Summary
- The energy sector was - by far - the best performing sector of the market during the 2022 bear-market.
- Much of that was due to Russia's invasion of Ukraine and the resulting sanctions placed on Russia by the United States and its Democratic and NATO allies.
- However, damage to the global economy due to the tangential effects of the war, primarily high energy and food inflation, could be a headwind for energy investors going forward.
- Energy investors face a duel between China re-opening demand vs. high-inflation, higher interest rates, and slowing global growth.
As most of you know, the price of oil skyrocketed after Putin's decision to invade Ukraine on Feb. 24 of last year (see graphic below). As shown below, Brent crude - which already was recovering from the depths of the global pandemic - jumped from $94/bbl on Feb. 23 to $128/bbl on by March 8 (+36%). Natural gas, especially in the EU, soared by an even higher percentage. That was a welcome gift to long-suffering energy investors (but obviously not the Ukrainian people ...), who suffered what I commonly refer to as the "lost decade" in which, year-after-year, the energy sector was typically the worst performing sector (by far ...) of the entire market. However, energy investors might not have such easy sledding this year. Here's why.
MarketWatch
The chart above - despite a sharp correction year-to-date - shows just how much the energy sector, as represented by the SPDR Energy Select ETF ( XLE ), has outperformed the broad market averages of the S&P500, DJIA, and Nasdaq-100, as represented by the ( VOO ), ( DIA ), and ( QQQ ) ETFs, respectively.
Yet, as shown in the first chart, while the price of Brent rallied strong following the invasion of Ukraine, it's now down to where it was prior to the invasion.
The domestic natural gas market is even more bearish and has effectively crashed-n-burned. As I have been writing in my Seeking Alpha articles, U.S. natural gas production has continued to soar despite the new "disciplined spending" mantra in the shale patch. And that growth is not only due to increased drilling in the Marcellus and Haynesville shale basins to feed LNG exports to the EU, but also because of associated natural gas from oil drilling in the Permian Basin and elsewhere:
EIA
Indeed, as can be seen on the chart above, domestic dry-gas production last year exceeded 100 Bcf/d for the first time in U.S. history. Expect new record highs again this year. That production, combined with a relatively warm winter in the EU and the U.S., led to a rather startling inventory build in in January. That's right, the U.S. actually added to dry-gas inventories in the middle of winter (i.e. the red circle is above "0"):
YCharts
As a result, EIA storage data as of Feb. 10, 2023, shows working gas in storage was 2,266 Bcf. Stocks were 328 Bcf higher on a yoy basis and 183 Bcf above the five-year average of 2,083 Bcf. You can only imagine what these fundamental factors have had on the price of domestic natural gas:
MarketWatch
As you can see in the graphic, after a huge rally post the invasion of Ukraine, the price of NYMEX gas has fallen (crashed is not too hard a word) to $2.259/MMbtu, a price last seen back in the middle of the worst of the global pandemic in 2020. As my followers know, I don't expect firming in the domestic natural gas price until additional LNG export capacity begins to come online in 2024 (for more detail on that subject, see APA: Natural Gas Is Down, But Not Out ).
Inflation
Meantime, the oil bulls had better pay attention to inflation data - which has been stubbornly high. January's CPI rose 0.5% after rising only 0.1% in December. As my followers know, Putin not only broke the global energy supply-chain (which in my opinion, has been totally re-engineered and will never be the same again) but considering Ukraine is the "breadbasket of Europe" and major grain exporter, he also arguably broke the global food supply chain as well. The "Putin effect" continues to show up in the CPI data with both food and energy still running hot:
U.S. Bureau of Labor Statistic
Why should oil bulls care? Those who follow me know that I have always maintained that the No. 1 impact on overall inflation is the price of oil. It not only impacts the price consumers pay for gasoline, but also the cost of freight delivery. And there at least are two reasons why this is important:
- High inflation will lead to higher interest rates.
- Higher energy and food costs means a weaker consumer, weaker consumer spending, and - all things being equal but realized they're not - therefore a generally weaker economy.
Indeed, after the hot inflation data last week, what had been a weakening U.S. Dollar - which was on a path to dip back below 100 - suddenly firmed, turned around, and headed higher (red annotations by the author):
MarketWatch
Now, in the old days, oil was predominantly priced in U.S. dollars the world over. So, a higher U.S. dollar typically led to lower oil prices. That "rule" was obviously violated last year as both the U.S. dollar and the price of oil increased at the same time. However, that too was influenced by the war and the breakdown of the global energy supply chain - and the fact that the U.S. had higher interest rates than any other country and attracted foreign capital.
Going forward, a larger percentage of the global trade in oil will not be conducted in U.S. dollars. For instance, Russian oil exports to countries like China and India probably will likely not be priced in U.S. dollars. Indeed, as energyintel.com reports :
Most oil still sells for dollars, but sales of oil by Russia, Iran and Venezuela to China, India, Turkey and a few others are now priced in a hodgepodge of Chinese yuan, Russian rubles, importing country currencies and barter. These prices are not transparent but are presumed to be at a discount of 30% or more at times to published dollar prices.
That said, the U.S. is now the largest exporter of LNG and a growing exporter of oil. So, a stronger U.S. dollar - pushed higher by Federal Reserve interest rate hikes - is likely to continue to put pressure on the price of oil, both WTI and Brent, which will also put pressure on consumers (think housing and credit card debt), dampening overall consumer demand.
China
Counteracting these negative influences on the global oil market and oil demand is the China re-opening thesis. China may import a record amount of crude oil this year due to the removal of pandemic controls, new refineries coming online, and increased demand due to more traveling by Chinese consumers. Indeed, Reuters reports :
China's crude imports may rise between 500,000 and 1 million barrels per day (bpd) this year to as high as 11.8 million bpd, reversing previous two years' decline to exceed 2020's record of 10.8 million bpd, according to analysts from four industry consultancies - Wood Mackenzie, FGE, Energy Aspects and S&P Global Commodity Insight.
Push-Pull
I see a push-pull dynamic in the global energy market this year: Consumer stress in major markets like the EU and the U.S., along with the potential for further increases in the value of the U.S. dollar, vs. bullish demand from China. It will be very interesting to see how it plays out - especially during the U.S. summer driving season, which will likely prove critical to U.S. inventories and therefore the price of WTI.
Supply/Demand
I touched on demand, but what about supply? The oil bulls' dominant theme seems to be the never-ending mantra that there has been a severe "lack of investment" that will lead to a significant shortage of supply. As I mentioned in my popular Seeking Alpha article The New-Era of Energy Abundance , I am not buying it. As I pointed out in that piece:
- The U.S. shale producers have tens of billion of bbls of proven reserves (at WTI=$40/bbl, let alone $75/bbl ...), that can be easily, very economically, and relatively quickly drilled and lifted with a near 100% drilling success rate. That is, shale oil is still "short-cycle" even though the CEOs recently pushed back on that adjective (despite the fact that they marketed shale oil as "short-cycle" for the past decade). The rapid and massive increase in natural gas production to provide the EU with LNG exports proved that shale is still, very much, a "short-cycle" resource.
- Ditto the Canadian oil sands producers: Tens of billions of proven reserves. But certainly not short-cycle. Yet look how fast the tar sands producers filled up Enbridge's ( ENB ) Line-3 pipeline expansion capacity.
- Exxon keeps ramping up Guyana - Q3 production was 360,000 boe/d and the current plan is to grow to 1 million boe/d by 2030. Using a recoverable reserves estimate of 11 billion boe (the latest I have seen), a 1 million boe/d production rate would last 30-plus years.
- Chevron is ramping up Permian production to an estimated 1 million boe/d by 2025 and by up to 1.2-1.5 million boe/d by 2030. Chevron currently plans to hold production at that level for at least a decade after that.
- Meantime, OPEC+ is still holding millions of bpd of spare capacity off the global market.
Bottom line here: As I have been writing about for years, the global O&G markets were totally disrupted by U.S. shale technology (i.e. horizontal drilling + fracking). The planet has an abundance of petroleum reserves - by far much more than the planet can afford to burn (without burning up the planet as well). And, despite all the protestations by some politicians that the U.S. is somehow not "energy independent," here are the facts: the U.S. is the No. 1 oil producer on the planet, the No. 1 LNG exporter on the planet, and the top total petroleum producer. Those are simply the facts.
Meantime, two companies - BYD ( OTCPK:BYDDY ) and Tesla ( TSLA ) - alone sold more than 3 million EVs last year. Assuming they replaced ICE-based vehicles that get 20 mpg and are driven 10,000 miles per year, that's a reduction of 1.5 billion gallons of gasoline demand that otherwise would have been there. And the EV transition is accelerating with many more EV manufacturers up-n-down the vehicle cost curve.
In addition, while natural gas use continues in power generation, the vast majority of new incremental electric power generation capacity in the U.S. continues to be solar (primarily), wind, and battery backup (74%):
EIA
Geopolitics
Luckily for Ukraine and the free world, President Biden has been a step-ahead of Russia from day 1. He was on TV telling the world days ahead of the invasion what Russia was up to. United States intel was informing Ukraine's defense of what to expect and from where. Since the invasion, Biden has pulled NATO back together with two potential new members - Sweden and Finland. That was after the previous administration tried to undermine Ukrainian and NATO defense (i.e. impeachment No. 1 - the "perfect phone call") and arguably pivoted American foreign policy away from its Democratic and NATO allies toward the world's worst dictators. This weekend, Biden was again ahead of Putin by visiting Kyiv, Ukraine, and grabbing global headlines a day before Putin's "celebratory" speech on the one-year anniversary of his invasion.
As a result of President Biden's leadership, the strong and united stand of NATO and the world's Democratic and free allies, and western technology and arms, the fighting Ukrainian patriots have exposed Russia's military for what it is: Poorly led, poorly trained, poorly equipped, and poorly supplied.
My point here is that Putin, the supposed "genius," has been outplayed and is losing. While that's good, it also means he's likely to get ever more desperate.
Things to consider going forward:
- Will China aid Russia based on their "strategic partnership"? If so, that would be a game-changer and likely result in big-time U.S./EU/NATO economic sanctions on China that would most probably lead to a global economic recession/depression. That would be bad for energy investors, for sure (not to mention Ukraine and the Democratic free world).
- China wants a weakened Russia so it will be more economically dependent on China. So far, it has definitely achieved that goal.
- China also likely wants a long drawn-out affair in Ukraine in order to distract the U.S. away from Taiwan and run-down supplies of US/NATO key military hardware. From all indications, that's what we will have as Russia shows no signs of backing down, and how can any negotiated peace agreement be signed with a "leader" who has continually lied, apparently lives in a delusional world, and simply cannot be trusted?
Summary and Conclusions
Let's start with what we know with relative certainty: This is going to be a bad year for the price of domestic natural gas price. That being the case, and given the fact that old shale wells get gassier over time (a big factor that many shale investors are ignoring these days), the shale oil producers that have a high percentage of gas production may struggle. EOG ( EOG ) will be a company to watch in this regard. EOG will release Q4 earnings on Friday before the market opens. As I reported last week, only ~50% of EOG's production is oil - the rest is dry-gas and NGLs, both of which have seen prices collapse (see EOG: What To Expect From Next Week's Earnings Report ). Another key shale producer to keep an eye on is Pioneer Natural Resources ( PXD ).
The bigger companies that have significant exposure to global LNG prices, with long-term supply contracts based on the price of Brent, will likely do better. These are companies like Chevron ( CVX ), Exxon ( XOM ), and ConocoPhillips ( COP ). Indeed, asia.nikkei.com reported last month that "China tightens grip as dominant LNG buyer with long-term deals" as "Sinopec leads way with Chinese companies locking in 40% of recent contracts." Exxon and Chevron also have the advantage of significant refining capacity, and I expect the diesel and jet-fuel markets to remain very strong this year. That's one reason I'm bullish on the refiners - including Phillips 66 ( PSX ), which has a higher distillate yield than its peers and is killing it on diesel margin. Earlier this month, PSX raised its quarterly dividend 8% to $1.05/share. The stock currently yields 4.22%.
Bottom line: it's going to be another fascinating year for the global energy markets. But for energy investors, I suspect it likely won't be near as easy as it was last year.
I'll end with a one-year total returns chart of some O&G companies and note that, year-to-date, most of these companies have taken a big leg down (far right-hand side of the chart):
For the reasons stated earlier, note that Exxon and Chevron, and to a lessor extent ConocoPhillips (which has no refineries) have led the pure-play shale operators EOG and PXD. That said, what EOG and PXD have given up in the stock price, they have regained some through superior dividends paid directly to their shareholders. Meantime, Exxon, Chevron, and ConocoPhillips have decided to greatly prioritize buybacks over dividends directly to investors. Exxon, for instance, despite massive profits and FCF, only raised its quarterly dividend by a piddly 3 cents per share. Chevron's dividend increase was also a big disappointment . Meantime, PXD rewarded its shareholders with over $25/share of dividends in 2022. So, going forward, energy investors certainly have a choice: Do they want to own stock in companies that are effectively forcing them to double-down on investments in oil and gas via share buybacks, or, do they want to own companies that are paying out a much higher percentage of FCF directly to investors in the form of dividends? It's a good debate, and I look forward to the comments.
For further details see:
Will Energy Investors Suffer From The 'Kremlin Gremlin' This Year?