S&P 500 up, Energy down. For energy investors, it’s getting kind of old. We sympathize, particularly since we believe the fundamental backdrop for the sector continues to improve on multiple fronts. Earlier this year, lackluster performance by energy equities was easier to understand. Inventories in the U.S. continued to expand despite the OPEC production cuts; shale producers were unashamed in boasting about their abilities to aggressively grow at lower breakevens (quoting single-well economics); the risk to oil production in global hotspots (e.g., Libya, Nigeria) was to the upside; and the weekly U.S. oil rig count was steadily expanding, implying an upcoming abundance of new supply.
But, as detailed in our last blog “Oil: It’s getting tight in here,” we believe all of these factors have now shifted to the positive. Saudi Arabia has upheld its pledge to drastically reduce its oil exports, and OPEC as a whole has vocalized its intention to maintain its policy of production cuts well past the current March 30, 2018 expiration. Also, geopolitical issues in countries like Iraq, Iran, and Venezuela, in addition to aforementioned Libya and Nigeria, now present downward supply risks.
Maybe most importantly, excess oil inventories are largely gone. Internationally, this is evidenced by the steep backwardation in the Brent forward price curve, signaling tight supplies and little financial incentive for producers/speculators to hold inventories. In the U.S., inventories remain above average due to still bloated supplies at the Cushing, OK hub. Nevertheless, we believe continued strong demand and a growing export market (supported by a favorable Brent-WTI spread) should lead to further U.S. inventory draws, which are already at a record pace in recent months. Moreover, the U.S. oil rig count figure that was recently causing investors so much nervousness has seemingly plateaued and even appears to be on the decline (falling by six last week in the critical Permian Basin, the largest drop in 19 months).
Finally, on the corporate front, some energy executives appear to be better embracing capital discipline (e.g., Anadarko Petroleum’s September 20 press release), as well as more openly discussing constraints to growth, including labor, trucks, water, pipes, well productivity declines, etc. We believe the implication is lower future supply growth from U.S. shale producers than many analysts have forecasted.
These bullish factors seemed to receive some attention by the market recently, with many energy equities bouncing strongly off their early-September lows. (We recognize that value stocks in general finally experienced some outperformance relative to growth equities in September 2017.) Still, despite dramatically improved sector fundamentals, most stocks across the oil spectrum (E&Ps, services, midstream) remain in the doldrums. What gives? Have investors collectively misinterpreted the data, or do they doubt the longevity of such positive factors?
Alternatively, is the market simply being complacent to energy fundamentals? This would be similar to what many pundits believe was the case in 2014 (on the positive side) just prior to the large decline in oil prices. In hindsight, it is evident that oil prices then of $100+ per barrel (as well as the corresponding robust equity prices of most upstream companies) overlooked troubling fundamentals, such as demand destruction and rapidly growing U.S. shale production, that would ultimately prove extremely deleterious to the sector. Similarly, in today’s context, one could argue that such complacency may explain the groups’ malaise despite improving fundamentals.
We believe this complacency theory toward energy can be supported by a few factors:
- Passive investing. The broad trend toward passive investing via ETFs (electronically-traded funds) generally benefits larger, momentum equities (read FANG stocks) relative to out-of-favor sectors. Simplistically, greater buying in those stocks pushes up their equity prices and therefore, absent adjustments, increases their weightings within a given index. This requires newly-invested passive money to buy more of those equities relative to underperforming stocks, resulting in further outperformance and even larger index weightings.
- Investment managers do not feel pressure to have energy exposure. Today, energy constitutes only 6% of the S&P 500. This is only slightly above the lows the sector experienced in the tech boom of the late 1990s/early 2000s. With such a low weighting, many portfolio managers and investment advisors do not feel any need to allocate, or overweight, funds to the sector or take the time to study the current fundamentals of energy.
- Easy to dismiss energy on longer-term worries. It’s become easier for investors to dismiss energy on oft-discussed, longer-term factors, particularly the rise of electric vehicles (EVs). Although EVs may ultimately have a disruptive impact to oil demand, we believe a major impact is likely further away than many investors appreciate. The key reasons include the still small overall vehicle penetration rate of EVs expected over the next several years (e.g., 2.5 – 4.5% by 2020) and the current overwhelming fleet of combustion engine vehicles that are unlikely to be retired over the next decade. Nevertheless, the increased attention on EVs may provide investors an easy reason to scratch energy off their list of potential investments.
We acknowledge that these macro and sentiment-driven factors may remain headwinds for energy. Still, we believe, like 2014, the underlying physical fundamentals for oil will prevail and that any current market complacency will prove temporary. Acting on inertia bias (one of the common cognitive biases leading to bad investment decisions), investors often believe things will stay as they are. However, in reality, things stay the same until they don’t. Thus, expecting equity markets to remain complacent to improving fundamentals not only seems irrational, but ignores what we believe is an attractive investing window prior to energy equities better reflecting the current oil environment.
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