The following is a proposed top-down framework for energy investing and thoughts on what to do with energy during the current downturn. Included is an overview of energy cycles, when energy stocks work, and when they don’t.
Long thread and a lot of charts. Enjoy.
A few rules:
- Equities follow crude.
2. Crude time spreads momentum dictates crude price momentum.
- Over the medium term, crude follows:
a) global inventories
b) Emerging Markets (BRICS) growth
In a nutshell, as goes the global business cycle, so goes the energy cycle #1 Crude vs OECD inventories #2 Crude vs BRICS GDP.
The energy sector broadly follows the global business cycle. When growth accelerates, demand for crude grows, forcing tightness on the crude market to force global inventories are drawn down to meet global demand. The inverse holds when the global business cycle inverts.
The generic energy cycle consists of inventory build and inventory draw periods. Inventories build when supplies exceed demand. Conversely, inventories draw when demand exceeds supply.
Draws = Bullish
Builds = Bearish
Energy equities (orange, inverted) and crude inventories:
Next, an examination of the behavior of energy equities within the phases of the energy cycle. History doesn’t repeat itself, but it rhymes across cycles. We’ll look at the behavior of various facets of the energy market under the four phases of the energy cycle.
For our purposes, OECD crude inventory peak/trough levels will mark the inception/terminus of the cycle.
Time spreads will serve to define the four phases of the energy cycle.
The 2010-2016 cycle serves as the template for the model. After the GFC, crude inventories peaked 2H10 and began ~3yr draw until late ’13 as global growth recovered. Inventories built gradually in ‘14, then aggressively following the 4Q14 OPEC collapse and peaked ’16.
Energy Cycle Phase Progression
Energy Cycle Phase Progression Using timespreads as the barometer of global crude market tightness or weakness, we break the cycle down into 4 phases:
Phase I (Bounce): Time spreads bottom near peak inventories, at a level adequately baking in onshore storage economics. This is the move off the bottom that signals a positive rate of change (“it can’t get any worse”). Weak but not weakening further.
Phase II (Stability): Next comes the slog, the Stability phase. During this period, the market contends with the overhang of bloated inventories, gradually being worked down over an extended period. Time spreads oscillate but don’t break out decisively.
Phase (III Euphoria): Once inventories have been worked down to a level signifying true supply/demand tightness, time spreads break out. So begins the Euphoria phase. Supply < Demand. Time spreads rally as market signals need for more crude promptly
Phase IV (Crash): Invariably, the good times come to an end; so begins the Crash phase as Supply > Demand. Excess supply pushes time spreads back into contango and inventories begin building again.
Below is progression of the crude curve throughout the phases of the 2010-2016 cycle. Starts in serious bearish contango, heads to flat, eventually bullishly backwardated, then fades to flat en route to contango again.
Equity Performance Across the Cycles
Now shift to equity performance across the cycle. In general, equities trend in the direction of time spreads, moving concurrently with a tightening or loosening crude market.
Phase I (Bounce): Equities rally hard. Visibility into worst case scenario has improved and positioning adjusts to a more constructive macro outlook.
Bounce violence = crash violence
Phase II (Stability): Following the bounce, the equities normalize in the Stability phase. Volatility subsides and the market gradually absorbs the crude storage overhang. It’s broadly a neutral/slightly positive environment that favors quality – long duration.
Phase III (Euphoria): Eventually, the storage overhang is worked off and the market enters truly tight supply/demand dynamics in the Euphoria phase. As time spreads rally to reflect tightness, the equities respond in kind and head towards cycle highs.
Phase IV (Crash): Euphoria gives way to the Crash as the cycle abruptly ends. Equities plummet until the cycle low is set by timespreads pricing in the worst-case scenario again.
What works during each phase of the energy cycle?
Long term within energy, high quality beats low quality. In a cyclical commodity business, the producers with best assets, best returns, and best balance sheets win over time.
However, there are brief periods of time where low quality beats high quality.
1) After market-wide risk-off, high VIX periods Blue: high vs low quality energy. In a selloff, high obliterates low. In rebound, low quality enjoys a short-lived burst of relative strength.
The second scenario in which low quality > high quality occurs during a Phase I Bounce off the bottom in the cycle (e.g. 1Q16, 3Q10, 2Q20?)
How does the energy sector fare relative to the entire market? Given the industry’s well-deserved chronic underperformance, it seems reasonable to expect a continuation of this high qual > low qual trend – EXCEPT for the move off the bottom.
During the Bounce phase (3Q10, 1Q16), the sector can beat the aggregate market briefly. After the move off the bottom though, energy should continue to lag the broad market until global growth exceeds trend, and global crude spare capacity has been exhausted 3Q10 & 1Q16 bottoms.
Where Are We Now and Where Are We Headed?
Returning to the framework — time spread momentum determines crude price momentum. Equities follow crude. Crude follows inventories and global growth.
Status today, in order:
- Time spread momentum = crude price momentum. M1-M2 have bounced off a bottom and pulled up crude. Longer dated M1-M6 looks even healthier. Crude curve, still contango, flatter than a week ago
2) Equities follow crude. Equities did follow crude on the way down and on the bounce up, but have outrun crude the last two weeks. This is a gap that needs to be reconciled by equities falling, crude rising, or some combination thereof for the historical relationship to hold.
3) Crude follows inventories and growth is happening as expected. Unique in this cycle is storage capacity constraint. Market can’t get fuller than full. Timing might be imprecise, but max storage capacity will be reached in coming weeks/months and then has only one way to travel.
Growth is the moving target.
A conclusion the market has reached though, is that after taking a beating in ’20, historical growth rates will resume in ’21 and ‘22 EM (BRICS) growth Marking up EM GDP with 2021/2022 estimates.
Market hates uncertainty. It believes today that the Corona crisis has an end, be it vaccine or herd immunity.
In April, it has dramatically reduced uncertainty around left tail risks (Fed), max Covid-19 eco damage (May+ reopenings), peak crude inventories (physics), and EM growth.
These have all allowed it to focus on a more normalized ’21 environment, treating ’20 as a one-time natural disaster.
So two of the three energy rules are holding — spreads and growth visibility are conducive. But there is a nagging gap between equities and crude. We’re not in Euphoria, nor are we in Stability. Either mid-crash or early-bounce. How does the data line up relative to precedents?
Bottoms share traits — but none are identical.
A look back at 30+ years of crude crashes — note consistency of aggressive bottom (crude, spreads, equities) followed by a bounce, followed by grinding stability.
’85-’86: limited data availability. Near term spreads bottom in line with crude. Bounce a few weeks, test the lows, then grind on.
’98-’99: Panic spread collapse ahead of actual crude lows, which are set at traditional contango levels. Rally a few weeks, retest the lows, then grind on. Sector bottoms at second retest of crude lows.
’08-’09: Multiple tests of lows. Sector bottoms after second re-test.
’15-’16: Crude tests lows twice in a few weeks. Spreads bottom on retest of lows, though equities bottom at initial lows.
Supply and demand have both inflected, that’s positive. They’re both decidedly out of whack, which is negative, but the market has seen the worst of the imbalance.
Based on the severity of the selloff, the proximity of max storage and inflection of the cycle, the bottom in the energy sector is in. We’re in the Bounce phase where prices are off lows, but will need to stay below cash costs to ensure that necessary shut-ins are implemented.
However, after the April sector rally and pernicious gap between crude and equities, it’s reasonable to expect near term weakness in the equities (10-20% depending on flattening of curve).
After the Bounce phase, the market will transition to Stability where it will spend a long time at survivable (for some), albeit low crude price (~$30-35/bbl) level to work down inventories and disincentivize new capex.
The longer prices can stay suppressed, the better it is for balances in 2021+. Equities see this already —it is this trade we’re eyeing. This is the long high quality – short low quality trade that grinds and grinds and grinds for a while.
We are using this period of NT weakness as the rare opportunity to pick our spots and add quality energy positions. Equities will see with each passing day that 2021+ could be quite meaningful for those companies that will make it. Hedging long quality with short low quality.
Don’t chase, be patient for entry points, the cycle takes time. Recall that the material P&L in energy is made at the inflections. Buy low, sell high. Stick with what you know. Adhere to the process.
This post was originally a Twitter Thread by @viscosityRedux. Go give them a follow.