Ivy Sector Insights – Energy
Commentary as of April 1, 2020
Let’s start by outlining the current state of the oil markets. For those not paying attention, the world is drowning in oil. We are facing a situation where West Texas Intermediate crude is at $20 per barrel, down 65% year to date. Wholesale gasoline prices are at about 50 cents per gallon, and we may soon see prices at the pump below $1 per gallon in certain parts of the U.S.
How did we get here? Both oil supply and demand are in really difficult trends.
On the supply side: The world is drowning in oil right now. OPEC and Russia are in nothing short of a feud. The roots of this are understood by looking at the different interests of each entity, which are widely divergent: The ruble and tax regime in Russia and the fiscal breakeven points for the two are quite different. During the last production cuts announced by Saudi Arabia, the Russians were reluctant participants. When Saudi Arabia went back to Russia asking for more cuts, Russia just got up and walked away from the table. So, it feels like you have children in charge of this process who are more concerned with saving face and power than a functioning market. The cash cost to currently produce oil is in the mid-single digits in Saudi Arabia, so OPEC can produce it very quickly and at a very low cost.
On the demand side: The globe is experiencing COVID-19, which has destroyed the demand side. It’s hard to overstate the impact of this situation on global energy markets. Estimates are for demand to decline 25-30 million barrels per day, which equates to about a 25-30% demand drop. Jet travel, motor travel … it is all down.
Unconventional drilling, also known as shale drilling, has been the foundational pillar of the U.S. oil resurgence and it is now completely uneconomic. This has been a cataclysmic shift in the dynamics regarding how oil is produced.
Keep in mind that this is a cyclical industry. The current situation is the culmination of a very deflationary cycle, which started in the oil markets about five years ago. These can be long cycles, but COVID-19 has really accelerated this cycle to the downside. The real question is, “how long do we stay here because oil prices cannot stay this low forever?”
With every commodity downcycle, we sow the seeds for the potential of an inflationary cycle on the other side. In the U.S., we need a massive cleansing. We have too many producers and capital has been too plentiful. This morning (April 1), we saw the first high-profile bankruptcy – Whiting Petroleum Corp. We are going to experience many more bankruptcies in the oil patch in the U.S. At these prices, drilling in North America has to completely stop for the time being. There is also a good amount of production that isn’t profitable on a cash basis, which means we need to not only stop drilling, but also turn off some existing wells. This may sound scary, but we think it is necessary to set the stage for the next cycle. It will take time and capital to bring that productive capacity back online.
The key takeaway: We are in the later innings of a long and painful deflationary cycle in the oil space. But this is not a monolithic space – there are options that have less sensitivity to oil prices like refiners and midstream companies. These cycles are as old as oil production itself. Some companies with fully integrated business models have been around for more than 100 years. Some oil and gas producers have come and gone during this same time frame. To survive these cycles, a company needs to have other assets that can help it weather the worst of the storm. So, we are focused on the integrated companies that we think have sustainable business models even at the lowest possible oil prices.
We have spent a lot of time thinking about how we should be positioned for the other side of this situation. We still think it is too early to be buying exposure to the commodity price so we might characterize this as the beginning of the end of the down cycle. We believe when the dust settles, there will be a lot of opportunity across the spectrum, and not just in oil and gas but also in renewable energy, electric vehicles, etc. We are working to position ourselves for a good up cycle but we think we will be in a bit of a minefield until we reach the bottom of the down cycle.
Ivy had been looking at high-quality business models versus pure commodity driven resource extractors, and that was well before the most recent downturn. Given recent events, is this still Ivy’s view?
Absolutely, we are not just stuck with companies within the energy space. We seek companies within other sectors, like materials. We have made recent recommendations or are looking at opportunities related to companies outside of energy like firms that specialize in coatings. We think these are good, non-commodity businesses with very sustainable business models.
Do you think there will be a storage issue with all of the oil being produced?
Yes, Canadian oil in some cases is selling for $5 per barrel. There is storage available, but it is limited. We could carry on at this rate for months, but not years. The really concerning part is that once these facilities are at capacity, the discussion turns into oil being a waste product and producers will have to pay others to take the surplus.
The Trump Administration is calling for rollback of efficiency. How are alternative energy companies faring in the current environment?
We are still in early days for this space. We are going to find out if alternative energy and electric vehicles are viewed as a bull market luxury or if they are more secular trends that will persist longer term. In our opinion, these are durable trends. For example, as battery costs decline, there will be greater adoption of electric vehicles. If the current administration decides to pump the breaks on some of these issues, we think it would be temporary. This could unveil an opportunity to take advantage of weakness and look at parts of the energy sector that have strong secular tailwinds. Renewable energy is not monolithic and there are very different business models from which to choose.
Regarding a V-shaped recovery versus U-shaped recovery, are there any types of businesses that tend to perform better in those two different environments?
We think the answer to that question is clear, but successful investment decisions depend on the risk assigned to each scenario. Our opinion is that this recession will be longer and more durable than a lot of folks anticipate. If a V-shaped recovery occurs, we think the companies with the most financial leverage and most exposed to commodity prices should do relatively well. But those are the same companies that could go bankrupt if the recovery is L or U shaped. So success here will depend on risk tolerance and portfolio construction.
Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through April 1, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Several technical terms and acronyms were used throughout this commentary. West Texas Intermediate crude is a grade of crude oil used as a benchmark in oil pricing. OPEC is the Organization of the Petroleum Exporting Countries, an intergovernmental organization with the stated mission of coordinating and unifying the petroleum prices of its member countries and ensuring the stabilization of oil markets. In a V-shaped recession, the economy suffers a sharp but brief period of economic decline with a clearly defined trough, followed by a strong recovery. A U-shaped recession is longer than a V-shaped recession, and has a less-clearly defined trough. An L-shaped recession or depression occurs when an economy has a severe recession and does not return to trend line growth for many years, if ever.
Ivy Energy Fund – Top 10 equity holdings (%) as of 12/31/2019: Concho Resources, Inc. 4.97, Phillips 66 4.92, Valero Energy Corp. 4.66, Pioneer Natural Resources Co. 4.62, Marathon Petroleum Corp. 4.15, WPX Energy, Inc. 3.90, Cactus, Inc. Class A 3.68, Parsley Energy, Inc. 3.61, Diamondback Energy, Inc. 3.5, and Continental Resources, Inc. 3.56.
Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. Because the Fund invests more than 25% of its total assets in the energy related industry, the Fund may be more susceptible to a single economic, regulatory, or technological occurrence than a fund that does not concentrate its investments in this industry. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in natural resources can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments; and the cost assumed by natural resource companies in complying with environmental and safety regulations. Investing in physical commodities, such as gold, exposes the fund to other risk considerations such as potentially severe price fluctuations over short periods of time. The Fund may use a range of derivative instruments in seeking to hedge market risk on equity securities, increase exposure to specific sectors or companies, and manage exposure to various foreign currencies and precious metals. Such hedging involves additional risks, as the fluctuations in the values of the derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Not all funds or fund classes may be offered at all broker/dealers. These and other risks are more fully described in the Fund’s prospectus.
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.