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.