Energy’s Early Spurt Sputters

Global stocks keep clocking new highs as the summer rolls on, but one sector is notably absent from the party: Energy, which also happened to be the best-performing sector in 2021’s first half. That hot start fanned widespread expectations that vaccines, reopening, resurgent travel and a new Roaring Twenties would stoke vast demand for fuel, making oil-related stocks surefire winners for a long while. At the time, we thought that seemed rather far-fetched, and now Energy has returned to earth somewhat. We don’t think dismal times are in store for the sector, but its recent travails do show the danger in extrapolating hot performance forward.

As Exhibit 1 shows, Energy’s 38.2% return through mid-June far outpaced the MSCI World Index’s 13.0%.^[i] Propelling this move: oil prices, Energy’s main driver. Brent crude oil climbed from about $50 a barrel at 2021’s start to over $75 in July.^[ii] Then, pundits claimed countries’ reopenings and rebounding travel would send demand soaring. Coupled with American shale drillers’ and OPEC’s newfound production discipline, limited supply would supposedly keep oil prices elevated to usher in the Roaring Twenties.

In our view, this all sounded a bit overstated. Sure, easing lockdown restrictions should raise demand, but only back to a pre-pandemic normal. After an initial pop, extrapolating accelerating growth forevermore didn’t appear wise. Then, too, in markets—especially commodity markets—higher prices invite greater production. Maybe at a lag, but with the Middle East’s abundant proven reserves and America’s ready supply of drilled but uncompleted wells, global production rising before too long never seemed in question, likely keeping a lid on oil prices—and Energy stocks, whose earnings are sensitive to prices rather than production volumes.

That now seems to be playing out. In August, Brent crude oil sunk toward $65 before bouncing somewhat.^[iii] Meanwhile, Energy’s year-to-date return has shrunk to 20.7%—its lead over the MSCI World Index’s 16.8% substantially diminished.^[iv] Pundits attribute this to COVID’s Delta variant inspiring new restrictions, which probably is hitting sentiment some. But in our view, the world isn’t close to spring 2020’s nearly complete global shutdown of economic activity. So-called “zero COVID” nations like Australia and New Zealand are the exception, not the rule. More broadly, we think markets have simply priced in the reopening pop—plus pundits’ pronouncements—and are looking beyond it to the likely slower-growth reality ahead along with a more balanced oil supply and demand landscape.

Exhibit 1: Energy Comes Back to Earth

Source: FactSet, as of 8/24/2021. MSCI World Energy and MSCI World Index returns with net dividends, 12/31/2020 – 8/23/2021.

Now, we wouldn’t recommend extrapolating Energy stocks’ recent drop forward, either. Some of its magnitude also looks sentiment-driven. Yet there are some fundamental shifts at work, too: Chiefly, global supply is rising to meet post-lockdown demand. For example, US shale supply is ramping up. (Exhibit 2) After two brief dips in May 2020 (lockdown-related) and February 2021 (weather-related), shale production was off as much as -28% from its November 2019 peak. As of July, it is still down -13% from there, but industry projections see it climbing higher in the coming months.

Exhibit 2: US Shale Oil Output Ramping Back Up

Source: EIA, as of 8/16/2021. US shale oil output, January 2007 – July 2021, projected production, August 2021 – September 2021.

Shale oil drillers—the bulk of America’s current world-leading 11.4 million barrels per day (bpd) production—have demonstrated the ability to produce over 9 million bpd.^[v] We see no reason they can’t get there again as long as it is economical to do so. Moreover, it isn’t just the US that can readily boost daily oil production by millions of barrels. Russia and Saudi Arabia, the world’s number two and three producers, respectively, have self-imposed quotas for a reason—they have ample spare capacity. There are no physical limitations to getting oil out of the ground to meet demand.

The question occupying pundits now seems to be whether demand will be there. Delta-variant breakouts may delay reopening in some places, but the world economy has experienced erratic lockdowns for over a year—and they haven’t stopped overall recovery. COVID restrictions in China, Japan, Australia and New Zealand are well-known, with their surprise power over markets sapped. Though sentiment swings can drive periodic volatility in oil, markets mostly see through these fits and starts.

Over the 3 – 30 month stretch we think stocks focus on, we expect global economic activity to return largely to pre-pandemic trends, including oil supply and demand. Oil producers aren’t capacity constrained and as supply chain kinks elsewhere resolve, demand should grow modestly. In the US and China, the world’s largest economies, GDP already exceeds pre-lockdown levels. Except for areas like travel and recreation, pent-up demand has already been unleashed and is petering out as normal habits return. The reopening rebound is mostly behind them. We suspect the rest of the world will follow that general trajectory.

In the environment we foresee, oil likely stays range bound around current levels—much like it was pre-pandemic. That has proven profitable enough for Energy, particularly for the higher-quality firms in the sector with lower extraction costs and less debt to service. But don’t expect a return to the heady days of early-2021 gangbusters leadership. Perhaps more sentiment adjustment—and volatility—is in store, but longer-term Energy expectations seem broadly back in line with a balanced global oil supply-demand outlook.