Oil has been on the move. Oil equities, however, not so much. Naturally, the performance of stocks and commodities can deviate at times as they are generally influenced by various idiosyncratic and sector-specific factors. Still, any sustained disconnect between oil equities and oil prices (a primary driver behind earnings/cash flow estimates in analysts’ models) seems quite illogical. Would one expect Apple’s stock performance to disconnect with iPhone sales? How about banks from interest rates? Or Wal-Mart with consumer spending trends? Tesla with Model 3 orders?
We acknowledge it hasn’t been all sour grapes for energy investors this year, as the S&P 500 Total Return Energy Index is up 6% year-to-date. Keep in mind, this follows an abysmal 4Q18 when the index fell 24%, easily representing the worse performing sector in the US market for that period. Since January, which accounts for the vast majority this year’s recovery in energy stocks, sub-indices reflecting the performance of US oil and gas producers and oilfield service companies have largely flat-lined. This has been despite a strong move higher in both oil prices and the overall stock market.
Over the past ten years, the SPDR S&P oil and Gas Exploration & Production ETF (XOP) has had a 0.68 weekly correlation to the WTI oil price. Similarly, the VanEck Vectors Oil Services ETF (OIH) has correlated by 0.66 to the commodity. The group’s high correlation to oil prices can be reestablished by one of two possibilities: either energy stocks rise to catch up with the commodity or oil prices sink back in line with oil-related equities. Given the current backdrop of positive industry fundamentals and our constructive outlook for most of the sector, we expect the former outcome to correct this dislocation. Our reasoning is based on both industry-specific and macro factors, which should promote not only a catch-up trade (ala one year ago), but also outperformance relative to other sectors of the market.
The Catch-Up Trade
First, we note that the disconnect between the recent rise in crude prices and relatively stagnate oil equities feels much like the market environment a year ago in our piece “Energy Stocks and Oil Prices – Opportunity in the Disconnect.” Then, the combination of a widespread market selloff in January/February 2018 and a tightening oil market resulted in oil equities significantly underperforming the price performance of crude early in the year. As shown in Exhibit 1, this disparity peaked in late March, when energy equities (both oil producers and oilfield service companies) began to make up ground to oil prices.
Today, oil prices are again experiencing a significant lift from tighter supplies. This is the combined result of OPEC production cuts, further Venezuelan export declines, and the looming reestablishment of Iranian sanctions following the expiration of last fall’s Trump waivers. Once again, however, oil equities have remained relatively unresponsive, as investors have wrestled with mixed 4Q results and 2019 guidance, as well as numerous reduced growth outlooks under tightened CapEx budgets. Nevertheless, given the high historic correlations between oil equities and oil prices and the positive fundamentals in place for crude, we believe the recent disconnect will prove temporary similar to a year ago. In our view, this catch-up trade could occur rather rapidly (again like Spring), as investors move from an attitude of “not needing to be there” to FOMO (Fear of Missing Out) with oil prices reaching new psychological levels (e.g., Brent oil above $70/barrel).
Beyond the Catch-Up
In addition to simply a near-term catch-up trade to oil prices, we believe there are compelling fundamental reasons supporting medium and long-term investments in oil-related equities that are being overlooked by the market today.
- OPEC Remains Extremely Relevant and Highly Supportive of Oil Prices. A dramatic rise in US oil production in recent years, combined with numerous Presidential Tweets arguing for lower oil prices to help US consumers at the pump, could have some investors thinking OPEC’s roll in influencing oil prices has been diminished or at least significantly compromised. We would argue that is far from the truth. OPEC in total still controls roughly 30% of the global oil supply and over 40% when including the OPEC+ countries (mainly Russia). Most significantly, a recent IMF report estimates Saudi Arabia (roughly one third of OPEC production) needs a Brent crude price of $80-$85/barrel to fund its government. Despite Saudi’s latest initiatives to diversify its economy, that figure has risen in recent years due to its enhanced social programs and increased military expenses. Finally, Saudi Aramco’s recent bond filing supports the notion that the Kingdom’s production has significant limitations. A key disclosure was that its massive Ghawar field has potential production of only 3.8 million barrels per day (mmbpd), well below the 5+ mmbpd most energy experts have estimated. All in all, we expect Saudi and OPEC in general to remain very supportive of oil prices, likely extending its current policy of production cuts at its next formal meeting in June.
- Consolidation and Capital Discipline Should Serve as Catalysts. We believe we are in the early innings of two major themes that will largely define the energy sector over the next decade. First, we see the current opportunities for US shale growth and the vast number of US shale E&Ps as a ripe environment for consolidation by the larger producers. Larger operators have numerous benefits of scale, both in terms of operating in the field and with capital efficiency. In fact, recent commentary by both Exxon and Chevron of their intensions to significantly grow their shale production (particularly in the Permian Basin) provides strong confirmation behind our consolidation expectations.
Secondly, and maybe most important, many US producers have embarked on a new course of focusing on capital returns and a strategy of spending within cash flows. This new emphasis on free cash flow was discussed at length in our recent piece, “The Evolving Energy Business Model: A Transformational Change from ‘Drill-Baby-Drill’ to ‘Show Me the Money.’” We believe this new strategy marks a major shift in the minds of US oil producers that will ultimately be rewarded in higher equity values.
- A Weaker US Dollar Would be Highly Supportive of Higher Prices for Commodities, Including Oil. A strengthening USD provided a large headwind not only for oil, but most commodities, in late 2018. (Since most commodities are priced in USD, a strong dollar reduces the purchasing power of consumers paying in local currencies. The result is lower global demand.) The rally in the USD in 2H18 primarily transpired from stronger than expected US economic growth, a major slowdown in the Chinese economy due to PBOC’s monetary tightening, and large deceleration in global trade that most negatively impacted trade-sensitive countries in Europe. Nevertheless, as discussed in a recent Morgan Stanley report titled “Too Many Dollars,” the current environment of a more dovish Fed, but a stricter US fiscal policy is typically a precursor to USD weakness. We believe this forecast for a materially weaker USD has substantial merit and is a scenario that could transpire for much of the remainder of 2019. In turn, such USD weakness would likely play the role of an enabler for a broad commodity reflationary trade, including further upward pressure for crude prices.
This material is for informational purposes only and is an overview of the future for oil equities and the potential impact on the energy market, and is intended for educational and illustrative purposes only. It is not designed to cover every aspect of the relevant markets, and is not intended to be used as a general guide to investing or as a source of any specific investment recommendation. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. This material does not constitute investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. In preparing this material we have relied upon data supplied to us by third parties. The information has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by BP Capital Fund Advisors, LLC as to its accuracy, completeness or correctness. BP Capital Fund Advisors, LLC does not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regard to the results obtained from its use. BP Capital Fund Advisors, LLC has no obligations to update any such information.