Monthly Commentary from Dan Pickering
Decent back-to-back months. October was another good period for energy with Diversified Energy +9.9% (S&P1500 Energy, S15ENRS), Upstream/E&P ahead by +10.0% (XOP), oilfield services gaining +6.7% (OIH) and Midstream adding +4.1% (AMZ). Meanwhile the S&P500 gained an impressive +6.9%. Oil gained +11.4% (~$83.30/bbl), while gas took a breather, down -7.5% to ~$5.43/mcf.
When supply is constrained, demand is recovering, and inventories are lower than average, price tends to improve. That is the current oil markets in a nutshell. As we expected and as consensus continues to doubt, US shale producers are maintaining capital discipline despite higher prices. With its biggest competitive threat playing nice, OPEC has the breathing room to manage the market. The cartel is slowly adding supply back to the market (~400kbbls/day per month), allowing the monthly recalibration to find a balance between price-driven demand destruction and covid-related timing/risks. High global gas prices have contributed to ~500kbbls/day of (likely temporary) gas-to-oil switching, further tightening the oil market on the margin.
Prices are now high enough that oil-consuming countries are more vocal in asking OPEC+ for additional supply. Ah, the irony of politicians requesting more hydrocarbons in the short term as they gather at the COP26 conference to discuss pathways for ending long-term hydrocarbon consumption. Necessity breeds strange bedfellows. We wouldn’t be surprised by conciliatory language from OPEC+ during its early November monthly meeting. Whether that will translate to an acceleration of barrels and/or lower prices is uncertain. Chartists say the move in WTI is biased higher with $90’s possible after oil broke out from over a decade of “resistance”. With front month crude sitting in the low $80’s, we wouldn’t be surprised by a $10+/bbl move either way. Investors will likely have better results from multiple years of oil at a good/strong price ($60-$80/bbl) versus one year at a very high price ($100+), so we are actually rooting for a price moderation/plateau. But to quote the Rolling Stones, “you can’t always get what you want”, and therefore we remain vigilant.
More of the same in the world of natural gas. Inventories are low, Europe and Asia are worried about winter and prices are high. The interconnectedness of the globe’s energy consumption has never been more apparent. High gas prices and low availability have resulted in a myriad of reactions. China has simultaneously spurred coal production and limited coal price increases, allowing for substitution in the power markets. Asian markets have shifted from $150+/bbl LNG to fuel oil. Of course, this plays havoc with carbon goals and environmental targets, but price is king in the short term when consumer consumption (and wallet) is in play.
While we will continue to point out the contradictions of the current hydrocarbon/Net Zero conundrum, we will also continue to highlight decarbonization as a megatrend that must be respected. The COP26 climate conference will run through November 12th. Proclamations will be plentiful. Plans will be abundant. Behind all the posturing, there is underlying momentum. Even Saudi Arabia has now made a (2060) Net Zero commitment! Trillions of dollars are going to be unleashed. Sifting through the noise to understand realistic action plans will be important to calibrate decarbonization investment opportunities.
All eyes remain on US energy companies and anticipated spending plans. At the time of writing, per Q3 earnings releases, Exxon and Chevron are generally toeing the line, allocating incremental dollars to share repurchases rather than reinvestment. We remain convinced that US upstream management teams will stay true to their capital discipline pledges. It is simply too early for CEO’s to pivot to higher production growth after more than a year of pledging reinvestment abstinence. Calls from US politicians for more supply should be politely ignored – that fox has raided the henhouse too many times. Meaningful spending increases will come as/when Wall Street shifts from rewarding discipline to rewarding growth. Many will say “that will never happen”, but we’ve seen too many cycles to believe it. In our opinion, this cycle will end with enthusiasm over commodity prices and investor’s calls to take advantage of the “amazing” economics of drilling wells. It’ll take a few years, but it will happen…it always does. Even in a decarbonizing world. Until then, Value Over Volume (financial returns over production growth) is the only mantra that should matter for energy companies.
October, while a strong month, saw none of the energy stock indices matching the +11% oil price move. At this point, oil prices are “good enough” that absolute price isn’t really the driver for stocks. Duration will be the key driver, as well as company behavior. How long will companies mint this kind of money? What will companies do with all this cash? We believe 2022 drilling budgets will be higher year-over-year on cost inflation but will target flattish production levels. We believe OPEC will remain disciplined. We believe demand will continue to recover. Valuation is inexpensive even with a $65/bbl oil price expectation. If we didn’t have scars from the long downcycle, we’d be shouting-from-the-mountaintops bullish on the energy sector’s risk/reward. As it is, we are cautiously, nervously, looking-over-our-shoulder-all-the-time optimistic on a continued run for energy in 2022.
As always, we welcome your questions and appreciate your interest.
