August 2022 – Commentary from Dan Pickering

August was anything but a boring summer month. The macro dance continued as the main driver of oil markets. US Federal Reserve Chairman Powell’s speech put a damper on sentiment and heightened fears of recession

August was anything but a boring summer month.  The market faded with the S&P500 falling -4.1%, while Diversified Energy gained +2.8% (S&P 1500 Energy, S15ENRS) with subsector performance as follows – Upstream/E&P +5.6% (XOP), Midstream +4.0% (AMZ) and oilfield services -0.8% (OIH).  Crude oil had a third consecutive down month at -9.2% (~$89.55/bbl).  US Henry Hub natural gas was strong again at +10.9% (~$9.10/mcf)(1).

The macro dance continued as the main driver of oil markets. US Federal Reserve Chairman Powell’s speech put a damper on sentiment and heightened fears of recession and slower energy demand.  Additionally, China shut down Chengdu (21 million people!) due to covid outbreaks.  On the supply side, Iran and the developed world continued to negotiate a potential nuclear deal and the lifting of sanctions.  We believe a deal is unlikely, but the potential return of 60-100MM+ of stored Iranian barrels is an overhang that has the market’s attention, as does ongoing violence in Libya and new unrest in Iraq. The factors above saw oil trade between ~$86.50/bbl and ~$97/bbl during August, closing near the lows. (1)  Adding yet another wildcard to the equation, OPEC+ foreshadowed a potential production cut should Iranian barrels overly weaken oil prices.  Additionally, at the early September meeting, the cartel implemented a 100kbbls/day production cut – a token amount, but we believe it signals a willingness to protect price despite weakening economic conditions.

Russian oil production has remained relatively consistent near its pre-war levels.  The dynamic will become even more complex as winter weather and much tougher European sanctions approach in early December.  We expect Russian production to fall over time as the developed world remakes its supply chain and finds new sources of crude and products.  However, given the fragile nature of the global economy, practicality will dictate the timing.  Regardless of the enthusiasm to support Ukraine, we doubt world leaders will willingly drive oil prices to painful levels ($125+/bbl WTI).  Next month we’ll know more and talk more about recently proposed price caps on Russian crude.

Turning to natural gas, Europe is in real trouble.  Netherland TTF gas prices were volatile, ranging from ~$56 to ~$91/mmbtu during August, settling at ~$67/mmbtu. (1)  Thanks to aggressive purchases of LNG from around the globe, Europe’s gas inventories are near average.  This has come at extreme financial cost, with consumers and businesses reeling from higher prices.   The popular press is littered with articles of industrial shut-downs, small business distress and retail customers with 10x utility bill increases.  European energy providers are at or near default with government bailouts appearing inevitable.  Even with inventories building now, Europe cannot escape the need for Russian gas to continue to flow during the winter.  And of course, Russia is flexing its muscles via supply interruptions/cancelations from the Nordstream pipeline (driving prices into the $70-$80/mmbtu range in early September).

While the current situation is quite grim, this might be as bad as it gets.  Our base case assumption is that Russia will not cut off European gas during winter.  The political fallout of freezing Europeans is too risky.  Although it is in Russia’s best interest to create maximum uncertainty (and therefore maximum gas prices, maximum revenue generation and maximum financial pain for Europeans), at some point a more dovish outlook will become obvious and gas markets should moderate.  We must not forget winter weather has the ability to swing the pendulum in either direction, so find your favorite European weather website and buckle up.

August was a continuation of the new normal for the conventional energy industry:  Generate substantial cash, return that cash to shareholders and rationalize the asset base.  Notable upstream transactions included Devon’s purchase of private equity-backed Validus (using low-returning balance sheet cash to do an accretive deal) and Shell/Exxon’s sale of its California joint venture Aera to a German private equity firm.  Private market transactions are occurring at 2.5-4x EV/EBITDA (assuming the current NYMEX futures curve).  While this is quite “cheap”, it is consistent with public market multiples and the absolute dollar value of the transactions are high due to strong commodity prices.

The biggest surprise during August was the passage of the Inflation Reduction Act.  Unequivocally good news for the energy transition sector given $360B of support for clean energy and renewables.  In absolute dollar terms, solar was the biggest winner, along with wind and power storage.  In terms of relative impact, carbon capture saw a huge uplift with increased tax credits and the allowance of simpler financing structures.  Hydrogen also saw a big bump, as did battery/utility-scale storage projects which can now receive tax credits for any generation source (instead of only renewable sources).  Not to be outdone, the California Air Resources Board (CARB) mandated that all of California vehicle sales must be electric by 2035.  Whether or not the California power grid will be ready for an all EV future is still to be determined.  The clearest takeaway from events on the national and state level – the juggernaut of clean energy will not be stopped, even as world events highlight the critical importance of hydrocarbons.  All-of-the-above continues to be our view of the path forward for the next decade.

On the energy stock front, highlighting its correlation to tech/growth stocks (Nasdaq Composite -4.5% during August), the iShares Global Clean Energy ETF (ICLN) fell -0.5% even with all the good news from the Inflation Reduction Act.  Despite the pullback in oil prices (WTI -9%), conventional energy had a good month on an absolute basis (S&P1500 Energy +2.8%) and a great month compared to the S&P’s -4.1%.  Strong dividends and return of cash may not be generating high valuations for energy stocks, but they are protecting them in this choppy market.  While there are plenty of scary elements, we continue to find all aspects of energy compelling.

Lest we forget, please enjoy the 7th repeat of our 2022 mantra:

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