Bearish Sentiment Prevails As 2016 Kicks Off

In the latest edition of the Numbers Report, we’ll take a look at some of the most interesting figures put out this week in the energy sector. Each week we’ll dig into some data and provide a bit of explanation on what drives the numbers.

Let’s take a look.

1. Upstream companies down double-digits in 2015

- Unsurprisingly, 2015 was a rough year for energy stocks and their shareholders.
- Chesapeake Energy (NYSE: CHK) is faring worse than most. Its share price was off 78 percent in 2015, and its senior unsecured notes with a 6.125 percent interest rate due in 2021 was only selling for about 26 cents on the dollar as of December 24.
- "We believe equity and debt markets are effectively closed for all but the highest quality E&P's," Jefferies & Co. analyst wrote in a Dec. 22 investor note. "Spring bank redeterminations are coming and will likely feature severe cuts to available liquidity. Leverage is generally high for producers, meaning hefty cuts to budgets are likely."
- Morningstar analysts say that “the risk of a credit event” for Chesapeake Energy “has significantly increased as oil and gas prices have fallen.” Two key developments to watch: the result of Chesapeake’s debt exchange and the April credit redeterminations.
- The bond prices for EOG Resources (NYSE: EOG), widely considered one of the better shale oil and gas companies, stands out among its peers. EOG is one of the few companies of its size that has bond prices above face value for 2021 maturity dates. Many competitors have seen bond values plummet over the past year.

2. Shorts start to close out positions

- In the last week of 2015, hedge funds began to close out some short positions, with shorts declining by 8.5 percent, according to CFTC data.
- Although short positions hit a six-week low to close out the year, they are not far from the peak hit in December. Net long positions are still near their lowest levels in five years.
- Short and long positions can be used as a metric for market sentiment. For now, oil traders remain profoundly pessimistic about the direction of crude prices.
- Still, as we have mentioned before, investor sentiment is fickle. If momentum to close out short positions starts to pick up, oil price rallies can occur quickly and sharply.
- But the fundamentals remain negative in the short-run: High crude inventories; U.S. oil production remains at 9.2 million barrels per day; and financial instability in China – all point to a bearish market.

3. All you need to know about the Middle East

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- Colombia University recently published a stunning collection of maps, one of which goes a long way to depicting the complexities of the Middle East.
- The bulk of the oil and gas reserves in the Middle East are located in and around the Persian Gulf. Saudi Arabia has 266 billion barrels of oil, or 16 percent of the world’s total oil reserves. Iran (157 billion barrels) and Iraq (143 billion barrels) also hold vast amounts of oil and gas, and all of them can produce oil cheaply.
- At the same time, the overlapping complexity of religious demographics explains a lot of tension in the region. Primarily Sunni Saudi Arabia has oil in its east, where the country’s minority Shiites are located. Unrest in the east occasionally raises concern in the oil markets about security of supply.
- The oil kingdom is in sharp conflict with Shiite-dominated Iran. The conflict is both a traditional geopolitical struggle for regional power but also a cultural and religious fight as well.
- Nearly one-third of the world’s global oil trade passes through the narrow Straits of Hormuz, the most significant oil chokepoint in the world. ? About 2/3 of Iraq’s oil production is located in the south near the Persian Gulf, which is safely away from ISIS controlled territory in the north. This illustrates why oil prices have not spiked even though ISIS captured some oil producing territories.

4. Something has to give in Riyadh

- Oil prices are going to force some decisions in Saudi Arabia, one way or another. 

- Saudi Arabia unveiled a 2016 budget a few weeks ago, which included a 14 cut in spending. But it will still need to turn to the bond markets to cover its $87 billion deficit.
- The markets are growing concerned. The cost to insure against a Saudi default has risen to its highest level since 2009, even though such a scenario is extremely unlikely. S&P cut Saudi Arabia’s credit rating in October.
- There is growing pressure on the country’s currency, which is fixed to the dollar. Oil producers like Canada and Russia have seen a sharp deterioration in their currency, which has negative effects (higher inflation, higher imports costs), but provides a cushion against government deficits.
- Although Riyadh has slashed government spending, more decisions will need to be made if oil prices do not rebound. Deeper spending cuts? Faster drawdowns in foreign exchange? Or a currency devaluation?

5. Oil prices come down to fundamentals. The rest is noise

- Daily price movements for crude are highly dependent on oil trader activity. Prices routinely move by several percentage points in a single day, even though fundamentals change slowly.
- Yet, over the long-term, the fundamentals of supply and demand are what really matter. The above chart is probably all that an oil investor really needs to know about the current downturn.
- Oil production and consumption have generally increased steadily over time. But since about 2013, production growth has exceeded consumption. Global consumption leveled off in 2014 just as output, particularly from U.S. shale, surged.
- As a result, more oil was diverted into storage. In a rather staggering conclusion, the EIA estimates that the world saw net oil storage levels rise by 1.72 million barrels every day on average in 2015, the highest rate in at least two decades.
- The billion dollar question is when the production and consumption lines on the graph above will converge. Most expect the gap to narrow beginning in the second half of 2016.

6. Manufacturing activity weak in the U.S.

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- Manufacturing activity in the U.S. shrank in November and December, according to the Institute of Supply Management. The ISM index measures business activity in the manufacturing sector, with any reading below 50 signaling a contraction.
- The negative readings at the end of 2015 were the worst in three years, and activity has been slow for at least six months.
- As John Kemp of Reuters points out, freight activity on rail, road, barge and pipeline was also flat in 2015, after nearly a half decade of strong growth. Rail shipments fell by 4.5 percent in 2H2015.
- A stronger dollar is weighing on business activity, but overall weakness is a worrying sign for the global economy that is struggling to find new sources of growth.

7. Access to capital drying up for E&P companies

- As oil prices tanked beginning in mid-2014, energy companies rushed to fill the gaps with debt and equity. Wall Street was all too eager to help out, hoping to cash in on the downturn as a swift rebound was widely expected.
- After the summer of 2015 when oil prices once again plunged, fewer banks and lenders are willing to throw a lifeline to struggling drillers.
- In the second half of 2015, access to capital significantly tightened, according to the FT. While E&P companies raised $14.6 billion in new equity 1H2015, only $3.26 billion was issued in the latter half of 2015.
- Fresh bond issuance also plummeted. In the first half of 2015, about $23.9 billion was issued to E&Ps, while that fell by about 80 percent to just $4.57 billion in the second half of the year.
- The door for new financing will continue to close, and the April credit redeterminations could be a pivotal moment for a lot of companies.

That’s it for this week’s Numbers Report. Thanks for reading, and we’ll see you next week.