Beyond the headline-grabbing 9.1% inflation print, a development worth paying attention to is the plunge in oil prices, with Brent crude oil briefly dipping below $100 a barrel (bbl) and West Texas Intermediate finishing last week at $99/bbl.1 In our view, this correction was understandable and expected given: 1) the 61.6% run-up in Brent prices from the start of the year through June 8; 2) recent recessionary concerns in the United States; and 3) more COVID tremors in China.2
Early indicators of softer U.S. demand were one of the reasons we saw value in taking profits in energy in mid-April. Indeed, U.S. energy demand has been running below its 2015 to 2019 average since April, with gasoline demand down 8% year-over-year and demand for distillate flat at +0.4% year-over-year.3 Only jet fuel demand is up, rising an impressive 6.6% year-over-year.4
However, energy stocks have fallen roughly 25% since the beginning of June. Further, we expect supply constraints to help keep oil prices in the $90-100/bbl range despite slowing demand (barring a true recession in the second half of the year). As such, we would be adding back to energy stocks now.
Demand may slow but supply constraints are likely to support prices
One of the most significant reasons for the oil demand-supply equation becoming more balanced has been releases from global strategic petroleum reserves (SPR), which are contributing 1.2 million barrels a day (b/d) in a market that would otherwise be running a deficit of 1.4 million b/d.5 However, those releases are poised to stop at the end of October, with the supply-demand balance forecast to return to a deficit of -0.3 million b/d.6 Meanwhile, global SPR inventors are at their lowest levels since 2005 and Organization for Economic Co-operation and Development commercial crude oil and liquid fuel inventories are well below their five-year averages (See Exhibit 2).7 While there is some hope that Organization of the Petroleum Exporting Countries (OPEC) – and Saudi Arabia in particular – might be able to increase production, we would not count on it as both their ability and willingness to do so are questionable. Like everyone else, OPEC is likely to worry about slowing demand, especially in the second half of the year, and given that it collectively undershot quotas by over 1 million b/d in 2020, we question its ability.8 Finally, Saudi Arabia’s oil production (10.5 million b/d) is already near record levels, leaving it with just 1 million b/d of spare capacity.9 All of these factors combined point to continued tight supply for the oil market.
Upside risks from geopolitics and mother nature
While the energy complex has moved materially lower from its early-June peak, the geopolitical situation around Russia has hardly improved and further decoupling between Russia and its Western consumers of oil and natural gas could create an upside risk for oil prices. Front and center this week will be Gazprom’s decision whether to restore natural gas flows through the Nord Stream 1 pipeline. If the flows do not resume after July 21 (at the end of scheduled maintenance), the 66.5 million cubic meters per day it previously transported will be difficult to quickly replace, especially ahead of the winter season in Europe (See Exhibit 3).10
Germany, for example, gets roughly a third of its natural gas imports via Russian pipelines and its current reserves are only at 65% capacity – below the 90% target for the winter season.11 Other European countries are in a similar position.12 This creates a risk of gas rationing in Europe and continued price spikes ahead. All of this suggests additional upside for oil. For example, European natural gas is today priced at three times the price of Brent on a U.S.-dollar barrel of oil equivalent basis (See Exhibit 4).13 Given how elevated current natural gas prices are relative to oil, some industries may need to further switch to oil. We may see 300,000 b/d in additional oil demand from gas-to-oil switching in Europe in the second half of 2022.14
Another source of potential upside price risk to oil is the looming hurricane season, which peaks from mid-August to late September. The National Oceanic and Atmospheric Administration (NOAA) predicts a 65% probability of an above-average season, with more frequent storms and more major hurricanes.15 Between 2010 and 2020, NOAA’s predictions have been off by only 2.5 storms per season when you factor the average of each season’s number of storms, hurricanes, and major hurricanes.16 This poses a risk to Gulf of Mexico oil production and refining capacity. The region accounts for roughly 15% of U.S. crude oil production and 5% of natural gas output.17 It also accounts for 47% of U.S. LNG refining capacity and 51% of U.S. natural gas processing capacity.18 Furthermore, the Gulf is now crucially important to Europe’s LNG supply, with exports to Europe tripling since Russia invaded Ukraine in February.19
During Hurricane Ida, which made landfall as a Category 4 hurricane in August 2021, 96% of crude oil production and 94% of natural gas production in the U.S. federally administered areas of the Gulf of Mexico were shut down (See Exhibit 5).20 As such, a heavy hurricane season poses at least a temporary risk to oil and gas prices, as well as retail gasoline prices.
Downside growth scenarios could send oil prices 10-23% lower
The counterpoint to the stable/upside outlook above is the risk of a recession in the United States or globally. We have already seen demand pull back and a recession would exacerbate this trend.21 For example, between 2007 and 2009, U.S. oil demand fell 9.2%22 and global demand dropped roughly 3%.23 In the 2015 to 2016 period, despite slower economic activity, global demand grew 0.8%, but energy prices tumbled 35% peak-to-trough because the world was then awash in oil.24 With oil inventories now much lower, oil price declines could be less acute. According to J.P. Morgan, in a second half of 2022 recession scenario we could see Brent oil prices pull back to $78/bbl.25 At current prices, this represents a 23% downside risk. In the case of a late 2023 recession, they would likely fall to $91/bbl, and in a soft-landing scenario the decline would be even less, to $98/bbl.26
Case for energy equities
Given the current economic uncertainty, planning for this downside scenario is prudent. However, the risk of a recession is not 100% (the latest implied recession probability is 42% based on economic indicators27), a “soft-ish landing” is still possible, while the upside risks to oil are significant. Stabilization of oil prices around the $90-100 level is good news not only for headline inflation and an eventual Fed “pause”, but also energy equities. Here are three reasons why energy stocks screen as attractive again given the current pricing and future outlook.
- Energy is the cheapest sector in the S&P 500 and is discounted at a lower forward price than actual forward strip prices.28 At present, the energy sector has a blended next-twelve-month price-to-earnings multiple of 7.7x, which is in the 2nd percentile over a 20-year lookback.29 Energy equities are discounting a $69 forward strip versus an actual two-year strip around $80.30
- Energy companies are highly profitable and free cash flow positive. With current oil prices around the $100 range and breakevens at $50, cash flows for energy companies are strong.31 Median 2022/2023 free cash flow-to-equity yields are roughly 19% and 17% at current prices and would decline only slightly to 17% and 11% if oil prices fell $20.32 This solid margin promotes a very healthy shareholder return profile. The energy sector’s 4.65% dividend yield fits in well with our “get paid while you wait out the volatility” theme.33 On top of this, record levels of share buybacks across the energy sector should drive total return to shareholders higher: Big oil companies are collectively expected to initiate $38bn in share buybacks this year, the largest total since 2008.34
- Demand for U.S. oil should further incentivize production. U.S. crude oil production grew 5.5% in the first half of 2022 and based on current levels is expected to grow another 5% in the second half of 2022 and 10% in 2023.35 Also, the trend of Europe shifting away from Russia and towards friendlier jurisdictions should continue, thereby boosting U.S. LNG demand. U.S. LNG exports are forecast to grow 17% year-over-year in 2023.36 Government incentives or not, we believe a stable and elevated price environment and diverse sources of demand should prompt U.S. producers to invest in expanding production.
1. Bloomberg, as of July 18, 2022.
2. Ibid.
3. U.S. Energy Information Administration, as of July 8, 2022.
4. U.S. Energy Information Administration, as of July 8, 2022.
5. JPMorgan Commodities Research, as of July 11, 2022.
6. Ibid.
7. Bloomberg, iCapital Investment Strategy, as of July 18, 2022.
8. Bloomberg, July 17, 2022
9. Reuters, “Explainer: How much extra oil can Saudi Arabia pump?”, as of July 18, 2022.
10. Nord Stream Network Data, AFP News, as of July 13, 2022.
11. Germany Federal Network Agency (Bundesnetzagentur), as of July 14, 2022.
12. Reuters, Bloomberg, as of July 14, 2022.
13. Bloomberg, iCapital Investment Strategy, as of July 18. 2022.
14. Goldman Sachs Research, as of July 13, 2022.
15. NOAA, as of July 18, 2022.
16. NOAA, iCapital Investment Strategy, as of July 18, 2022.
17. U.S. Energy Information Administration, as of July 18, 2022.
18. Ibid.
19. U.S. Energy Information Administration, as of June 7, 2022.
20. U.S. Energy Information Administration, as of September 16, 2021.
21. Bloomberg, as of July 18, 2022.
22. U.S. Energy Information Administration, as of July 18, 2022.
23. IEA, as of August 11, 2021.
24. Ibid.
25. J.P. Morgan Center for Commodities Research, as of July 11, 2022
26. J.P. Morgan Center for Commodities Research, as of July 11, 2022
27. JPMorgan, as of July 18, 2022
28. Bloomberg, iCapital Investment Strategy, as of July 18, 2022. Strip prices are average daily settlement prices for next 12-months contracts
29. Bloomberg, iCapital Investment Strategy, as of July 18, 2022.
30. Bloomberg, Goldman Sachs, as of July
31. Bloomberg, iCapital Investment Strategy, as of July 18, 2022.
32. Morgan Stanley Research, as of July 11, 2022.
33. Bloomberg, as of July 18, 2022.
34. Bernstein Research, Financial Times, as of February 20, 2022.
35. EIA, Short-term Energy Outlook, as of July 12, 2022.
36. Ibid.
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