January 2024 – Commentary from Dan Pickering

More of the same. For January 2024, the S&P500 gained +1.7%, the Nasdaq Composite rallied +1.0% while Diversified Energy (S&P 1500 Energy, S15ENRS) fell -0.6% with subsector performance as follows – Midstream +4.4% (AMZ), Upstream/E&P -2.8% (XOP), Oilfield Services -5.5% (OIH) and Clean Energy -11.3% (ICLN). WTI finished the month at $75.85/bbl (+5.9%) while natural gas closed January at $2.10/mmbtu (-16.5%).⁽¹⁾‍

Last month we characterized the outlook for 2024 energy markets as a slog – January 2024 is what a slog looks like. Increased violence in the Middle East sparked a (relatively small) upward move in crude oil that was mostly ignored by energy investors. The Biden Administration announced a climate review of earlier-stage LNG projects, potentially slowing their start-up timeline. Saudi Arabia announced it would not boost oil productive capacity from 12mmbopd to 13mmbopd in mid/late decade as it had previously targeted. Energy stocks lagged the broader market.

Industry consolidation continued in January. In the midstream sector, Sunoco (part of the Energy Transfer family of companies) acquired NuStar, while offshore producer Talos almost doubled its size with the acquisition of private QuarterNorth. Both transactions had notable components. Sun paid a significant premium (+32% offered vs. NS previous closing price), a departure from most Upstream transactions where premiums have been in the low single digit range. The Talos transaction was followed quickly by an equity offering to partially fund the transaction. A follow-on deal is not unusual in these circumstances. However, the fact the offering was upsized illustrates that investors can be enticed when the right set of conditions emerge (strategic fit of the underlying acquisition, inexpensive stock, supportive anchor investors). Consolidation is about 1) inventory (for business longevity), 2) size (for investor relevancy), 3) scale (for increased efficiency and profitability) and 4) value (attractive financial metrics). In our view, consolidation will keep happening until some mix of these four components are no longer present. Said another way, if investors won’t buy energy companies, they will buy each other.

Right now, Saudi Arabia is THE most important player in the global oil markets, so a discussion of their recent capacity announcement is warranted.

• The prior plan had Saudi increasing its nameplate capacity from 12mmbopd to 13mmbopd by 2027. With current production at ~9mmbopd, the path to 12mmbopd of actual production is windy and feels years away without some sort of global geopolitical escalation. Thus, from a pure capital efficiency perspective, why should Saudi spend many billions over the next 3-4 years when the resulting capacity is unlikely to generate revenue in the medium term? Historically, the answer has been to cement Saudi’s place atop the world oil market, as well as provide comfort to consuming nations that Saudi will deliver supplies when needed. No mas.
• Some have speculated Saudi’s move is a signal regarding long-term crude oil demand, cutting future capacity because demand will disappoint. Certainly possible, but a stretch. If Saudi’s outlook has become more negative, why publicize this capacity move years in advance?
• Saudi’s move smacked the oilfield service sector, particularly the larger cap companies with 5-10% revenue exposure to Saudi. SLB, the bellwether international OFS company, was down -7.3% on the day of the Saudi announcement. The magnitude of the move may have been overdone, but the direction certainly makes sense. Less spending means less OFS revenue.
• Physical oil markets should be indifferent to this announcement in the short run (where status quo is in place) and slightly more bullish longer-term given less Saudi supply/capacity. Saudi’s move begs the question of whether other Middle East players, such as the United Arab Emirates or Kuwait, will follow Saudi’s lead. A capacity scaleback is a longer-term version of today’s production cuts. In theory, if Saudi is leading on reduced intermediate-term capacity, other players could follow that lead with net benefits to all involved. Stay tuned.

Gas markets can’t catch a break. In our year end 2023 writeup, we discussed the double whammy to 2024 gas demand with a warm start to winter and the startup delay of Exxon’s Golden Pass LNG project. Fundamentally, higher storage levels create an inventory overhang that is likely to linger through 2024 and will require lower rigcount/lower wellhead supply to alleviate. Sadly, the axiom of “low prices cure low prices” is going to have to play out here. Adding insult to injury, in late January, the US government added a further curveball to gas market analysis as it announced a temporary pause on future LNG projects to assess climate impacts and potential energy cost increases for American consumers. The White House fact sheet can be found here: FACT SHEET: Biden-⁠Harris Administration Announces Temporary Pause on Pending Approvals of Liquefied Natural Gas Exports. This pause impacts projects that would begin exporting gas in the 2027+ time frame. However, scarred and snakebitten energy observers can’t help but wonder what government-driven risks might come forward on more mature LNG development projects which are scheduled to start in the next few years.

Thinking about energy investing, the capacity move by Saudi and the LNG climate review by the Biden Administration are two more datapoints for energy investors that “macro” items seem to lurk around every corner and are very difficult to anticipate. Anything that makes the sector harder to analyze/anticipate 1) discourages generalist investors from investing, and 2) pressures valuations (you pay less when the surprise factor is higher). Energy stocks remain cheap, energy balance sheets are excellent and energy industry capital discipline is embedded. BUT the sector is momentumless…in a market where momentum appears to be king. What can change the dynamic? We see a few possibilities:

• Technology stocks could roll – right now, tech is sucking all the oxygen out of the energy room. Investors can’t really focus on anything else as the Magnificent Six (sorry Tesla) seem to go up every day. Roll tech, run energy.
• Inflation could reignite – energy stocks are an inflation play, so any uptick in inflation (or downtick in expectations for declining interest rates) would pull investors toward energy.
• Lower OPEC spare capacity – With at least 3-4mmbopd of shut-in production, OPEC’s spare capacity is an upside-dampener for enthusiasm/valuations. When true supply-demand drives oil price, rather than the cartel’s production cuts, investors will feel more comfortable deploying new capital.
• Headlines could calm down – When the energy macro does something surprising every few weeks, it diverts attention from the positives of the energy sector (solid returns on capital, supportive dividend yields, excellent balance sheets, etc., etc., etc.) With wars on two fronts involving oil producing countries/regions and a US election upcoming, calmer headlines feel far away. Boring would be very welcome.
• Physical supply disruptions could materialize – Oil markets currently appear unconcerned about tail risk. However, if a tail-risk event actually happens, tail risk outcomes will occur. Oil trades over $100/bbl if the Middle East tensions spill over into active conflict with Iran, closure of the Straits of Hormuz or any of the other possible ugly outcomes come to pass. Investors will be forced to own more energy in this scenario.

At the risk of being an Eeyore, something has to change to move energy from the doldrums. Cheap is not a catalyst. It could take a while. This makes 2024 the Year of Execution, the Year of Consolidation and the Year of Stockpicking. It isn’t going to be a Year of Boredom!

(1) Source: Bloomberg