[Editor's note: A version of this story appears in the July 2019 edition of Oil and Gas Investor. Subscribe to the magazine here.]

Imagine a jigsaw puzzle falls to the floor, and what was a complex but connected picture turns into a mix of pieces with no clear image. Uncertainties and offsetting factors abound. And the pieces are seemingly so disparate that they provide little of the clarity needed to move forward.

A similar set of circumstances appears to have arisen in the E&P sector of late. If E&Ps are trading at attractive levels, few investors are jumping in to seize the opportunity. Rather, potential buyers seem paralyzed by a myriad of externalities: price volatility, geopolitical risks, trade wars, etc.

In early June, the energy sector suffered “massive underperformance,” said a Simmons Energy report. The sell-off was sparked by a negative weekly crude oil inventory report released against a backdrop of trade war fears. The XOP (S&P Oil & Gas Exploration & Production ETF) tumbled to a point “essentially flat with its level in February 2016 when WTI [West Texas Intermediate] was about $26/bbl.”

With WTI almost twofold higher, closing at $51.68/bbl on June 5, Simmons advised clients to “prepare their shopping lists as the weakness should provide attractive entry points.” However, the firm was quick to add a note of caution. “We also, in due candor, advocate patient vigilance as the macro complexities afflicting the current risk/reward framework are non-trivial.”

Others have also recognized headwinds, with Raymond James suggesting “capitulation seems to have taken hold,” as WTI retreated into the $50s from $60-plus/bbl in mid-May.

Raymond James said the situation was akin to a “chicken and egg problem.” On the one hand, with an energy weighting of only 5% in the S&P 500, the sector needs long-only money to return to the group for energy to outperform the broader market. On the other, energy must first outperform meaningfully in order to compel investors to care about energy and attract generalist funds.

In the meantime, a repeated investor observation was that the risk/reward in energy was skewed to the downside, according to Raymond James. Investors cited that E&P stocks failed to participate in what at one point was a strong first-half oil price rebound, but the stocks got “hammered” upon any sign of weakness in the commodity.

Is all lost for the energy sector? Do fundamentals justify fresh 52-week lows for some of the E&P stocks?

Geopolitical issues are hard to measure but harder to ignore.

Venezuela’s economy is in free fall, and its crude output continues to slide. Iran’s exports are forecast to fall to 500,000 to 600,000 bbl/d in the near term, down from a March level of 1.33 million bbl/d (and a spring 2018 high of 2.58 million bbl/d), according to RBC Capital Markets. Meanwhile, Russia has been seeking—for months now—a solution for contaminated pipelines to Europe and is trying to offset lost production by boosting seaborne volumes. Libya continues to have factions fighting in a near civil war.

Saudi energy minister Khalid al-Falih downplayed the idea that recent price volatility reflected a need for new measures to manage the crude market. “These levels [of volatility] are totally unwarranted in light of both the current market fundamentals, which remain healthy, and the high levels of discipline by OPEC plus producers,” he said.

Ed Morse, Citi’s head of global commodity research, recently published a report with the title, “Brent is more likely to hit $75 than $50.” In it, he raised the likelihood that bearish expectations related to trade frictions could result in the market being “too complacent, ignoring the bullish fundamentals.”

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In a subsequent Bloomberg TV interview, Morse drew a distinction between the “turbulence” seen in financial markets and what was happening in the physical crude market. He noted that inventories were, indeed, increasing in the U.S., which he attributed largely to bottlenecks likely to persist until new pipeline capacity comes onstream, mainly in the third quarter.

“Meanwhile, the rest of the world is, you might say, screamingly tight,” said Morse. “And we’re moving into a season in which refinery demand for crude oil is growing. It’s going to grow by 3 to 4 MMbbl/d between the end of May and the middle of August. The physical markets are showing a very different sign from the financial markets,” which he called “spring-loaded.”

When are financial markets likely to “trust” a rally in crude?

“I think all signs are market sentiment is changing,” said Morse in the June 6 interview. “By the end of June, we should see refinery runs going up.”

Chris Sheehan can be reached at csheehan@hartenergy.com.

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