If an investor only tracked energy stocks and not commodity prices, there is a good chance he or she would not be aware that oil prices have surged. While many energy equities remain in the doldrums, today’s stout WTI oil price above $63/barrel represents a dramatic improvement from the mid-2017 low of $42/barrel. Similarly, the spot Brent price (a seaborn crude), now at roughly $68/barrel, has spiked from a low of $45/barrel last summer. A lot has changed fundamentally to drive the oil price improvement, namely:
- A dramatic tightening of global oil inventories. This has been largely the result of production cuts from the OPEC + group (primarily Saudi Arabia and Russia), in addition to strong refinery runs across the globe.
- Growing political risk in several key oil-producing countries. Most importantly, Venezuela has seen its production plummet nearly 30% over the past two years to 1.7 million barrels per day (mmbl/d) and could see a further large drop given the current chaos in the country. Also, Iran could experience a significant falloff in oil production should US-led economic sanctions resume.
- A lack of large projects on the horizon. The impact of large project cancellations during the prior oil downturn should begin to be felt in earnest in 2019. We believe oil markets have increasingly recognized the upcoming supply impact.
- Robust global energy demand. This is being driven by the goldilocks economic environments in most key developed markets, as well as particularly strong growth in emerging markets.
- A substantially weaker USD. Currency movements have been supportive of not only oil, but for commodities across the board which are priced in American greenbacks (e.g., copper and gold).
Unfortunately for investors, while these factors have provided a strong tailwind for oil prices, they have had little consequence to the performance of many oil equities. This disconnect is most glaring when analyzing the broad performance of oil producers and oilfield service providers. Despite approximately a 50% improvement in the WTI oil price off the June 2017 low, the XOP and OIH (the two primary ETFs for oil producers and oilfield service companies) have returned only 14% and 0% respectively over the same period. This divergence has occurred in spite of traditionally-high correlations between oil-related equities and oil prices. Specifically, over the past five years, both XOP and OIH have approximately 0.7 correlations to the WTI oil price.
The breakdown in the correlation between oil equities and oil prices has many investors scratching their heads. This is particularly the case for E&Ps, where the commodity price input represents the main variable in the earnings and cash flow models for analysts across Wall Street. It seems equivalent to Apple’s stock disconnecting from the number iPhones it sells, or Boeing being uncorrelated to the price it gets for its planes. Still, as we seek answers for the divergence in energy, we have arrived at a few possible explanations. We don’t necessarily believe these reasons justify the lackluster performance of the group. Rather, they may just represent mainly temporary factors that are preventing investors from allocating funds to energy equities.
1.Continued fears of oil oversupply. The oil price curve remains significantly backwardated. In other words, prices for future periods are lower than the spot price. (At the time of this writing, the WTI front-month price is slightly above $63/barrel, while the mid-2019 price [July] is just below $58/barrel.) This backwardation is reflective of the ongoing tightening in oil markets, where inventories across the globe have drawn dramatically. It also in turn reflects expectations of “less tight” oil markets (i.e., rising inventories) in the future, particularly given forecasts for rapidly growing US shale production.
For most of 2017, US oil output, as stated by the EIA’s monthly production reports, hovered in a range of 9.0-9.2 mmbl/d. However, a series of large step change increases in those figures beginning last fall (see Exhibit 4) appears to have accentuated fears that US supply growth will ultimately dwarf the growth in global oil demand, particularly if this growth is accompanied by a resumption of full OPEC + production.
As we have written previously, we believe there are numerous real-world constraints to US shale production, as well as new capital discipline strategies among E&Ps, that should inhibit this supply growth going forward. (Extrapolation – When Excel Loses Touch with Oilfield Realities) Moreover, with the IEA expecting demand to expand roughly 1.5 mmbl/d, combined with the dearth of large projects entering the market, we believe the world desperately needs the added short-cycle US production. Finally, recent oil price increases have occurred across time periods, with the entire forward price curve shifting higher, rather than simply backwardation increasing.
2. Coming off a tough 4Q reporting season for many energy companies. The most recent 4th quarter 2017 reporting season for energy, occurring from mid-January to late February for most E&Ps and oilfield service companies, was filled with numerous landmines for investors. Operational issues included weather impacts, sand delivery delays, extended employee holiday breaks, and new geologic concerns (most particularly in the MidCon region in Oklahoma). Naturally, many of these issues (especially weather) were transitory in nature. Still, they reminded the market of the ever-present company-level execution risks that go along with investing in the sector. As such, the latest reporting season was clearly not a positive in improving investor sentiment toward the group.
3. Company factors that lessen the impact of higher oil prices. There are several factors among energy companies that could partially negate the benefit they experience from higher oil prices. The most obvious is prior E&P price hedging. Here we would note, however, that most producers have only hedged a portion of their upcoming production. (As of 4Q17 reporting, US oil producers had hedged on average roughly 50% of their 2018 expected production and approximately 10% of their 2019 anticipated output). Also, option strategies used include tactics like three-way and costless collars, which provide producers the opportunity to still benefit from higher oil prices while protecting the downside.
Separately, the potential for a shortage of takeaway capacity in certain regions has led to widening geographic price differentials. This could result in certain oil producers realizing a meaningful discount to the spot price. The threat is having the largest impact on Canadian oil prices, as well as the price at the Midland, Texas hub (Permian Basin) versus the benchmark Cushing, OK price. As shown in Exhibit 8, the price differential between Midland and Cushing has recently blown out to levels not seen in recent years, reflecting near-term concerns that oil supply could be trapped in basin due to a lack of takeaway capacity. Importantly, we view these regional price discounts as relatively short-term phenomenon, as widening spreads will naturally invite more takeaway capacity to be added, ultimately reducing the price differential.
Finally, higher than previous expected costs for labor, materials (e.g., steel under new Section 232 tariffs), and services in general could serve as additional headwinds for oil producers. Still, we see a silver lining to this as such cost increases imply a shift higher in the marginal costs for US producers. And, under a marginal cost argument, higher oil prices will be needed for incremental barrels to come to market.
4. Many investors remain scarred from their latest energy experience. The growth in FAANG and other technology stocks, combined with recoveries in other sectors in recent years (e.g., financials), has left energy at below a 6% weighting the S&P 500. This compares to an average weighting of 9% since 2000 and above 10% for much of the 1990s. One of the explanation for the decline is that investors have become scarred from the boom-bust energy cycles over the past decade. Combined with concerns regarding the growth of alternative energy and electric vehicles (EVs), we have heard of energy being referred to as a potential “value trap” or even worse classified as taboo stocks like tobacco that represent the market’s past, not its future.
Our pushback to the latter is that energy is in fact a growth sector. Even with concerns over EVs and diminishing per capita oil consumption in developed economies, demographic-led growth in emerging markets should continue to propel oil growth well into the future. In fact, outlooks from major independent energy research organization, such as the EIA and IEA, all show oil and natural gas demand rising roughly 1% annually through 2040.
Furthermore, we believe a perceived “value trap” risk with energy is more than offset by a simple cash flow argument. Logically, for companies that are well managed, higher oil prices should lead to substantially higher cash flows. With the industry’s new focus on capital discipline, such cash flows should increasingly be used to finance prudent growth, as well as shareholder return via buybacks and dividends. (Read our blog US Shale Capital Discipline: Fact or Fiction?) In short, we find it hard to fathom that companies engaging in such practices will not see their share prices benefit from growing cash flows driven by higher oil prices or other factors.
In summary, we view it as unlikely for the current disconnect between oil equities and oil prices to persist. And, since we believe near-term oil prices will remain well supported by the factors discussed above, we expect this disconnect to be resolved ultimately by a meaningful appreciation in the equity prices of the group in general. Naturally, the sector will be divided between the good operators and the bad, which should remain key to individual stock performance. Also, we believe the potential for further industry consolidation, following last week’s Concho Resources (CXO)-RSP Permian (RSPP) announcement, could drive equity outperformance for some companies. In our view, this highlights the need for active investment management in the energy space in differentiating between the winners and losers and investing in those companies where the market’s mispricing has created the best reward-to-risk opportunities.
The opinions and forecasts expressed are those of BP Capital Fund Advisors as of April 4, 2018, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security. In addition, the examples highlighted above are hypothetical. Actual rates of return cannot be predicted and will fluctuate. Past performance is no guarantee of future results.
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