COM - IEO's Recent Discount Could Be Short-Lived

Summary

• IEO, like the rest of the oil industry, took a hit as crude prices declined on price cap announcements by European countries.
• The price caps are supposed to limit the price that will be paid for Russian oil imported to Europe.
• Speculators were likely expecting a more severe and immediate retaliation from Russia, and have unwound their long oil positions since supply chains haven't been hit.
• We think Russia has every opportunity, with only minor hurt to its current account, to retaliate against Europe in a cold season by diverting supply elsewhere.
• Urals price is about $40, so while $60 is a lot better per barrel, the price floor is more than profitable. Also, traders may still not want to deal with Russia because of the admin burden.

The iShares U.S. Oil & Gas Exploration & Production ETF ( IEO ) owns key assets in the oil space. Mostly, the exposures are levered to the price of oil, which of late has declined. Therefore, IEO has been slightly discounted. The primary reason is to do with geopolitical volatility concerning the price caps that a union of European countries is attempting to place on Russian oil inputs. We explain in detail, but our view is that speculators have unwound long oil positions as Russia hasn't retaliated as forcefully as expected, but they will soon and it should cause problems in energy markets.

IEO Breakdown

IEO is skewed towards a couple of big names, namely ConocoPhillips ( COP ), in the E&P space. Oil price levered issues dominate the ETF at 73%, with the rest being refinery and transportation, which either operates on fixed tolls and volumes, or on the basis of crack spreads which can be uncorrelated from oil prices sometimes too. However, generally as refineries do run cuts, which is usually brought on by poorer crack spreads, oil prices eventually fall as well. Crack spreads will typically decline, but the declines of crude are a cushion. Nowadays, the repurposing of refining capacity for renewable diesel purposes has been a boon to the refiners that remain, as the refinery capacity is very limited, and utilisation rates are extremely high. But because of demand declines from recessions in China and Europe, crack spreads have come down quite meaningfully, more or less into early 2021 levels . The toll road stocks should be very solid, and this forms about 7% of the overall allocations.

E&P stocks which are directly levered to the price of oil have come down too as well, causing the IEO to retreat 10% over the last two weeks.

Bottom Line

The reason are the price caps instituted by European countries against Russia. The idea is that Europe will not be an end-market for any oil from Russia that was purchased at above $60 per barrel. Oil prices have retreated towards that level, we think because long trades on oil have unwound as markets expected immediate retaliation from Russia.

The reality is that $60 is not a very low price cap, and is still 50% above the Urals price, which has been determined by trade with the Middle East, South/Southeast Asia and other countries that are neutral towards the Ukraine war. Trade with Europe will be very profitable for Russia still. The reason for this weak-sauce price cap is firstly because US influence on the negotiation process likely moderated the cap in order not to trigger an energy supply catastrophe. The other reason is that Europe is probably not wanting to risk overreaching since winter is here, and if there are energy supply problems, an already weak Europe is going to get even weaker. Not all European countries are on board with the price caps either .

Russia has already stated that it intends to not permit the price cap to be effective with its trading partners. What this means is a little unclear, but it is likely a signal that Russia will just redirect supply to major off-takers like India , who have surged imports of Russian oil at low prices to their city-sized megarefineries, to then sell refined product into an incredibly tight western market. The profits of Indian refineries lately have been grotesque, although cracks are falling. If supply to western markets suffers, the Brent and other benchmarks for crude for western producers will shoot up again. We think Russia will flex all its mercantilistic power in order to cause as much pain to nations on the other side of its hostilities with Ukraine, since the $40 Urals price is more than sustainable for the Russian war machine.

Whether Russia retaliates or not is speculative, but what is for sure is that a $60 price cap, if western prices were indeed to arrive there, is way above breakeven levels for western E&P producers. The worst among them, shale producers, which feature heavily in the IEO, are breakeven at around $32-36. The NCS producers at $18, and the western average is somewhere around $25. IEO will do well at the price cap prices.

However, we still think the retaliation will create supply side issues. Also structurally traders are not going to want to fool around too much with Russian supply, just because sanction compliance is likely a massive administrative pain. Prices should remain well cleared of the $60 level, where now it's at $79 for the Brent, without much problem. Moreover, the Chinese reopening should fuel a demand thesis for oil soon.

Admittedly, IEO is a bit expensive. 17.7x is a high multiple for oil stocks. You can get much better deals in single stocks. Aker BP ( DETNF ) is a good pick , but the most ear-splitting bargain is JAPEX ( JPTXF ). We would never invest in IEO when those sorts of deals are available on the market outside passive investing.

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