Monthly Commentary from Dan Pickering
A September to remember. Energy had a strong month while overall markets were lackluster/weak. Against the backdrop of the S&P 500 falling -4.8%, energy indices played a little rock-and-roll with Diversified Energy adding +9.7% (S&P1500 Energy, S15ENRS), Upstream/E&P jumping +17.0% (XOP), oilfield services gaining +6.0% (OIH) and Midstream adding +3.0% (AMZ). Oil popped +9.5% (~$75/bbl), while gas roared another +35.1% to finish the month at ~$5.90/mcf.
Shazam! WTI oil closed September at ~$75/bbl and (briefly) touched $80/bbl since then. Global OECD inventories are below the 5-year average as demand has continued its recovery from covid lows and Hurricane Ida took ~30mmbbls offline in the US Gulf of Mexico. Meanwhile, sky-high European and Asian gas prices resulted in almost 500kbbls/day of demand switching from gas to oil!!! Despite oil price strength, OPEC continued its slow-and-steady approach to bringing production back to the market, leaving November’s game plan unchanged at +400kbopd. Finally, oil’s move over $77/bbl in early October represented an important technical breakout, opening up mid-high $80’s as the next “level”.
Big Wall Street banks are as bullish as we’ve seen them in the past 5+ years. Goldman Sachs has been talking $80/bbl for a while, and JP Morgan’s global strategist just signaled global economies can endure $130/bbl WTI (and 2.5% interest rates) without adverse impacts. Sheesh…what a difference nine months makes. At the beginning of 2021, the WTI forward curve was flattish, with the 2021 calendar year trading at ~$48/bbl and 2025 calendar year at ~$45/bbl. At the end of September 2021, those two contracts are trading ~$74.60 (+55% YTD) and $56.60/bbl (+26%), respectively. We’d expect OPEC supply acceleration to dampen further near-term oil price rallies, but respect the power of momentum and the near-term bias clearly has an upside feel. We’ve stated our expectation of a $60-$80/bbl fundamental trading range, so oil now feels a bit expensive in the short term and remains cheap in the long term.
International gas prices went nuts during September as Europe and Asia fought over incremental LNG cargoes. Gas prices traded over $30/mmbtu (>$150/bbl oil equivalent) with low inventories and fear of a cold winter driving the surge. China’s central government officials supposedly instructed Chinese energy industry players to “procure supply at all costs”. The term “energy crisis” is now frequently mentioned and countries across Europe are implementing everything from consumer subsidies to discussions around a windfall profits tax. US front-month gas prices rose +35% in tandem with European tightness. Elevated prices are likely the norm until there is some visibility on the severity of European winter.
More reasonable gas prices will likely return in 2022, but September was a shot across the bow for those pushing for rapid global decarbonization. As Europe rushed toward renewables and deemphasized or decommissioned nuke, coal and natural gas, their system has become inherently more volatile. Volatility translates to higher costs in periods of tightness. US policymakers should take note. But they aren’t. US Secretary of State Blinken cited high European prices as “reinforcing the need for a transition to new forms of energy, particularly sustainable energy…” We remain firmly in the all-of-the-above camp.
Looking to the energy transition, unless delayed due to covid, the 2021 UN Climate Change Conference (COP26) in Glasgow, Scotland begins at the end of October and runs for ~10 days. We expect a serious amount of decarbonization press and some eye-catching proclamations and goals. We’ve commented extensively on the achievability of many of these goals. We believe NetZero 2050 is aspirational, not practical. We are firmly convinced that decarbonization efforts are a megatrend that will be the biggest capital deployment of our lifetime. But results will take longer than hoped. Investing around this theme absolutely makes sense. Investing carefully is paramount. Sidenote which might win you a trivia contest beer – the conference is known as COP26 because it is 1) a Conference of Parties associated with the original 1994 UN climate treaty and 2) it is the 26th meeting of the group.
Turning to energy investing, it was a good month to be long. Conventional wisdom says energy has become such a small portion of the S&P500 (under 3%) that institutional money managers don’t have to pay attention. Absolutely true when the sector is languishing. Absolutely not true when commodity prices are ripping, inflation is the topic du jour and the energy sector is outpacing the S&P500 by a meaningful amount. A perfect example of the cliché of climbing the wall of worry. At the end of September, prices averaged ~$62.50/bbl WTI and ~3.55/mcf Henry Hub through 2025. The energy sector will print MOUNTAINS of cash at these levels, and it seems like much of it will be returned to shareholders for the next few years. This is Goldilocks territory. Per data from Wolfe Research, using current 2022 futures prices and current hedges (which are well below the money), larger cap E&Ps are trading at 4x EV/EBITDA (ranging from 2.7x for MRO to 5.1x for HES) with free cash yields at 16% (ranging from 23% MRO to 7% HES). At these kinds of valuations, the inevitable oilpatch volatility is worth enduring. Who cares how much these names are up off the bottom? In our opinion, there is much more to go.
As always, we welcome your questions and appreciate your interest.