For the oil industry, 2021 is shaping up to be one of the most exciting years since the last bull run from 2010 to 2014. During that period, investors saw an average price per barrel between $80 $100 USD. From then, the market became oversupplied and the industry saw a sustained drop in prices. At the trough, a COVID-19 induced global economic shutdown brought oil futures to a negative price. Now, as global economies emerge from the pandemic, investors are inundated with headlines of rising oil prices and predictions for a return to a $100 per barrel.
We try to avoid prognosticating on how high oil prices can go. Energy companies themselves make operating and capital investment decisions based on a relative range of prices, rather than a potential all-time-high price that could last for only a brief moment. Currently, our team views the macro oil dynamic to be favoring an elevated oil price for longer.
The Case For Elevated Oil Prices
In the short term, the demand for oil could be exasperated by colder winter weather. Some countries in Europe are expected to switch from natural gas to oil to fuel their power needs as some jurisdictions face higher natural gas prices than oil on a per barrel equivalent basis. That could add another tailwind to oil demand.
Structurally, we feel the predominant driver of the price increase is from the supply of oil – or the lack thereof. Over the past decade, there has been an underinvestment in oil which has resulted in an undersupply. As per Veritas Research (chart below), due to the demand destruction from COVID19, rig counts in the US fell by 74% from Jan 1, 2020. Although the renewed demand and higher oil prices have led to a doubling of the rig count, it is still 36% lower than the pre-Covid levels. Companies have prioritized shareholder returns (dividends, stock buybacks, debt reduction etc…) rather than drilling for more supply. As a result, in the past 12 months, the inventory of “Drilled but Uncompleted Wells” (DUC’s) has fallen 35%. This means production growth could be at risk unless more capital is allocated to drill in search of more inventory. This could be difficult to achieve as attracting capital into this industry has been more difficult due to more environmentally conscious investors and what appears to be a hesitancy from the White House to expand oil exploration.
How about Oil Stocks?
What is good for oil prices should be good for energy equities; And yet, energy stocks seem to have dramatically lagged the recovery in oil prices. As of October 12, oil is now 19% above the pre-pandemic levels of Dec 31, 2019. However, Energy stocks (XLE) is -6% below and Oilfield Services stocks (OIH) is -18% below. To see these energy-related equities trail by 25% to 37% is a sizable performance gap.
It is possible that the popularity of ‘ESG’ investing, which has shunned traditional energy stocks, will lead to a permanent discount in energy stocks. However, at this point in time, the performance gap cannot be attributed to the idea that these companies have become worse businesses as free cash flow margins for the entire S&P500 Energy Sector is already higher than its’ pre-pandemic levels. As per Fundstrat Research, the last time Oil futures (WTI CL4) hit $74 was in late 2018 and free cash flow margins were 5.46%. As of the end of September 2021, with futures hitting the same $74 level, free cash flow margins were 7.64% (218bps higher). Hence it has been our view that this performance gap should gradually narrow.
Over the last decade, our experience is that investors have struggled with their energy and oil-related equities. We have our own reservations that the traditional energy incumbents can become long-term investments without addressing the concerns of ESG investors or pivoting themselves towards alternative energy production. That said, we feel that the structural undersupply of the commodity, the renewed global economic recovery, and the strong financial performance from energy companies warrants a second look from investors. Please contact your advisor to review the suitability of rebalancing one’s portfolio to include energy-related exposure.