Tuesday, October 04, 2022
Michael Heim, CFA, Senior Research Analyst, Noble Capital Markets, Inc.
Refer to the bottom of the report for important disclosures
Energy stocks, as measured by the XLE Energy Index, were essentially flat during the third quarter rising 0.1%. The performance was impressive given overall market weakness. The S&P Composite Index declined 5.0% during the quarter. What makes the performance even more impressive is the fact that spot oil prices declined 25% during the quarter. We believe energy stocks remain an attractive investment and are an important part of a diversified investment portfolio.
WTI prices peaked at $120 per barrel in the first week of June. Since then, prices have declined in response to signs of a global economic slowdown. Near month oil future contracts are now below $80 per barrel. We believe recent weakness largely reflects demand concerns and foreign currency changes but is not a condition of oversupply. The domestic rig count remains at less than half peak levels. What’s more, rig count has leveled off in recent months in response to the decline in oil prices.
Production has risen to 90% of peak, but it has been done by harvesting the low-hanging fruit. When oil prices began falling early in 2020, there was an increase in Drilled Uncompleted (DUC) wells. When prices rose, drillers focused on completing DUCs. With the number of DUCs having fallen in half, future supply increases will be more difficult. If demand does not decrease in reaction to a slowing economy, domestic production may be hard pressed to meet demand. If worries about a recession are overblown and demand increases, there’s a good chance oil prices will be back at a price of $120 or even higher.
Energy industry fundamentals remain strong. The recent drop in oil prices does not concern us as long-term prices are still above the levels assumed in our financial and valuation models. Energy company cash flow generation is high, and companies are facing the envious position of trying to decide what to do with the cash. Debt levels have been pared down and managements are reluctant to initiate/raise dividends in case the industry goes into a down cycle forcing them to reverse course. Share repurchase remains a viable option especially if energy stocks continue to be weak alongside the overall market.
Energy Stocks
Energy stocks, as measured by the XLE Energy Index, were essentially flat during the third quarter rising 0.1%. The performance was impressive given overall market weakness. The S&P Composite Index declined 5.0% during the quarter. What makes the performance even more impressive is the fact that spot oil prices declined 25% during the quarter. We believe energy stocks remain an attractive investment and are an important part of a diversified investment portfolio.
Oil Prices
Oil prices rose steadily over a two-year period beginning the spring of 2020. WTI prices peaked at $120 per barrel in the first week of June. Since then, prices have declined in response to signs of a global economic slowdown as governments raise interest rates to fight inflation. Near month oil future contracts are now below $80 per barrel.
Figure #1
We believe recent weakness largely reflects demand concerns and foreign currency changes but is not a condition of oversupply. Historically, oil prices are lower when the dollar is stronger. This is because most oil suppliers, including international suppliers, demand payments in dollars.
The domestic rig count remains at less than half peak levels. According to Baker Hughes, there were 764 active rigs as of September 23, 2022, as compared to 1600 in 2015. What’s more, rig count has leveled off in recent months in response to the decline in oil prices.
Figure #2
Rig count is one way to forecast future supply. While only half the peak number of rigs are active, that does not mean that production is half of peak levels. In fact, as the chart below shows, domestic daily production surpassed 2015 peak rig production levels in 2018. Production declined sharply when oil prices fell in 2020 but have recovered to a point where production has reached 90% of peak production. The increased production demonstrates an improved productivity per well as drillers better tailor drilling techniques to individual formations.
Figure #3
But before we chalk up increased production to improved technology, let’s look at one more chart. The chart below shows the number of drilled but uncompleted (DUC) wells against active rigs. The chart shows that the number of uncompleted wells has declined sharply the last two years as the active rig count has grown. When oil prices began falling early in 2020, drillers continued drilling but often did not complete the wells. This led to a large increase in the number of DUC wells. When prices started rising in the summer of 2020, drilling returned. However, drilling was largely focused on completing or reworking wells.
Figure #4
The implication of a declining DUC count is that the industry is running out of low hanging fruit. Future drilling will need to focus on wells that are likely to have a lower production rate per rig than what we have witnessed recently. Declining production could exasperate already low inventory levels (see chart below). Thus, if demand does not decrease in reaction to a slowing economy, domestic production may be hard pressed to meet demand. If worries about a recession are overblown and demand increases, there’s a good chance oil prices will be back at a price of $120 or even higher.
Figure #5
Natural Gas Prices
Natural gas prices tend to track oil prices but with a few distinctions. Natural gas demand and supply is less global than oil. Imports (and now exports) of liquefied natural gas represent a small portion of domestic supply and demand. Secondly, natural gas is used primarily for space heating. That means demand is more seasonal. It also means demand can be affected by weather conditions. On the other hand, natural gas demand is less affected by general economic conditions than oil. As the chart below shows, natural gas prices do not seem to be affected by recession concerns as compared to oil prices.—-
Figure #6
Source: Natural Gas Intelligence
Summer is usually a quiet time for natural gas prices. Wells are producing more gas than is demanded, and gas is put in inventory. As is the case with oil, inventory levels are running below historical averages as we approach the point of withdrawing from inventory. This bodes well for natural gas prices remaining at current historical high levels and perhaps even rising higher.———- page break ———-
Figure #7
Outlook
Energy industry fundamentals remain strong. The recent drop in oil prices does not concern us as long-term prices are still above the levels assumed in our financial and valuation models. Energy company cash flow generation is high, and companies are facing the envious position of trying to decide what to do with the cash. Debt levels have been pared down and managements are reluctant to initiate/raise dividends in case the industry goes into a down cycle forcing them to reverse course. Share repurchase remains a viable option especially if energy stocks continue to be weak alongside the overall market.
We also believe the case for smaller cap energy stocks is strong. Major oil companies are facing increasing pressure to focus on renewable energy. While the majors are increasing drilling, they are doing so in a controlled manner as they also invest in green energy. Smaller cap energy companies are less tethered and often able to acquire and exploit properties being ignored by the majors. If our belief that a world-wide recession is already factored into energy prices is correct, small cap energy companies will be in the best position to take advantage of any price increase.
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ANALYST CREDENTIALS, PROFESSIONAL DESIGNATIONS, AND EXPERIENCE
Senior Equity Analyst focusing on Basic Materials & Mining. 20 years of experience in equity research. BA in Business Administration from Westminster College. MBA with a Finance concentration from the University of Missouri. MA in International Affairs from Washington University in St. Louis.
Named WSJ ‘Best on the Street’ Analyst and Forbes/StarMine’s “Best Brokerage Analyst.”
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