VDE - VDE: Energy Stocks Face Their Greatest Bull Market Threat

Summary

• The US energy sector is facing challenges today as lower commodity prices and rising costs threaten the rebound in profitability.
• In the short term, most energy stocks will see EPS decline due to lower product prices, but more excellent production cuts could cause shortages to return.
• Oil refiners benefit from a rebound in crack spreads, benefiting the industry despite its higher valuations.
• Oil and gas explorers and producers are at the most significant risk as the commodities decline toward breakeven levels.
• The Vanguard Energy ETF appears lackluster overall, with individual energy stocks offering superior risk-reward potential.

Energy stocks have been in a bull market since energy prices began to rise in 2020. Most fossil fuel commodities have stagnated or declined since last spring, but the energy sector, as seen in the Vanguard Energy ETF ( VDE ), has risen slightly as their profits and dividends soar. Valuations remain lower in the energy sector than all other sectors today, with VDE carrying a weighted-average "P/E" ratio of just 8.1 and a TTM yield of 3.8%. VDE is trading at its highest price since the "shale glut crash" of late 2014, having nearly tripled in value since its 2020 lows. Of course, energy stocks are notoriously cyclical, and oil and gas prices are much lower than last year. Further, many energy firms see costs rise quickly due to labor shortages , elevated interest rates , and regulatory measures .

With this in mind, many stocks in VDE may struggle to make a profit as long as oil prices remain relatively low. Further, the somewhat surprising continued release of the SPR reserve may extend the glut . However, low energy commodity prices also encourage Russian production cuts and reductions to the US drilling rate. In my view, while the immediate profit outlook for energy stocks is weak, that challenge may spur a quick shift back toward a shortage dynamic that eventually produces higher profits. Still, investors may want to take a cautious outlook on energy stocks, with individual stocks likely superior to the overall basket.

The Energy Market Regime is Changing Again

From late 2014 to mid-2020, the energy market "regime" was overwhelmed by a global glut dynamic. The excessive growth of the US shale industry led to a vast oversupply of oil, hampering energy sector profits and causing many oil companies to take on excessive debt. This situation reached a critical level in early 2020 as the rapid demand decline (from lockdowns) caused oil storage levels to swell so quickly that there was a shortage of storage facilities, causing oil prices to become negative temporarily .

The "regime" changed quickly in early 2020 as producers made excessive production cuts and layoffs. Energy demand returned to normal relatively quickly in 2020, but US crude oil production remains below pre-COVID levels. This situation created a shortage dynamic, leading to higher prices and profits. However, the acute shortage ended last spring as the Biden administration began immense SPR reserve releases to fill the gap, leading to a significant decline in oil prices. See below:

Total US oil production remains below pre-COVID levels. Although some oil is still coming out of the SPR reserve, it is very low compared to last year's levels and may reverse as the SPR is eventually refilled . The recent SPR release is primarily due to legal technicalities and not a continued effort to support low prices, and I anticipate a refilling effort is likely since the SPR is arguably at dangerously low levels. However, US oil exports have slipped due to low prices. More importantly, US oil demand appears to be falling due to a decline in refiner output . See below:

The slight decline in exports and a more considerable decline in refinery capacity utilization have hampered oil demand, causing total oil storage to rise despite lower domestic production. Refiner output fell over the past two months due to the sharp reversal in the "crack spread," or the difference between gasoline and oil prices - an indicator of refiner profit margins. The crack spread was very high last year but declined in December as refining output rose. Unsurprisingly, the recent decline in refining output has caused the crack spread to rise again. See below:

The rising crack spread is good news for integrated energy stocks and refiners as it will increase refining margins. That said, most refiners struggle with rising costs associated with skilled labor shortages and dilapidated infrastructure . With the crack spread rising, refining output may increase again and boost oil demand, but refiners likely require a permanently higher spread to turn a profit.

The last significant segment of the energy industry is natural gas. Natural gas prices have recently collapsed due to warm weather and overproduction. While I believe natural gas prices are bottoming, they may maintain low levels for some time, as US production could take time to return to baseline levels. However, with the crude oil and natural gas rig count falling, both commodities are likelier to see output fade over the coming months. See below:

Overall, I believe these macroeconomic data suggest that the entire US fossil fuel energy market is at a critical turning point. Most of the immediate impacts from 2020's lockdowns no longer affect the market. However, long-term issues such as skilled labor shortages, aging infrastructure, and regulatory pushback (against continued fossil fuel growth) hamper US energy production levels. For the coming year or two, higher interest rates will also slow output growth due to the higher cost of project financing. These factors negatively impact the production of crude oil, natural gas, and refined products.

Notably, Europe and OPEC face similar circumstances in their energy markets. OPEC's production shortfall seems to relate to internal issues in many Middle Eastern countries causing significant output volatility . Russia is the obvious wildcard factor since it is the second largest exporter . Russia's recent unilateral production cut is exceptionally bullish for oil since the country reduced exports without OPEC. Considering Russia's oil production costs are well-below US levels, the cut was almost certainly not a business decision but a geopolitical gamble. In my opinion, it appears Russia is trying to spur a shortage in western countries, potentially forcing the US to drain its SPR reserve or increase US & European prices - both of which would be particularly damaging to NATO countries. While I would not necessarily bet on the "Russia catalyst," further production cuts from that country could dramatically increase global oil prices.

VDE Headed For Greater Volatility

In the immediate term, lower crude oil and natural gas prices hamper the profits of most energy stocks. Crude oil is near the breakeven price for new wells (which is rising), while natural gas is likely below producer breakeven prices today. Oil and gas producers and developers account for around 30% of VDE's holdings and are the most volatile segment in VDE. Although many trades at very low valuations, I believe this industry will see much lower profits in 2023 than in 2022 unless oil and natural gas prices rise soon. That said, "bad news" could be good news for the segment since lower profits will likely spur significant production cuts - creating a shortage later this year. The extensive recent declines in natural gas and crude oil rig count indicate impending domestic production cuts. The SPR refill and Russian cuts may also accelerate a "return to oil shortage" sooner.

VDE's other major subindustry is oil and gas refining and integrated oil, making up ~ 50% of the fund . These companies have generally fared better over recent years since they were less directly impacted by volatility in production levels. The recent rise in crack spreads has benefited refiners such as Phillips 66 ( PSX ) and Valero ( VLO ). However, rising production costs and infrastructure issues could wane long-term profits. That said, the lack of refinery infrastructure growth over recent decades creates natural oligopolistic pricing power in the market since refining capacity is falling and will not rise without significant new investments (which take years and are unlikely due to EV growth concerns ). This segment's outlook is less volatile than producer and explorer's, but higher profits are offset by higher valuations.

One of my favorite segments in VDE today is oil and gas transportation, only directly accounting for ~9% of the fund . This segment has had much lower volatility recently as the shale industry has matured. Although valuations are higher in this segment, better dividends are often found. That said, VDE does not have significant exposure to midstream MLPs, such as those in the ETF AMLP , where the best yields are often found today.

The Bottom Line

Although VDE has a lower TTM "P/E" valuation, most of the segments in the fund will likely see their profits decline this year. Direct crude oil and gasoline commodity producers will probably take the largest hit since those commodities are back near breakeven prices. Some may benefit from higher fixed-price contracts that extend profits, but the general trend for producers and explorers is significantly strained compared to a year ago. Other segments in VDE are stronger but are still struggling with growing costs and capacity constraints.

Overall, I am neutral on VDE but suspect the fund will see much greater volatility over the coming months than it has over the past ten months. While the profitability of many energy companies is falling, there are many reasons to suspect the market could fall back into a shortage soon, chiefly due to falling US oil and gas rig count, Russia's efforts to reduce supplies, and OPEC's apparent challenges sustaining higher production.

Though many producers see profits decline, they could eventually rebound significantly if oil rises to record highs. In my view, it is likely that short-term factors hampering oil (such as the SPR release and post-COVID production rebounds) will quickly fade as producers see profits fall. Some individual "deep value" producers may be decent bullish opportunities today, but I would not be bullish on the segment entirely until the rig count falls faster. Until then, I believe midstream MLPs may offer the best "rewards for risk," while VDE, as a whole, is lackluster and potentially due for a sharper negative correction.

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