Monthly Commentary from Dan Pickering
July was a soggy month for energy. While the S&P500 gained +2.3%, energy indices fell across the board. Diversified Energy dropped -8.7% (S&P1500 Energy, S15ENRS), Midstream fell -7.1% (AMZ), oilfield services declined -12.8% and Upstream/E&P was the subsector laggard at -14.4% (XOP). Energy commodities outperformed energy stocks as oil gained +0.7% (~$74/bbl) and gas tacked on +7.2% to finish the month at ~$3.90/mcf.
Be still, sad heart! And cease repining
Behind the clouds is the sun still shining
Thy fate is the common fate of all
Into each life some rain must fall
Some days must be dark and dreary
– Excerpt from The Rainy Day, Henry Wadsworth Longfellow, 1842
Longfellow knew in 1842 that not every day or month can be perfect. July followed that playbook for the energy sector. OPEC confusion and an increase in covid fears associated with the delta variant brought some rain to energy investors. Stocks were worse than commodities. Both were volatile. We remain constructive on both.
July’s oil markets started with confusion. OPEC was somewhat in disarray with a quota disagreement between Saudi Arabia and UAE resulting in “no result” from the monthly OPEC powwow. By strict definition, this meant there would be no incremental barrels returned to the market in August or beyond. Bullish? Perhaps mathematically, but as we penned last month, fractures within OPEC create uncertainty….and uncertainty is a bad thing in financial markets. WTI oil drifted from ~$76/bbl to the low $70’s as a result.
OPEC uncertainty resolved itself mid-month with an OPEC+ agreement that gave both UAE and Saudi what they wanted. UAE received a higher baseline of production; Saudi got an extension of the OPEC+ agreement through YE2022. However, the OPEC resolution coincided with a surge in delta variant covid cases. This one-two punch (higher supply and the potential for lower demand) resulted in a gap-down day for crude as it tumbled from ~$71.50/bbl to $66.40/bbl, with an intraday low of ~$65.60/bbl. However, oil finished July a tad bit below $74/bbl. Can’t keep a good man down? Somewhat – the physical market continued to tighten (ongoing inventory draws), and overall economic activity remains strong. Thus far, delta variant is causing fear of renewed lockdowns, not an actual, meaningful deceleration of demand.
Looking ahead the delta variant is certainly a risk for energy commodities and stocks. Some corporations are delaying their return to office work. Some businesses are renewing mask mandates. There is a very real possibility of selective state/government-mandated lockdowns. All of which could lead to a dip in energy demand or a plateau of demand recovery. However, compared to the initial emergence of the virus, we now have vaccines. While cases are rising, covid deaths are a fraction of prior levels. There is also meaningful pent-up demand for a return toward normalcy, which is resulting in ongoing increases in air travel, even as covid news has turned more scary on the margin.
Factoring in the above, we have chosen to remain constructive on the oil markets. This doesn’t mean that oil can’t/won’t fall back into the $60’s (or maybe even the high $50’s). There’s a decent chance (at least 50%) that oil prices finish the year lower than current.
But probably not dramatically lower. OPEC is back on track, inventories are normalizing, demand issues should be transitory. In sum, we think it’s more appropriate to be bullish than bearish about the oil markets over the next 24 months. Of course, we fall back to a quote attributed to the economist John Maynard Keynes – “When the facts change, I change my mind. What do you do, sir?” We will be keeping a close eye on the facts.
US natural gas has been very strong, trading over $4/mcf for much of July. European gas is trading at record levels. Ironically, many US producers increased hedges during Q2 at levels well below the current strip. This has translated to gassy E&P stocks being punished as Q2 results were reported. Hedges in the high $2’s and low $3’s would have been greeted with jubilation this time last year. But when the marginal buyer of energy stocks is a hedge fund playing for upside, high $2’s and low $3’s has gotten a big fat raspberry. The free cash yields from gassy E&Ps are 8-15% even with below-market hedges and we have added to our (relatively small) gas-oriented position on weakness.
In the land of energy transition, the rush continues for partnerships, joint ventures and overall increased exposure. The current Infrastructure bill contains significant funding for various energy transition initiatives such as hydrogen and carbon capture. Electric vehicle incentives have been scaled back from the original bill, but allocations to EV charging infrastructure remains significant. We remain firmly in the camp of decarbonization as a megatrend, although finding public company plays at reasonable valuations remains challenging. We’ll keep looking! In the meantime, traditional oil and gas stocks present more consistent value and risk/reward. We’ll keep owning!
Given this month’s commentary is already sprinkled with quotes, it feels appropriate to end with another from Danny & The Juniors circa 1958 – I don’t care what people say, rock ‘n roll is here to stay.
As always, we welcome your questions and appreciate your interest.