Over the past 18 months, the energy sector has been a better group to trade than to own, with investor sentiment swinging as dramatically as the moves in oil prices.
After OPEC and other major oil-producing countries agreed to curb output in fall 2016, specialist and generalist portfolio managers alike bet heavily on West Texas Intermediate (WTI) rallying to at least $60 per barrel in 2017.
This shot of confidence prompted investors to pile into energy stocks in expectation of rapid improvements in utilization rates and pricing. US-focused oil-field service names and exploration and production companies were the biggest beneficiaries of this exuberance, thanks to their cyclicality.
From mid-2016 to the end of January 2017, SPDR S&P Oil & Gas Exploration & Production (NYSE: XOP) and VanEck Vectors Oil Services (NYSE: OIH) both gained more than 15 percent.
Investors also moved down the quality chain in the search for value and alpha, with marginal equities rallying hard and high-yield energy bonds acting as though the 2014 collapse in oil prices was an aberration. We expressed skepticism about this ebullience in an Alert published on Dec. 12, 2016, warning that the magnitude of the US supply response could surprise to the upside. (See OPEC Continues its PR Blitz.)
This macro call was directionally correct. In spring 2017, the story shifted to how the surge in US oil output and stepped-up drilling and completion activity in prolific shale plays—abetted by upstream operators’ aggressive hedging when WTI fetched more than $50 per barrel—threatened to overwhelm the extended OPEC and non-OPEC supply cuts.
WTI slipped into the low $40s per barrel in late spring and early summer, as crude-oil inventories remained persistently elevated and weekly data from the Energy Information Administration showed sharp increases in US production volumes. At the midpoint of 2017, the recovery in US oil output had offset about three-quarters of the 1.2-million-barrel-per-day supply cut targeted by OPEC’s agreement with other major producers.
Against this backdrop, investors’ confidence in the energy sector evaporated. From Jan. 31 to Aug. 31, SPDR S&P Oil & Gas Exploration & Production gave up about a quarter of its value and VanEck Vectors Oil Services plunged 33 percent.
In the July 13 issue of Energy & Income Advisor, we changed tack and asserted that the risk-reward proposition for oil prices and energy stocks had improved, arguing that the market had overreacted to the US production response and overlooked the potential for upstream operators to slow activity levels in response to lower prices. This assessment prompted us to call for WTI to rally to $55 per barrel or more by year-end.
Once again, our macro call was directionally correct, with WTI approach $60 per barrel as the year winds down. SPDR S&P Oil & Gas Exploration & Production has rallied almost 25 percent since the end of August, while VanEck Vectors Oil Services has gained about 20 percent.
We maintain our bullish outlook for oil prices and cyclical energy stocks as 2017 winds down.
Although we won’t hesitate to modify our views and positioning in response to incoming data points and developments, we expect 2018 to be less tumultuous for the energy sector, making the stocks easier to own and requiring less trading to deliver differentiated returns.
Energy stocks could also benefit from the ongoing rotation into value-oriented sectors.
Growth stocks tend to outperform the broader market when the US and global economies expand at a lackluster pace or decelerate; these names don’t require as much support from broader economic trends to increase their earnings and revenue. The technology sector, for example, is expected to benefit from powerful secular growth trends that will play out regardless of the economy’s strength.
Energy, financials, industrials, and other sectors that fall into the value category tend to exhibit more cyclicality and greater sensitivity to the economy’s overall health. Given the strength of recent economic data, we expect the momentum in value names to continue over the coming months.
Our outlook for further rotation into value stocks reflects the growing importance of quantitative factors—metrics related to earnings growth and quality, valuation, risk, and momentum—that drive trillions of dollars in investment flows. When the quantitative models favor one factor over another—for example, lower quality over higher quality—it pays to be on the right side of this trade.
More important, we expect to WTI crude oil to average $55 to $60 per barrel in 2018 while experiencing short-lived spikes outside of this range, with a floor around $50 per barrel and a ceiling around $65 per barrel.
Investor sentiment toward oil and gas producers has also shifted, with the market rewarding names that can grow production while living within cash flow and returning capital to shareholders.
As the market no longer encourages upstream operators to grow production at any cost, we expect more exploration and production companies to set their drilling and capital-spending plans at levels that would generate free cash flow if oil prices remain near current levels.
For example, Cabot Oil & Gas Corp (NYSE: COG), which generates the bulk of its operating income from natural gas produced in the Marcellus Shale, has returned about 20 percent year to date, making it one of the top-performing US upstream stocks. This relative strength likely reflects the company’s ability to generate positive free cash flow while driving strong production growth. A commitment to returning capital to shareholders via buybacks also doesn’t hurt.
Anadarko Petroleum Corp’s (NYSE: APC) stock also popped after the company announced that it would dip into the $6 billion in cash on its balance sheet to fund a $2.5 billion repurchase program. The market had widely expected the company to use that cash for acquisitions, with BHP Billiton’s (ASX: BHP, NYSE: BHP) acreage in the Delaware Basin touted as a potential target.
On a full-cycle basis, operators in the Permian Basin and central Oklahoma’s STACK play should be able to produce a solid return on their investment if WTI ranges between $55 and $60 per barrel.
Given expected cost inflation and upstream operators’ newfound focus on returns, we expect US production growth in 2018 to disappoint the most bullish forecasts. Fourth-quarter results and earnings calls, which usually include capital-spending guidance for next year, should help to communicate the extent of this newfound discipline to the market.
This outlook suggests that energy stocks may offer more upside potential than oil itself. History demonstrates that well-positioned energy stocks can deliver impressive gains during periods of flat commodity prices—exactly what happened between 1988 and 1998.
However, stock selection will still be critical to delivering differentiated returns; one of our biggest goals for the new year is for our picks to be just as timely and spot-on as our macro calls were in 2017.
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In October 2012, renowned energy expert Elliott Gue launched the Energy & Income Advisor, a twice-monthly investment advisory that's dedicated to unearthing the most profitable opportunities in the sector, from growth stocks to high-yielding utilities, royalty trusts and master limited partnerships.
Elliott and Roger on Sep. 27, 2019
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