Amid value’s short-term rally, Energy stocks surged late last year and in Q1, outperforming all sectors with a 21.8% gain.[i] Fueling Energy’s rise: Oil demand is improving while significant producers continue to hold back supply. That combination sent Brent oil up 24.0% in the quarter and 32.9% through May 7, adding to enormous gains since April 2020’s low—a solid tailwind for Energy firms’ profitability and relative returns.[ii] Now many see increasing oil demand from further economic reopenings, falling inventories and constrained supply as a sign more outperformance lies ahead. To me, that seems unlikely. Prices already reflect the chief, well-known tailwinds, while extant headwinds seem underappreciated. Some exposure to the sector is warranted from a diversification standpoint, but its early leadership doesn’t look likely to persist.
First, to be clear, Monday’s news of hackers disrupting the Colonial Pipeline that supplies about half the Eastern US’s gasoline needs has no bearing on this outlook. That is grabbing attention this week, but it is likely to prove fleeting—just as the Suez Canal blockage did earlier this year (not to mention the same pipeline’s outage in 2016). I doubt this sways energy prices or the sector’s performance for long. Gasoline futures echo this point. They rose as headlines broke over the weekend but haven’t budged much this week. So were oil prices.
Longer-term trends typically dominate these fleeting events. With that in mind, it is worthwhile to revisit the backdrop for oil’s outperformance this year to provide context. Energy’s run followed a disastrous 2020 as COVID lockdowns crushed oil demand, causing oil prices to collapse. Accordingly, Energy companies faced steep losses, and the sector tumbled -55.4% from world markets’ pre-pandemic high to the sector’s March 18, 2020 low.[iii] Despite the recent surge, Energy share prices remain below pre-COVID levels.
Moreover, the pandemic wasn’t behind all of Energy’s woes, which are much longer-running. Global Energy underperformed in 8 of the past 11 calendar years (2010 – 2020).
Exhibit 1: Energy Shares and Oil Prices Are Recovering from a Terrible 2020
Source: FactSet, as of 5/7/2021. MSCI World Energy Index with net dividends and Brent crude oil prices, 12/31/2019 – 5/6/2021. Indexed to 100 at 12/31/2019.
Exhibit 2: Energy’s Challenges Predate COVID
Source: FactSet, as of 5/7/2021. MSCI World Energy Index annual return with net dividends minus MSCI World Index annual return with net dividends and average annual Brent crude oil prices, 12/31/2009 – 5/6/2021. 2021 relative return data are year-to-date.
Huge, structural shifts in oil supply explain most of Energy’s perennial underperformance. High oil prices before the 2007 – 2009 financial crisis incentivized oil firms to find new sources of oil. The financial crisis put that on pause—temporarily. As oil prices rose swiftly alongside the eventual economic rebound, the incentive to find new sources gained steam anew.
The result? America’s shale oil revolution. Combining existing technologies—advances in hydraulic fracturing and horizontal drilling—US oil producers unlocked vast new crude oil resources. US output began surging around 2012 and hasn’t looked back. Not coincidentally, Energy’s long-term underperformance trend began in mid-2011, as markets anticipated the shift to an oversupplied market. This particularly gained steam in 2014, when OPEC elected to flood the market with supply in an effort to force US shale drillers to cut production in order to boost profitability. Oil prices halved, with Energy stocks tanking.
Exhibit 3: The Rise of US Shale Leads to Massive Increases in Output
Source: BP, as of 5/6/2021. 2020 Statistical Review of World Energy, World Crude Production Figures, annual change in US oil production, 2000 – 2019. Includes crude oil and natural gas liquids.
By mid-2016, though, prices had bottomed and began recovering. As they did, shale firms ramped up output again. In late 2018, the US became the world’s biggest crude producer. The modern US shale revolution shifted the oil market from undersupplied—with many fearing production had peaked—to oversupplied, with folks commonly claiming demand will soon peak and falter. COVID’s demand hit—oil consumption fell -9% last year—added to the sector’s woes, although that seems temporary.
That is the backdrop entering 2021. But past performance alone won’t tell you about the future—a fundamental look at demand and supply is more instructive.
Exhibit 4: World Oil Supply and Demand
Source: US Energy Information Administration, as of 5/6/2021. April 2021 Short-Term Energy Outlook, OECD and Non-OECD Consumption, OPEC and Non-OPEC Production, January 2019 – April 2019 and forecasts, May 2021 – December 2022.
Demand is improving, a relative bright spot now that should continue throughout 2021. The deployment of COVID vaccines is positive for oil demand, which the US Energy Information Administration (EIA) expects to rise 6% this year. That should first come from the US and China (the world’s number one and two oil consumers, respectively), with other countries following as their vaccination programs progress.
However, total world demand remains below its ~100 million barrels per day (mbd) pre-COVID peak. Neither the EIA nor the International Energy Agency expects a full recovery until late 2022 or early 2023. Of course, demand could return faster than expected. But the tragic persistence of COVID in countries like India and Brazil is a reminder it could also be slower than forecast. Then too, pre-COVID demand wasn’t an excellent environment for Energy stocks.
On supply, oil production presently remains below demand, driving prices up and OECD oil inventories down. This is bullish for Energy companies, and it is the primary reason shares have outperformed lately.
Exhibit 5: Increasing Demand, Constrained Supply Resulting in Inventory Drawdowns
Source: EIA, as of 5/6/2021. April 2021 Short-term Energy Outlook, OECD Monthly Inventory, January 2019 – April 2021.
But the situation is tenuous. The primary driver of restricted oil supply? Massive production cuts from OPEC+, a super cartel of 23 countries led by Saudi Arabia and Russia representing about 50% of global oil production. OPEC+ cut production by a historic 9.7 million barrels per day from pre-pandemic levels. Since then, they have returned just 2.5 mbd of the cuts.
OPEC+ now plans to boost production by 2.1 mbd over the next 3 months. Even after the increase, OPEC+ spare capacity—or sustainable oil production that can come online quickly—remains massive and represents a considerable headwind to prices. While OPEC+ compliance has been robust, higher oil prices will test its members’ resolve, as many need oil revenue to support their economies. The incentive to pump more above quota increases as prices rise. If America lifts Iranian sanctions, supply could rise even more.
Exhibit 6: A Historically Large Potential Supply of OPEC+ Production Looms
Source: EIA and World Bank, as of 4/30/2021. Monthly OPEC+ Spare Capacity, January 2020 –April 2021.
All that is before you even consider US producers. They have also supported oil prices by holding off on increasing production, choosing instead to invest their free cash flow into paying down debt. Investors rewarded US oil companies’ discipline in Q1. But looking forward, oil prices are now well above the average estimated cost of drilling new wells.
Exhibit 7: US Production Likely Increases With Higher Oil Prices
Source: FactSet, Federal Reserve Bank of Dallas and EIA, as of 5/6/2021. Monthly US Crude Production and monthly average West Texas Intermediate crude oil prices, 1/1/2019 – 5/5/2021.
Higher prices are already incentivizing more activity. US rig counts and oil well completions are rising, which generally leads to more US oil production. As the last decade proves, higher US production can be problematic for other global producers, namely OPEC+. If US production rebounds, OPEC+ may respond by flooding the market again—a source of significant uncertainty.
Taking demand and supply factors into account, the Energy sector and oil producers face conflicting drivers. While the recent rally had fundamental support from recovering economic growth and oil demand tied to reopening, these factors are exceptionally well known—sapping their power to sway Energy stocks much looking ahead. The recent rally in the sector likely reflects many of these positives.
Looking forward, producer discipline remains a looming question in the face of higher prices. Generally, higher prices have incentivized production, ultimately oversupplying the market. Maybe this time is different. But as Sir John Templeton famously put it, those tend to be the most dangerous words in investing.
[i] Source: FactSet, as of 5/7/2021. MSCI World Energy sector return with net dividends, 12/31/2020 – 3/31/2021.
[ii] Source: FactSet, as of 5/7/2021. Brent crude oil price percentage change, 12/31/2020 – 5/7/2021.
[iii] Source: FactSet, as of 5/7/2021. MSCI World Energy sector return with net dividends, 2/12/2020 – 3/18/2020.
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