Energy: It’s So Bad, It’s Good

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

Let’s face it. Energy was the worst-performing market sector last year, the latest in a string of years in which it’s disappointed. Yes, unpredictable presidential policy as regards Middle East issues—notably, waivers to purchase Iranian oil—played a part. But sentiment at year-end could scarcely have been worse, as scores of stocks hovered near 52-week lows.

If any tidings of comfort and joy existed, they were overshadowed by a variety of factors: broader stock-market volatility and its relationship to risk assets, including oil markets; E&P valuations bearing little resemblance to historical metrics; the majors boosting production in the Permian; talk of a persistent oil glut; weaker OPEC influence over global markets; etc.

Any early recognition gained by the E&P sector for improved capital discipline in the third quarter of 2018 likely went out the window with the commodity crash late last year. Capital discipline was no longer a desirable option, but an imperative for most E&Ps, as WTI fell from an early October high of about $76.40 to just over $45 at year-end.

For a sector that constitutes less than 6% of the S&P 500 Index, a drop in price of this scale and speed—a roughly 40% decrease in WTI in just three months—does little to lure new investors into the energy space.

Several factors contributed to the downward cascade in crude prices. Not least was the Trump administration’s switch from the threat of emphatically stringent sanctions on countries buying Iranian oil to—in its place—the granting of unexpectedly generous waivers to eight importers of Iranian oil, including China, India and S. Korea.

Once fears of a tightening market subsided—and Saudi/Russian moves to raise output to compensate for lost supply from Iran proved misguided—momentum to the downside accelerated price weakness. This was reinforced by a backdrop of broader concerns over slowing global growth, U.S.-Sino trade friction, U.S. dollar strength and potential interest-rate hikes.

The souring sentiment overpowered potential mitigating factors. There was little market focus on what follows, for example, when the current U.S. waivers expire in early May.

Administration officials said they’re “not looking to grant any more waivers for Iran purchases next year,” Helima Croft, RBC Capital Markets’ global commodity head, said in a December CNBC interview.

“So I don’t think we’re going to have the same degree of waivers as were granted in November.”

More immediately, the move by the OPEC+ group to cut daily production by 1.2 million barrels (MMbbl), effective Jan. 1, clearly failed to inspire confidence in December crude prices. This was in spite of optimism from OPEC, which cited a lower level of oversupply than that prevailing at its prior action to stabilize markets effective in January 2017. Oversupply then stood at 340 MMbbl vs. just 37 MMbbl in November of last year.

In the U.S., producers have again been victims of their own success. As growth in U.S. oil output has exceeded expectations, adding to talk of a global glut, E&Ps saw a 38.5% collapse in the XOP (SPDR S&P Exploration & Production ETF) in the fourth quarter.

However, as widely discussed, E&Ps are increasingly aligning themselves with investors in prioritizing returns over growth and, thus, targeting a line of sight on free cash flow, dividends and debt reduction. Early action in pursuing the strategy came from Diamondback Energy Inc., which was quick to revise its capex plans for 2019 in line with the lower price outlook, while also raising its dividend.

The “capital discipline message” offered by Diamondback is what most investors want to hear, noted a December report by Credit Suisse. Investors “are not only demanding growth within cash flow, but also lower than historical growth rates with increasing focus on sustainable cash return to shareholders.”

Collective capex restraint by E&Ps, coupled with shareholder returns, may be able to deliver “more with less” in terms of E&P performance during a period of lower crude prices. However, this presumes some slowdown in U.S. growth at a time when the majors—with bigger balance sheets—are a growing force in unconventional plays. Exxon Mobil Corp., for example, now runs the most rigs in the Permian Basin.

With so many ingredients in a stew of global factors, offering a long-term outlook is tough.

But with the selloff of the energy sector so heavy at year-end, leaving plenty of potential for mean reversion, one stock-market technician ventured a short-term view: “It’s so bad, it’s good.”