Over the past month, a disconnect between crude prices and the value of oil companies has manifested itself in the market and until supply and demand fundamentals bring the regional crude prices, futures commodity prices, and equity valuations back into equilibrium, a tiered price disconnect will continue to exist.
The start to the decade has been quite the whirlwind thus far and there are still 240 days until 2021. The year started bumpy with Australian wildfires, threats of war after military actions, and impeachment trials for the President. Then things began to get crazy as fears of the coronavirus began to take effect on the economy and industries far and wide.
These fears caused energy company stock values to follow crude prices as the stock market sank lower and oil prices began to tank. While times were tough and the future seemed grim, the market seemed to be acting as expected. That is until March 23rd when the stock market began to turn around after a period of horrific losses. During this time, energy funds and the stock values of oil and gas companies they contain began to rebound as well; but oil prices did not. Over the past month, a disconnect between crude prices and the value of oil companies has manifested itself in the market.
Large Cap and Small Cap Price Fluctuations
Since the beginning of the year, WTI has seen some incredible price swings. In fact, on April 20th the WTI benchmark spot price had lost 158.45% of its value from just a few months prior when prices went negative for the first time in history. Such dramatic price swings have been felt throughout the industry by major oil companies, small mom and pop operators, and energy ETFs containing shares in those companies.
The entire industry was in the same boat from January 6th of this year (the high point of commodity prices for 2020) through March 23rd. As seen in Table 1, the entire industry was losing value along with the WTI price slide. Then the stock market rebounded on March 23rd and equity prices for oil companies and the oil ETFs followed suit. Over the last month oil stocks have reversed and started to gain value while crude oil futures have continued to fall.
From January to March, several major oil and gas companies (Chevron, BP, EOG, and Exxon) saw their stock value fall by 55-60% while smaller oil company values (Pioneer, Centennial, Berry, and Continental) fell by 62-88%. When the market rebounded, the majors saw a 30-65% increase in value over the next month while the smaller companies only recovered 20-48%. Over this same period, WTI futures prices fell an additional 47%. The market valuation upside for oil and gas equities has become disconnected from oil prices while favoring larger companies (such as Chevron or BP) more than smaller companies (like Continental or Berry). Factors that play a role in these valuations vary by company such as short-term and long-term debt, interest rates, asset allocation, and dividend payments. Even with these variables, the crude price uncoupling is a common theme in most publicly traded oil companies likely due to COVID related support from financial institutions.
Intervention in the Bond Markets
As the stock market crashed at unprecedented rates following stay-at-home orders due to the coronavirus pandemic, the Federal Reserve and central banks had to intervene by buying Treasury notes to stabilize the market. Prior to the crash in the equity market, investors began moving money into 10-year Treasury bonds causing the yield to fall very quickly from February 18th to March 8th as seen in Figure 1. To stabilize the yields, the Federal Reserve began buying these bonds as seen in the total asset growth in Figure 2. With the Treasury bond stabilized, corporate bonds were the next assets purchased at levels greater than during the 2008 recession.
As the government and central banks began purchasing corporate debt, some of the downward pressure on the stock market was alleviated around March 23rd. Figure 3 shows the LQD ETF with investment grade corporate bonds that fell in the same pattern as the 10-year Treasury bond until reversing in mid-March and stabilizing in April.
These interventions allowed for liquidity in the debt markets to prevent the equity market from locking up. Liz Ann Sonders of Charles Schwab noted the effect these government actions had, “The Federal Reserve has pushed interest rates so low that many savers are being pushed from cash vehicles and US Treasuries into stocks in search of both income and capital gains” . If debt prices are propped up by federal institutions, investors feel safer in the equity market since possible debt default is backed by the government. An example of this is seen in Figure 4 as the S&P 500 compared to Chevron and Exxon stocks all followed the same trend during this time while oil prices continued to collapse.
These movements were seen across the entire market, and as a result has caused a larger disconnect between oil price and oil companies as investors see the risks removed by government intervention.
ETF Price Disconnect
Figure 5 tracks prices of the top oil ETF (the XLE) with WTI price since the beginning of 2020. It becomes clear that this fund (along with all major oil ETFs) were in lockstep with WTI until March 23. Then most of the companies in the ETF saw a price rebound while WTI continued to fall. When prices dropped again on April 3rd, the fund continued its growth through the end of April. It is worth noting the only ETF that directly followed the WTI price trend was the USO because that specific fund attempts to track the price of WTI to be exchange-traded instead of commodity-traded. Looking at the XLE, the ETF follows the same trend as the S&P 500 since investors in the stocks were less worried about equity risks once the government stepped in and started backing corporate debt.
While the XLE fund “seeks to provide precise exposure to companies in the oil, gas and consumable fuel, energy equipment and services industries” it also “seeks to provide an effective representation of the energy sector of the S&P 500 Index” . In other words, the fund is meant to represent the value of the energy industry or more specifically the oil and gas industry, taking into account the value of major energy companies on the stock market. So, when oil prices crash and the industry struggles, if the stock market is growing, the fund will grow as well. It is not a perfect correlation to the strength of the oil and gas industry but rather the strength of the industry backed by the stock market.
Major Oil Company Stock Value Spread from WTI Prices
Oil companies from worldwide supermajors to small independents create the most value by producing oil efficiently at the lowest possible lifting cost. The more efficiently you can pull a barrel of oil from the ground, the bigger the profit margin. If companies make their revenue by selling a commodity (in this case oil), it makes sense the intrinsic value of an equity would be influenced by the commodity value. By examining the percentage spread in major oil company stock value from WTI prices (Figure 7), this is exactly the phenomena seen until March 20th. After that date, the value of the major oil companies deviated from WTI prices showing additional influence outside of the commodity they produced.
After March 23rd, oil prices continued to fall but stock prices were rising. This only makes sense if the market is propped up by financial market intervention. As examined earlier, this is likely due to the government intervention in the bond markets mitigating underlying equity risk. While the commodity that generates revenue for these companies was decreasing, the sentiment of the market for the future stock value was positive causing a disconnect in pricing. The market realized that incredibly low commodity prices will affect future performance of these players, but if corporate debt is backed by the Federal Reserve, the likelihood of bankruptcy decreases.
Smaller Independent Oil Company Stock Value Spread from WTI Prices
How will companies continue to have the revenue to support their stock prices when a supply-demand imbalance is causing companies to shut-in production? Figure 8 shows the stock price of Continental and Centennial compared to Chevron and the WTI price. They all fell at similar rates until March 23rd and have shown some recovery in the last month, but the smaller companies did not rebound as much as Chevron. Figures 7 and 9 show the year-to-date growth in percentage spreads for several oil companies from the WTI futures price. Many of the smaller companies have only widened by 6% to 40% while the major oil companies have a spread increase of 100% to 500%.
There are several reasons the market allowed the percentage price spread for major oil companies to grow more than smaller ones. A major company has a better ability to absorb a greater market swing due to asset diversification, access to better credit facilities, and options for adjusting dividends if necessary. Having a better credit rating also makes the debt less risky if the government is looking at purchasing corporate bonds. These government interventions will make it harder for large companies supporting a major portion of the economy to fail. If the major oil companies were to go into default, many smaller operators with junk level credit ratings likely are already in default. With fewer assets, little or no dividend to cut, and depressed oil prices, it is more difficult for many smaller operators to generate revenue and create value. When commodity prices are low, selling the commodity efficiently is the name of the game and free cash flow rules the industry.
A Case Study for Bankruptcy
Examining Whiting Petroleum (the first major shale company to file for bankruptcy during this historic price crash) is an interesting thought exercise as it could be a precursor for the fate of future bankrupt companies. Whiting announced a share plan where its unsecured (old) notes would be converted into 97% of the new equity, while its common shareholders would receive 3% of the new equity . The problem is, Whiting’s unsecured notes are now valuing its new equity at close to $250 million, while its common stock (at $1) is valuing its new equity at over $3 billion. This shows there is a value displacement since the unsecured notes are trading for much less than the new equity shares of common stock. In reality, the unsecured bond price is a more likely value for the new shares, and the overvalued common stock will need to correct towards the bond value. This would allow for a more accurate market capitalization value as the company restructures its debt from bankruptcy. The same issues may unfold again in the future as other oil and gas companies declare bankruptcy, but this debt restructuring may also be needed to bring a correlation back between oil prices and company stock value.
Price to Earnings and Free Cash Flow Comparisons
Price to Earnings is one of the many metrics that investors use to evaluate a stock – which also forms a basis for comparison for companies operating in the same industry. But where does a P/E ratio come from, and what does it exactly tell us about a company?
P/E ratio is the price of stock divided by earnings per share (from latest available financial data). This metric often indicates whether a company’s stock is overvalued or undervalued. There is usually a growth estimate also embedded in a P/E ratio. Hence, the assumption that a company with a high P/E ratio is more likely to grow in the future, while companies with low P/E ratios are less likely to grow in the future.
Free cash flow, on the other hand, is the only number on a company’s financial statement that states exactly the amount of cash that an investor in the company could receive. It is the cash flow available to all the stakeholders of the business before being divided among the various different financial stakeholders of the company. In other words, the cash flow generated by the entire enterprise for all the stakeholders of the company that it uses to pay to the debt holders, equity holders and all other financial stakeholders. The free cash flow is another major focus when valuing a company.
From the free cash flow data in Table 2, Chevron reported earnings of $3.6 billion for the first quarter of 2020 which when compared with Exxon and BP, was significantly higher. This, however, was attributed to the sale of its assets in the Philippines and Azerbaijan, as well as favorable tax items in its international upstream business.
ExxonMobil’s quarter loss of $610 million was driven by a $2.9 billion non-cash charge from market related write-downs, in the hope of a quick recovery in subsequent periods. A write down describes an adjustment to the stated value of an asset when its fair market value has fallen to below its historical cost value. Even though a write-down reduces net income, it is however, only an accounting entry and does not involve the company’s cash flow.
BP P.L.C was the worst hit with a net loss of $4.4 billion dollars. Its CEO, Bernard Looney, attributed this to supply and demand interruptions on an unprecedented scale, which, of course, resulted in an extremely challenged commodity environment.
Of the selected companies in Figure 10 (as of May 6, 2020), Chevron reported the highest P/E ratio, followed (by a large margin) by Pioneer, Exxon, EOG, BP, Continental, and Berry. Centennial Resource Development and Whiting Petroleum, based on latest financial data, had a negative P/E ratio so they are not included in this comparison. However, the P/E values for the smaller companies (Pioneer, EOG, Continental, Berry) are expected to change significantly when these companies release their quarterly reports in the coming days.
Oil Sector Forward Plans
Chevron: Although Chevron entered the current crisis well positioned, it plans to further reduce its 2020 capital expenditure guidance and operating costs by $2 billion and $1 billion, respectively. The company also plans to reduce its oil output by 200,000 – 300,000 BOE in May and 200,000 – 400,000 BOE in June, a move that will narrow the gap and bring its value closer to the commodity market.
Exxon Mobil: Exxon Mobil, in response to current market conditions, plans to reduce its 2020 capital and cash operating expenditures by 30% and 15% respectively. This will bring down its Capex from previously announced $33 billion to $23 billion moving closer to the energy industries value on the commodities market. The company, however, is hopeful that the oil economy would return to pre-COVID-19 levels, and populations and standard of living will increase – driving demand for its products yet again.
BP: BP plans to complete the sale of its Alaska business to Hilcorp this year, while also anticipating an exceedingly difficult second quarter period. It also plans to reduce its cash costs by $2.5 billion by the end of 2021, with the global company likely to witness job cuts towards the end of this year. As far as production goes, it expects to produce less oil from its U.S shale business in the second quarter which makes sense as many companies are currently unable to store excess produced crude.
Centennial Resource Development: Centennial announced that it would be cutting its rig count from five rigs to zero and suspending completions in the Permian Basin. This would result in a reduced capital budget by about 60%, and would also include an organization restructuring that would reduce G&A expenses annually by 30%. Due to weak oil prices, the company will also curtail 40% of production in May and has hedged remaining 2020 oil volumes at an average weighted price of $26.79 per barrel with intentions of continuing hedges into 2021 .
A disconnect exists between the valuation of oil companies and WTI crude prices. Due to recent events this spread has grown as financial institutions have intervened to prop up the domestic economy. With financial institutions purchasing U.S. Treasury bonds first and then corporate debt, the equity markets have responded to the decreased risk by recovering some recent losses. Just as regional oil prices are seeing a disconnect from WTI futures, increasing spreads are now occurring between the futures price and value of oil and gas companies. Since the beginning of the year, oil stocks and crude prices both fell by at least 55% between January 6th and March 23rd. As the government began injecting liquidity into the market in response to COVID-19, oil stocks recovered 21% to 68% through April, while oil futures continued to fall an additional 47%.
Looking at the data does allow us to understand a few significant market observations. First, the market tends to have more faith in the success of major oil companies compared to smaller ones. With better rated debt than many smaller independents, continued government intervention will not allow them to fail. Allowing this would all but eliminate an industry providing a pivotal role to the U.S. Economy. The data has also highlighted the strength of market sentiment behind the energy industry even as crude prices have continued to fall. This sentiment has lifted energy market valuations, but eventually the disconnect between crude prices and oil companies will need to come back into alignment. As capital budgets are slashed and production curtailments are implemented, future revenues will decrease while being magnified by low prices. Stock prices will be forced to correct when less free cash flow is generated and the P/E ratio highlights overvalued equities as the earnings denominator declines. Until supply and demand fundamentals bring the regional crude prices, futures commodity prices, and equity valuations back into equilibrium, a tiered price disconnect will continue to exist in the market.
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