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April 2022 saw energy as the best house in a bad neighborhood. The S&P500 finished the month -8.8%, while Diversified Energy dropped -1.7% (S&P 1500 Energy, S15ENRS), with the following energy subsector performance – Upstream/E&P -2.0% (XOP), Midstream -1.1% (AMZ) and oilfield services -6.7% (OIH). WTI closed the month at ~$104.70/bbl, +4.4% and natural gas once again ripped +28.4% to ~$7.25/mcf.(1)
The story in April was the awful financial markets, the worst equity performance in years or decades depending on which index you assess. Of course, the market is reflecting the myriad of challenging macro datapoints including rising inflation and interest rates, supply chain bottlenecks, covid shutdowns in China and the ongoing Russia/Ukraine conflict. These issues all matter to energy markets – both specifically and collectively. Tight energy supply/demand dynamics and the rise of Energy Security are contributing to higher oil, gas, gasoline and diesel prices (good news for energy), but also contributing to global inflation which threatens economic health and therefore energy demand (bad news for energy). The circularity is only solved by making a determination of “how much?” for one of the variables. How much energy price escalation is likely? And/or how much global slowdown is likely?
History shows that it takes more than an economic slowdown to generate negative oil demand. Looking at International Energy Agency data, oil demand has contracted in 11 of the past 50 years, in four separate instances. 1974 (Arab Oil embargo, skyrocketing prices), 1980-1983 + 1985 (high prices), 2008-2009 (Global Financial Crisis) and 2020 (Covid pandemic)(2). Current negative conditions could escalate into something more dramatic, but for now we see the aggregate economic variables resulting in demand growth, not demand contraction.
This leaves high prices (and resulting demand destruction) as the primary risk to the current energy cycle. Russian production has continued near pre-conflict levels, but countries around the world are preparing to reduce/eliminate their Russian imports as 2022 continues. This means increased competition for non-Russian supplies. So far, this has generated WTI oil in the low-$100/bbl range and global natural gas at $20+/mmbtu. Punishing, but not cycle-ending.
Some pundits inflation-adjust 2008’s triple digit oil prices (the time frame when US gasoline last experienced a price-driven contraction) to arrive at the conclusion that oil could rise to the $150/bbl range before demand destruction would occur. We disagree. Even with higher wages, the double whammy of rising food and energy prices is already hurting global consumers, as is the strong US dollar. We expect pent-up demand for travel will result in a summertime spend-whatever-it-costs dynamic (and price-insensitive gasoline consumption), but we should carefully watch demand patterns later in 2022.
Also, keep in mind that governments around the globe are working feverishly to support the demand side of the equation, as witnessed by releases from Strategic Petroleum Reserves and continuation of retail-level price subsidies. Perhaps this will allow a softer landing for global consumers….or perhaps it simply delays the process of ripping off the cheap energy BandAid.
On the supply side, Q1 earnings results and 2022 guidance showed continued capital spending and production restraint from US-listed energy companies. In the midst of triple digit oil prices and a threefold increase in natural gas prices, compared to prior expectations, the 28 companies on PEP Insights upstream coverage list boosted 2022 capital spending by an aggregate of +3% (from $84.7B to $87.0B), while 2022 oil production growth expectations actually decreased -22 kbbls/day on lower 1Q22 volumes and 2Q22 downtime (y/y growth is now at +4.6% vs. +4.9% previously)(3). Producers are holding the line on growth, even though cost inflation is demanding incremental capex. Meanwhile, OPEC continues a measured production ramp. Supply is simply not going to spoil the energy party for the next few years.
Turning to energy investing, April was choppy, but the sector’s recovery is finally capturing mainstream attention. Bank of America research noted Q1 was the worst performance of mutual funds relative to their benchmarks since 2002, with lack of energy exposure contributing fully one third of the lag. Now at 4% of the S&P500 (versus less than 2% at the trough), energy is back on generalist money manager radar screens. This trend is exemplified by Warren Buffett’s purchase of $40B of Occidental and Chevron stock during Q1. The Great One himself is on board the energy train. As is activist investor Elliott Management, pushing for change at Canadian heavy oil producer Suncor. In addition to the strong underlying fundamentals, sector rotation has also begun to favor the energy sector. Some of the capital flowing out of technology stocks (which had generally poor results during Q1) is finding its way into energy names. Money flow is a force to be respected and it’s nice to see it flowing toward our sector.
We feel compelled to conclude with the mantra we adopted in February
The Russia/Ukraine conflict has elevated the strategic significance of oil and gas for the foreseeable future. Geopolitically risky barrels will be marginalized while Trustworthy Barrels will be more valuable, benefitting reserves and production in Western/developed countries. Energy can no longer dwell at the bottom of the S&P500 weighting as investors will be compelled to own more in the face of a potential or ongoing energy crisis. There will be significant volatility – both upside and downside – but the trend is stronger/bullish.
Please remember the PEP organization is standing by to help – whether it be investment exposure, capital needs, energy market intelligence or help with a specific problem. As always, we appreciate your interest and welcome your questions.
(1) Source: Bloomberg
(2) Source: International Energy Agency (IEA.org)
(3) Source: Company financials, PEP Insights
The above information does not constitute investment advice. Please note that these unaudited estimates have been prepared in accordance with our typical procedures for estimates and as such, final month-end prices may not have been received for all positions. Performance for all strategies is net of fees. Returns have been adjusted where applicable to reflect the highest level of fees available. The PEP Energy Equity Opportunities strategy performance is that of an investor invested in the USD share class of the one-year tranche. The performance calculation assumes that the investor’s account participated fully, on an applicable pro forma basis, in all investments, and was assessed a 1% management fee and 10% incentive fee. Additionally, the performance calculation assumes that all investors were given the same economic terms with respect to their investment. From Inception (May 1, 2022) the performance of the PEP TE&M Opportunities Fund is calculated pro forma to represent the highest fee level offered for the strategy. The performance calculation assumes that the investor’s account participated fully, on an applicable pro forma basis, in all investments, and was assessed a 1.5% management fee and 20% incentive fee subject to high water mark. Additionally, the performance calculation assumes that all investors were given the same economic terms with respect to their investment. Individual investors’ returns will vary from the strategy returns due to the timing of subscriptions and redemptions. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. The strategies represented consist of securities which may vary significantly from those in the indices listed in the Estimated Net Performance Benchmark chart, and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of the aforementioned indices may be of limited use. Please refer to fund documents for terms and appropriate risk disclosures. As a reminder, please note that the information provided is confidential and should not be forwarded or distributed by any recipient. If you would like to add someone to the distribution list or have any questions, please feel free to contact us at ClientServices@PickeringEnergyPartners.com.
