Tuesday, August 22, 2023

Two More Reasons to Be Bullish on Oil

By Whitney Tilson (View Archive)

Yesterday, I explained two bullish factors that point to optimism for the oil market...

As I said, the first factor is oil cartel OPEC's production cuts. Without high oil prices, countries like Saudi Arabia can't afford to balance their budgets, so OPEC is doing what it takes to keep oil prices up.

Additionally, Russia is atrophying...

In the near term, Russian President Vladimir Putin flooded the global market, looking to raise revenues to fund the war on his Western front. The effort is ultimately sapping its energy production in three ways...

First, the revenues they are raising are far less than they were prior to the war. That's less money for reinvestment. Second, the money it's raising is going toward its war efforts and away from the oilfields. This matters because of the third point: Russia is unable to reinvest in its infrastructure...

For the crippled Russian state apparatus, it's going to lead to irreversible decline in production, slowly but surely.

Today, I'll explain two more major tailwinds for oil stocks...

  1. The Strategic Petroleum Reserve is turning 

The Strategic Petroleum Reserve ("SPR") is our country's emergency oil stockpile.

Established in 1975 in response to that decade's oil crisis, the SPR's purpose is to provide a buffer against disruptions in oil supplies and to protect the country's energy security. It consists of underground salt caverns located in four sites along the Gulf Coast.

Over the years, the SPR has been utilized during times of supply disruptions, including the Gulf War in 1991 and Hurricane Katrina in 2005.

But those were mere blips compared with the massive liquidation that the Biden administration has engineered. First, as the economy recovered after COVID, the SPR started to release barrels... But in response to Russia's invasion of Ukraine, the selling accelerated.

As the price of oil spiked, President Biden directed the SPR to release barrels onto the domestic market in hopes of keeping a lid on prices at the pump. But even as oil prices declined, the administration kept draining the SPR an unprecedented amount...

In total, the current administration has sold nearly half of the country's SPR – more than 250 million barrels of oil, which has put more than $20 billion of downward pressure on the market.

But this setup can't go on forever.

Total SPR capacity is 714 million barrels. Today, inventories sit at 348 million, less than half-full.

Can it empty further? Sure. But this can't go on forever. And it's reckless, if not downright dangerous, to continue to liquidate the SPR.

This is a "strategic" reserve, put in place to mitigate risks to the U.S. energy complex. It only has value if it can be used in an emergency. And currently, the U.S. energy complex isn't facing an emergency. It's operating efficiently and smoothly, with or without the extra barrels.

It's inevitable that the U.S. will go from a massive seller of oil to a massive buyer of it. And when it does, we'll make a multibillion-dollar purchase that will send the energy market soaring.

  1. U.S. onshore is slowing

The other great swing factor in global oil markets over the past decade has been the U.S. onshore market. But unlike Russia, this only points to lower production.

The last decade saw a revolution in the onshore oil industry in the U.S. Hydraulic fracturing ("fracking") led to an explosion in drilling onshore in the U.S. in giant oilfields like the Permian Basin in West Texas.

However, the drilling came at a cost. Frackers dramatically outpaced their cash flow generation – in many cases, spending more on drilling than they generated in revenues. The result was minimal free cash flow ("FCF"), even at high oil prices.

Today, the opposite is true, dramatically so. A decade ago, when prices were high, FCF was negative. Today, with prices in the $80s per barrel, FCF is around an all-time high for the sector.

This means two things...

First, it's a pure reflection of the dramatically scaled-down drilling in the oil patch. Even with bumper cash flows, these executives are still paying for the mistakes their predecessors made, and so they refuse to drill.

Second, it means the stocks are dirt-cheap. This is what a great investment looks like, even when the outlook around it gets turbulent. If this were a rom-com, it would be the part toward the end of the movie, where you know the two people are made for each other... they just have to get through the hard part.

Tomorrow, I'll cover the hard part... and why it won't really matter for these stocks. Stay tuned!

Best regards,

Whitney Tilson

P.S. The incredible setup in the energy sector is exactly why we created our Energy Supercycle Investor newsletter...

To capitalize on this massive opportunity, we built a 10-stock portfolio of companies we think are poised to rise 100% to 1,000% in the next few years as this story plays out. In a special presentation, I share all the details – watch it here.