Monthly Commentary from Dan Pickering
August was a flattish month overall for energy, but there was plenty of activity beneath the surface. Much like July, the S&P500 gained (+2.9%) while energy indices fell. Diversified Energy dropped -2.7% (S&P1500 Energy, S15ENRS), Upstream/E&P was flattish (-0.2%), oilfield services declined -2.7% and Midstream fell -3.4% (AMZ). Oil retrenched -7.4% (~$68.50/bbl), while gas roared another +12.2% to finish the month at ~$4.40/mcf.
For the first time in 5+ years, our lead macro energy commentary is about natural gas. Our friend Mr. Front Month Natty closed August at ~$4.40/mcf and has since rallied further to ~$4.60/mcf on the back of some small Hurricane Ida dislocations and enthusiasm amongst paper traders. This 70% y/yincrease is impressive. Even more impressive is the bump in 2022/2023 full year futures prices to ~$3.70/mcf and ~$3.10/mcf, respectively. This move leaves longer-dated 2023 natural gas above $3/mcf for the first time since 2017. A combination of supportive weather, high global gas demand with resulting high LNG prices and lower gas-to-coal switching are all contributing to the rally. We expect an increase in hedging (grab that high price before it runs away!), an increase in private gas-oriented rigcount (drill/sell more gas while prices are strong!) and very little reaction from public gas-oriented producers (we promised spending discipline and increased return of capital and we can’t back off that promise in the short term!) With the high-productivity Marcellus shale essentially pipeline constrained; rigcount in the Haynesville, gassy EagleFord and SCOOP/STACK is the supply datapoint to watch going forward.
Front month WTI crude oil took a wild ride during August, falling as low as ~$62.30/bbl (-16%) before rallying to close at $68.50/bbl. The surging COVID delta variant was the primary driver, although big macroeconomic trades swept through the overall market, whipping around interest rates, currencies, commodities and stock indices. The increasing impact of trading programs and algorithms (if “X” occurs, buy “Y” and sell “Z”) makes it harder and harder to link commodity trading behavior to fundamental supply/demand influences. Said a different way –there is diminishing supply/demand information content carried in oil price behavior. Our fundamental view remains unchanged. Demand is recovering (despite the delta variant), OPEC is managing its excess supply quite well, public US shale producers are locked in a capital discipline box that doesn’t allow for much increased drilling and inventories are constructive. Oil should trade $60-$80 for the foreseeable future. As Larry David would frequently say in episodes of Curb Your Enthusiasm…pretty, pretty, pretty, pretty, good.
The US energy transition took a meaningful step forward during August with Senate passage of the Infrastructure Bill. Incentives for renewable energy, transportation electrification, hydrogen and carbon capture were scattered throughout. In a sign of the times, as President Biden was urging a greener future and providing cheap/free money to green initiatives, he also called on OPEC to increase oil production. The irony is thick. Although the US wants lower carbon, it remains the world’s biggest consumer of gasoline, and the Administration wants that gasoline to be cheap to keep voters happy (even if cheap gasoline encourages higher consumption). So the story line is: produce those hydrocarbons somewhere else, keep them cheap while we want them, invest aggressively to make them eventually obsolete and demonize the hydrocarbon industry in the meantime. It really isn’t a fair shake for fossil fuels, but it’s the reality of the world in which we live. The double irony is that by indirectly starving the oil and gas industry of capital, these government approaches are actually helping to make hydrocarbon prices higher and hydrocarbon investments more lucrative (for those willing to participate).
In early August, the UN published a report from the Intergovernmental Panel on Climate Change (IPCC). It was characterized as a “code red for humanity” by the UN Secretary General and called for quick action to avert a climate catastrophe. We see “quick” as a relative term when tackling decarbonization. No coordinated global effort will be quick as measured in stock market time. Achieving net zero carbon emissions by 2050 is aspirational, not practical. But the bell is ringing for action and capital continues to pour into the Climate/Decarbonization/Sustainability space at a staggering pace via SPACs, PrivateEquity funds, institutional investor allocations, ESG instruments, sustainability-linked bonds and other financial vehicles. We generally see high valuations and overcapitalization. That doesn’t make decarbonization wrong, it will just make it expensive and painful, a lesson investors learned the hard way in the US shale boom.
Finding/capturing alpha should be the highest priority for decarbonization-focused investors. The good investments are going to be huge (and relatively scarce). The bad investments are going to be donuts (and relatively plentiful). Energy stocks rode a roller coaster during August. Macro fears took them down 10-20%, only to see a broad recovery later in the month. Energy stocks are dealing with numerous crosscurrents. The Value vs. Growth debate. The energy transition overhang. The onus of being the best group in the market for most of the year (profits to take when people look to reduce risk). Discounting ~$50/bbl when the 2022-2025 forward curve averages ~$60/bbl. Lots of noise. Butunderneath the noise is a solid investment case. We find it hard to believe inflation is transitory given cheap money and expensive labor. Combine that with an industry that is getting better via improving returns on capital and you have a recipe for ongoing outperformance. We remain bullish.As always, we welcome your questions and appreciate your interest.