Barron's Streetwise - The Week Oil Got Weird

Episode Date: April 24, 2020

Chaotic trading in crude oil, what it means for the energy sector, and why tankers are sitting pretty. Learn more about your ad choices. Visit megaphone.fm/adchoices

With record levels of dry powder available for investment, find out what's in store for private markets in 2025 and beyond. Listen to Crafting Capital in partnership with UBS at partners.wsj.com slash UBS, Spotify and Apple Podcasts. In the first quarter last year, we generated annualized free cash flow of $400 million in TK tankers. Based on today's rates that we're seeing, that would jump to annualize $650 million. I'm Jack Howe. Welcome to the Barron Streetwise

podcast. The voice you just heard, that's Kenneth Vidd. He's CEO of a company called TK. They run giant ships that transport oil from place to place. So why is he talking about his free cash flow potentially being up more than 50% this year at a moment when economic activity is slowing and the oil price is collapsing? It's one example of why oil just got weird. In a moment, we'll talk to Kenneth and hear from some Wall Street experts about why. weird. In a moment, we'll talk to Kenneth and hear from some Wall Street experts about why. Meta, I have a money-making proposition for you. Okay, let's hear it. All you have to do is you have to receive a barrel of crude oil, and it's free. And then I'm pretty sure you can sell that barrel of crude oil at the end of the summer for maybe more than $20.

How does that sound? I have a studio apartment. I wonder where I would put it. Well, there are some complications there. The price that you pay doesn't include the actual barrel. Oh, okay. It's a BYOB. It's bring your own barrel. And you have to pick up the oil where it's delivered It's bring your own barrel. And you have to pick up

the oil where it's delivered and that's out west. And you have to store it. How many barrels can I put you down for? I'll have to think about that. I'll have to clear out some space, you know? I mean, you can't just do one barrel here to make the economics work. You need to go in for, I don't know, can you do a thousand barrels? No. Boy, you drive a hard bargain, man. This is not just a theoretical exercise for the energy sector. This dynamic produced one of the freakiest things I've ever seen in financial markets, and I've seen some freaky things. I mean, a couple of weeks ago, we did a podcast episode about retail,

and all of the malls and most of the stores are closed. That's weird. We did a podcast episode about entertainment and theme parks are sitting empty right now and movie theaters are empty. That's weird. But April 20th, I think, will forever be remembered as the day that oil in America went for negative $37 a barrel. And that's pretty weird. negative $37 a barrel. And that's pretty weird. In the USA, the price of oil has collapsed to a record low as demand dries up and storage runs out. The price settled at, get this, negative $37 per barrel. You probably think that couldn't happen. How do we make sense of this?

Meaning people would pay you today to take their oil off their hands. Let's start with a listener question about oil. I've been so pleasantly surprised by how many people our little podcast here is reaching around the world. And I understand we have a question from overseas. Yeah, we do. Hello, Jack Howe. I'm Ben, 21 years old, and I'm from Germany.

Ben says he invests in a globally diversified basket of stocks. Ben, I have seen the future and in it you're rich because you started so young, so congratulations in advance. But Ben says he's pretty worried now about the drop in oil prices and he has a question. Would you consider the oil price in these times as a leading or more as a lagging indicator? It's a really important question, Ben. If what has happened with the price of oil is a lagging indicator, then it means something crazy has already happened, but we can just move forward from here. If it's a leading indicator, however, it could mean that there's serious trouble coming as we move closer to summer.

So let's figure that out and see what it means for investors and consumers. Let's start with why exactly oil went bonkers, why the price went negative on April 20th. Now that's a futures contract. And when we talk about futures, what we mean is a particular type of oil delivered at a particular time at a particular place. In this case, it was a contract for something called West Texas Intermediate delivered in May. Now, Meta, West Texas Intermediate is lovely oil. It's light. It's sweet, meaning low sulfur content. If you were going to buy a barrel of oil, I'd really want you to buy Texas crude. Okay, I'm still not buying oil, but that's fine. All right, but there's one problem.

WTI, according to these futures contracts, has to be delivered to a facility in a little town in Oklahoma called Cushing. You have to have an agreement with the pipeline to bring it into the tank farm, basically. And it has to be approved ahead of time. That's Scott Schnipper. He's the global head of foreign exchange commodities and rates for JP Morgan. Scott says Cushing is completely stuffed right now. There's no storage available. And that's because oil demand is way down. I mean, we're all sitting around. We're not driving. We're not using gasoline and refined products

like we used to. So when people buy futures contracts, they're planning to do one of two things. Most people are planning to just sell the contract, hoping to make a profit before expiration. But some people are planning to take delivery of the oil. And April 20th was the day before expiration for the May contract. So if you didn't have arrangements to store your oil somewhere at Cushing, then your contract had to be sold into the close on weak volume. And the exchange had recently introduced a mechanism to allow prices to go negative, and they went negative, and not by just a little. So why did it gap down?

Just a simple imbalance, which is too many sellers and no buyers. No buyers because there's nowhere to store. So now the May contract has expired. The world is watching the June contract. It's positive, but I know what you're thinking. Could the same thing happen to the June contract as it approaches expiration? If there's no room for storage, could oil go negative again? Definitely possible, but it's not my base case. I think that in order to take advantage of negative prices in the June contract, there are likely

commodity players that are trying to free up storage capacity in Cushing so that if it does start to move towards negative, they would actually be the liquidity provider in that environment. Let's think about why commodity players would be working so hard to free up that storage capacity. The price of oil in the near term is quite low because nobody wants it. So I saw a June contract for WTI recently trading at $15. The September contract was much higher, about $26 when I saw it. Now, that's a big return for just sitting on oil for a few months. And the reason it's like that is because people expect the economy to open back up by the end of summer. They expect

oil demand to be better by then. So that condition, when oil is cheaper today than it will be in the future, that's called contango. Meta, don't confuse that with one of my many dance maneuvers. Contango makes storage economically attractive in the oil business. So people are looking for any place to put that oil right now. One place you can put it is on a ship. More about that in a moment. To figure out how long oil prices might stay depressed in the near term, we need to get a handle on both demand and supply. And for demand, we need an economist. I'm always happy to speak with the chief economist at Deutsche Bank, Torsten Slock. Hi, Torsten. It's Jack Howitt-Berens. How are you? Hey, Jack. Thanks for reaching out.

You came on the Berens Roundtable show maybe a month ago or something like that. I know. And I was there and we spoke in the green room. I'm pretty sure that you might be the last person on planet Earth that I shook hands with. I know. That was at the beginning of this craziness, and I don't shake hands anymore. I haven't washed my hands since. Torsten says with the economy on pause, there are a lot of factors contributing to the crash

in oil demand, but one stands out more than others. We have less transportation. Of course, we have a lot of transportation of goods to supermarkets. But given that 40% of demand for oil goes to trucks and cars, then when we have such a significant standstill as we have at the moment, it's not a surprise that demand for oil starts to drop significantly. So we need to get cars and trucks moving again to get demand for oil back up. But that's probably going to be a gradual process, Torsten says, because even after the economy opens, many people will still work from home. But in terms of the answer to your question of when we'll begin to see a pickup in demand, we should, as we get into May, begin to see some pickup in demand again. In particular, in the second half of May and going into June, we should see a more significant increase in demand for oil. A return to higher demand by June sounds hopeful.

And there's a sliver of good news for people who are still driving. Fuel prices have come down and could continue falling. So you would expect to see retail gas prices, meaning what we pay when we fill up our cars, to come down and potentially come down very significantly. Let's be careful about just calling that good news. Remember, a low oil price is both good news and bad news at the same time for the U.S. economy. It's good news if consumers are saving on gasoline and have more money to spend on other things. It's bad news if our energy companies have lower profits or losses that could cause them to have to lay off more workers. But the consumer is such a driving force of the economy that Torsten says the net overall effect will be positive despite the pain of energy companies.

The Fed has a model of the U.S. economy, and when you simulate in that model what lower oil prices will do to the economy, you do find that the net effect on consumers is more than offsetting the negative effect on the energy sector. And that actually makes sense if you think about it. The consumer and private consumption makes up about 70% of GDP, meaning 70% of the economy overall in the US. Therefore, lower gas prices means that you can take the money that you would have spent on gas and instead spend it on something else. So it is at least a little relief that gas prices have been falling.

So that should be net-net a positive for the economy overall. Meta, have you heard of a TV show called The Beverly Hillbillies? I think so. Is it like from the 80s? Yeah, before then. It's got like, you know, Granny and Jethro and Mr. Drysdale at the bank and Jed Clampett. And the introduction song for the show is called The Ballad of Jed Clampett. You know how it goes? No, but I want to hear. It's got great petrochemical references. Come listen to my story about a man named Jed, a poor mountaineer barely kept his family fed. And then one day he was shooting at some food and up through the ground come a bumpering crude.

and up through the ground come the bubbling crude. Oil, that is. Black gold. Texas tea. What do you think? Very, very nice. I think... It doesn't explain exactly how oil is extracted from the ground, but it makes it sound like there are easily reachable surface deposits

of high-quality oil there for the taking. You could just fire off a gun in your backyard and have oil spout up from the ground. And I don't even think Jed Clambett would be successful with that tactic in Saudi Arabia, certainly not in the U.S. In the U.S., the story of oil production in recent decades is all about something called hydraulic fracturing. That's not drilling, looking for some pool of liquid oil. It's drilling into shale or porous rock and then injecting water and chemicals and sand and creating high pressure to release oil from the pores. You combine fracking with a technique called horizontal drilling, where you

drill down once, you find a layer of shale, and then you move out horizontally to exploit all that shale without having to drill multiple times. Those two things together created a boom for U.S. oil production to the point where last year in 2019, the U.S. briefly overtook Saudi Arabia as the world's largest oil exporter. I'm just thinking of how the Beverly Hillbillies song would have to go if you updated it for modern drilling techniques. Come listen to my story about a man named Jed. He drilled into porous rock and injected water, chemicals, and sand and created high pressure to extract oil from the pores. And then he did some horizontal drilling down below

so that he didn't have to have a high number of wellheads. So the U.S. is an increasingly dominant energy producer. But if we're going to shift from looking at oil demand to oil supply, we can't just focus on the U.S. We have to consider all of the global players. And for that, we need to talk geopolitics. Perfect. I love this. It's my thing. I know. I know it is.

That's Halima Croft. She's the head of commodity strategy at RBC Capital Markets. Halima is the kind of person who travels to Saudi Arabia, knows all the key players. She knows the juicy background details of a price war that broke out earlier this year between Saudi Arabia and Russia. Oil prices are plunging as producers clash over cutting output. Brent crude fell as much as 9%. They're off more than 30% since the start of the year. OPEC and Russia failed to agree on emergency cuts of one and a half million barrels. Halima says Saudi Arabia initially saw signs of

weakening demand and wanted to cut production. Saudi Arabia, I think, saw the writing on the wall very early. His Royal Highness Prince Adel Aziz bin Salman, the Saudi oil minister, really wanted to do an early OPEC cut. He saw the situation as analogous to the 08-09 financial crisis and really wanted to have a million barrel plus cut to address the demand destruction concerns. Russia, however, had other ideas. They basically said, why should we have to bear the burden of adjustment? We keep cutting. U.S. producers keep growing. We get sanctioned. If anyone's going to cut, it should be the U.S. shale producers. The Saudis decided to put pressure on the Russians, so they cut prices and flooded the market with oil. What the Saudis were looking to do was essentially drive the Russians back to the negotiating table. It worked. And on April 12th, both parties agreed to cut production by almost 10 million barrels a day.

It was a historic output agreement. But now the question is, was it too little, too late? So politics help explain why Saudi Arabia and Russia were slow to cut production and why they might not yet have cut enough. Production is falling in the U.S. too. Just keep in mind that here there's no central authority telling companies it's time to cut production now. We have to wait for market forces to take effect, and sometimes that can cause a little bit of a delay. We're starting to see some slow reductions in output, but not enough to address the serious demand destruction. I mean, many of these producers have hedged their production for this year,

and so it takes more time for U.S. companies to be forced to shut in. I think that's part of the reason why there was such a focus on the OPEC producers, because they have a mechanism to be able to shut down production in a relatively swift fashion. Again, with the U.S. independence, there's no mechanism for coordinated output cuts, and there's tremendous resistance in the industry to doing anything that looks like it is collusion. So going back to Ben's question, is what happened in oil a leading or a lagging indicator? I mean, there's no question that it's a lagging indicator of what has happened in terms of storage capacity being full and production being too high right now. But if Halima says we don't yet have a handle on production, it needs to come down further.

And if Torsten is saying that demand is going to begin trickling back into a recovery in May and recover more fully beginning in June, it sounds like we could be headed for a couple of months more of weakness in oil at least. So I got to believe it's a leading indicator too. And that makes it a very difficult time to invest in the energy sector. Morgan Stanley says they recommend a defensive positioning in North American energy. They say the focus right now should be on asset quality, scale, and balance sheet strength. How many times have we heard that across different industries? The period we're coming up on looks difficult. Some smaller companies may fail. Bigger, stronger companies will be able to weather the downturn and maybe be in a position of profit

coming out of it and gain market share. This is at a time when when you look at the S&P 500 index, the top five companies in there by market value make up 20% of the index. That's a level not even seen during the dot-com stock bubble. The big are getting bigger. But for right now, especially in energy, the big companies might be the safest place to be. Let's turn our attention to someone who's making out quite well in this environment of weird oil. It's the shipping chief we heard from at the beginning of the podcast, Kenneth Vid. Hi, Kenneth. Hi, how are you? Doing well. Thanks for making a couple of minutes to speak with me. You're welcome. Could you help me with the pronunciation of your last name? Vid. Vid. I just don't say the H, right? No, that's right. Kenneth is a CEO of TK. That's

not the letters T and K. That's the word T-E-E-K-A-Y. And he says that it's typical of tanker companies to store oil when there's contango in the market. Remember, that's when oil is cheaper now than it will be in, let's say, a few months. And Kenneth says that normally 5% of the global fleet might be devoted to storage. And what we're looking at now, because we're running out of storage, is that we expect that we could be using up to 30% of the global Tanger fleet for storage. That's a massive jump from 5% of the fleet to 30% being used for storage. And the rates that TK is collecting for storage are up too. That explains why the company's free cash flow has grown so quickly. If you look

at the recent stock price for TK, the whole company is worth just over $800 million. There's debt there, net of cash. That's just over $800 million too. And remember, Kenneth said that annualized free cash flow was about $650 million. In other words, if it continues at that pace, you could pay off the debt in pretty short order. It raises the question of why the stock isn't worth more. Kenneth has a theory on that. So a lot of tanker stocks have been trading at a discount to the steel value that they have. It's obviously taking a bit of time for the market to fully understand how to value a business like that, which has gone from just covering, say,

its operating costs and finance costs to suddenly generating this type of surplus cash flow. When Kenneth talks about the steel value, he literally means the value of the ships. Sometimes when business is bad, investors forget about the money that's being made and they start to look at the value of the assets. But all of a sudden, the money TK is making is pretty darn good and investors are reconsidering. It helps explain why TK started the year around $24 a share. It bottomed around $12 and it bounced back to $24. For TK, if not for the rest of the energy industry, weird oil is good for business. Thanks, Ben, for sending in your question. And everyone, keep the questions coming. Just tape on your phone, use the voice memo app, send an email to jack.how, that's H-O-U-G-H, at barons.com.

Thank you for listening. Meta Lutzhoft is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, please leave a review. Follow me on Twitter to find out about stories and new podcast episodes. That's at Jack Howe, H-O-U-G-H. See you next week. You want to hear the second verse? Yes, for sure. Well, first thing you know, old Jed's a millionaire.

The king folk said, Jed, move away from there. Said California is a place you ought to be. So they loaded up a truck and they moved to Beverly Hills that is. Swimming pools. Movie stars. Thank you Jack. That was very nice. I can't believe I didn't go into music. I can't believe either. That voice.