Throughout the energy sector’s recovery rally earlier this year (a false spring), we warned of a second leg down for crude-oil prices, with the selling pressure intensifying in fall and winter, when refineries usually shutter some of their capacity for maintenance and upgrades.
Valero Energy Corp (NYSE: VLO) and other refiners have warned that this year’s turnaround season could involve more outages than usual because the industry ran flat out in the spring and summer to take advantage of robust demand for gasoline and favorable crack spreads.
And even after record refinery runs and gasoline demand this summer, resilient production and overseas imports have ensured that US crude-oil inventories remain about 26 percent above their five-year average for this time of year.
This overhang, coupled with the prospect of reduced demand, suggests that oil prices could suffer significant downside this fall. Albeit painful, such a correction could accelerate the process of squeezing production from marginal acreage and ratchet up the pressure on those with stretched balance sheets.
The potential for crude-oil prices to slip into the $30s per barrel (and perhaps even lower), coupled with slowing production growth in some basins and outright shrinkage in others, suggests that the energy sector could be in for more pain this fall and into early 2016.
Exploration and production companies likely face the most downside in this scenario, and we would continue to steer clear of onshore and offshore contract drillers and other equipment providers. Even midstream master limited partnerships face near-term uncertainties related to counterparty and volumetric risk.
However, we remain bullish on US oil and gas production over the next three to four years, as we expect reductions in non-OPEC drilling activity and reduced capital expenditures in international markets to create an opportunity for short-cycle shale plays to fill the gap and win market share.
Rest assured, there’s more pain coming for the energy sector in the near term, creating a real buying opportunity for investors with a longer time horizon. Keep your powder dry and your head level.
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Elliott and Roger on Aug. 25, 2015
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