In late December 2021, it appeared a variety of factors would contribute to continued volatility in the energy sector (XLE) during 2022. At that time, it appeared 2022 would provide investors a first glimpse at “normalized” post-pandemic demand. OPEC would settle the debate over spare capacity. Capital discipline in the shale patch would reshape the cost curve. ESG investing could take a back seat to fundamentals. And “value-vs-growth” would become a tailwind to the sector for the first time in years.
While the market has gained some clarity on these factors, three new variables have been added to the equation. Namely, the Western world attempting to restrict exports from the world's largest energy exporter. An apparent shortage of refining capacity. And the largest release of strategic oil reserves in history. At the midway mark of 2022, energy investors may be feeling less certain about the path forward than they were in December. On the sellside, Goldman expects $135 Brent (CO1:COM) in 2h, and believes we are in the early innings of a super cycle. While Citi sees oil prices collapsing to $75 in 2023 and the 50s thereafter. Bank of America's oil price (USO) forecast best reflects current uncertainty, as the bank see oil going up to $150 or down to $75 in the coming year.
“The reopening that wasn't” has frustrated investors, as demand has flagged in the first half of 2022. In the US, product demand remains below 2019 levels. And with TSA passenger traffic still down double digits from 2019, several international airlines have begun to restrict capacity. Fuel shortages have popped up in several EM countries, and “recession risk” has taken center stage. While China is just now reopening from pandemic-related lockdowns, stockpiling of crude during the 2nd quarter has supported demand for seaborne crude cargoes year to date.
Conversely, the supply side of the equation has buoyed prices. While Russian sanctions have proven entirely ineffective, as Russian oil exports have grown in Q2 over Q1, capital spending discipline in the shale patch paired with underperformance from OPEC has left the market short barrels. The US has organized an historic release of strategic reserves, but even with these volumes flooding the market, OECD commercial crude inventories have continued to fall.
From a policy perspective, three major dynamics need to be monitored in the second half. China has for ~12 months meaningfully curtailed refined product exports, contributing to rising gasoline and diesel prices and creating shortages in EM. Beijing's policy decision lifts margins for refiners, something China is long, while reducing demand and prices for crude oil, something China is short. Any pivot from China could quickly lower fuel prices and lift demand for crude oil. Second, Europe is set to implement a variety of Russian energy import restrictions between now and year end; investors are likely to remain focused on energy flows, as China and India attempt to soak up the additional barrels. Finally, the announced release of strategic reserves is set to end later this year, with subsequent announcements likely if the war in Ukraine continues.
On the fundamental side, there are a few key levers that could impact supply / demand balances into year end. Along with Q2 earnings, investors will get incremental insight into shale spending and growth plans. While Q1 brought reduced near-term guidance for many producers, elevated prices offset by disrupted supply chains could bring about altered 2h guides. And although investors have much more clarity into OPEC spare capacity now than they did in late 2021, analysts are sure to remain focused on the upcoming OPEC+ meeting. As the July meeting marks the end of the official pandemic response from the cartel.
Taken together, energy investors are in a good place at this moment in time. Oil (USO), gas (UNG), LNG (LNG), and refined product (CRAK) prices are all elevated by historical standards. Most companies in the sector are set to report record Q2 earnings, and most trade at historically discounted valuations. Capital allocation strategies are favorable to shareholders, for the first time in years. The sector appears to have been let out of the ESG penalty box, and Wall Street's aversion to “value stocks” has waned with rising interest rates. If nothing changes in commodity markets between June 2022 and year end, energy investors are likely to see strong share price performance.
In December 2021, the year ahead promised increased volatility. And the 2h promises more of the same, with war in Ukraine, recession risk, and China policy all sure to impact the sector. But as investors bridge from the current favorable environment to a more uncertain year end environment, its worth keeping one thing in mind. Commodities require capital investment to balance markets. Historically, energy cycles have ended when capital spending and technologic breakthroughs released millions of barrels onto the market. In the 1980s, North Sea production flooded markets (SHEL). In the 1990s, Gulf of Mexico production (CVX) oversupplied the world's growing demand. In the last decade, the shale revolution crushed prices (XOM). However, unlike those periods, there is a distinct lack of investment in supply currently. Whether a result of energy transition concerns, or windfall taxes, energy supply / demand fundamentals are on track to show improvement over the medium term, despite a period of heightened volatility in coming months.
Originally published on SeekingAlpha.com