Business Model Based on Depleting Assets, no Pricing Power and Occasional Black Swans

Long-term, fundamental investors like Thornburg understand that oil companies have an unusual set of challenges beyond the price of oil that drive their earnings power: a constantly depleting asset base, with the pace of depletion depending on how aggressively or efficiently fields are worked; how fast fields are replaced with new resources, the quality of that new resource base, the price at which it’s acquired, and the associated production costs; and lastly, how quickly new production can be moved to market, and at what transportation cost. A pipeline bottleneck restraining U.S. shale takeaway capacity is now being alleviated as new pipelines come online this quarter and next.

Another significant challenge: energy companies have no pricing power over oil and gas. That’s why it’s so important to focus on those that are structurally advantaged in terms of their asset base, enjoy a strong record of operational execution, and have sound financials. Certainly, higher oil and gas prices can cover for less efficient producers, but it’s worth highlighting that while oil prices were up 12% over the first eight months of 2019, the XOP was down 19%.

Moreover, the response times for U.S. shale producers to ramp generally run from three to six months. But unlike the U.S. mid-stream gathering and pipeline companies, which have spent the last three to four years reducing balance sheet leverage and increasing their retained distributable cash flows to help fund capex, most E&Ps have only recently gone in that direction. Upstream producers have been under great pressure to prioritize financial discipline—to lower debt levels and move toward free cash flow—rather than pursue output growth, as they historically and almost invariably have.

Following the bombings, they may now find more open capital markets. Financing was fast drying up as energy sector bankruptcies jumped more than 400% from the beginning of the year to early September, with total affected liabilities hitting about $20 billion, compared to just $3.6 billion in the year-earlier period, according to Bloomberg. Investor capital now flowing back into the space amid higher energy prices may keep other sub-par operators afloat after this black-swan event, but investors could still fail to see the hoped-for returns.

For Now, Inventories Can Cover Output Shortfall   

How high oil prices go near term and how long they stay elevated depend largely, as noted, on global spare capacity, inventories, and repair times at Saudi Arabia’s Abqaiq processing facility, which first prepares pumped crude for export or delivery to local refineries.

In its latest oil market report, the International Energy Agency estimated Saudi Arabia had around 2.37 million barrels per day (b/d) of spare capacity. It’s unclear how much of that, if any, was damaged in the attack. Iran certainly has spare capacity, but U.S. sanctions have caused its crude shipments abroad to plunge from 2.5 million b/d in April last year to some 360,000 b/d. As the Trump administration blames Tehran for the attack, the sanctions are unlikely to be lifted.

Goldman Sachs suggests Russia, the UAE and Kuwait together have some 500k b/d in spare capacity, but that’s less than a tenth of what Saudi Arabia has lost. Media reports cite Saudi officials saying more than a third, or some 1.7 million b/d, will be back on line this week and next. The sooner the better. As Thornburg Portfolio Manager Charlie Wilson points out, even before the attack, the “call” on the Organization of Petroleum Exporting Countries’ capacity thought needed to balance global supply and demand was expected to be higher in the third and fourth quarters, before declining again in the first quarter of 2019. “The near-term is likely the tightest,” Wilson notes.

“But, while there may not be immediate sources of production to offset the loss of Saudi output, global inventories are actually quite healthy at nearly 3 billion barrels, which is several hundred million barrels above the long-term average,” Wilson says. “Let’s assume Saudi brings back 2 million b/d in short order, but 4 million b/d are still missing. That means 420 million barrels are still needed to get through the end of the year, which is clearly manageable. Perhaps the initial jump in crude prices is overdone.”

U.S. shale output will also continue to grow, though just how much remains to be seen. Shale pioneer and Centennial Resource Development CEO Mark Papa, who is also chairman of oil services giant Schlumberger Ltd., said earlier this month U.S. producers were over-working the Permian and Eagle Ford, the premier shale basins, forcing energy companies into less prolific reservoirs, Bloomberg reported. He expects output to increase some 700,000 b/d next year, less than consensus expectations of 1 million to 1.2 million b/d, which would still push total U.S. production to around 13 million b/d, up from around 12.3 million b/d currently.

For Investor Returns, Commodity Price Forecasts vs. Individual Company Appraisal  

So between inventories, whatever Saudi brings back on line in the near term and the growth in U.S. shale, oil prices may not stay very elevated in 2020, though more attacks and a broader conflict in the Persian Gulf could easily drive them higher. If they go too high, though, demand destruction will come about due to the impact on global economic growth, and prices will fall.

Meanwhile, the degree to which U.S. energy companies focus on disciplined output growth, operational efficiency and free cash flow will really determine the attractiveness of their risk/reward propositions for investors, beyond the inevitable oil and gas price volatility. Some of the big, integrated energy companies, otherwise known as “supermajors,” have been generating significant free cash flow for two to three years now.

Global energy supply and demand dynamics, along with the extent and duration of oil and gas price movements, are far harder to assess and forecast than an individual company’s assets, operational efficiency and financial strength, which tend to be the most important longer-term drivers of returns for investors in their securities.