December 2021 - Monthly Commentary from Dan Pickering

December was an OK finish to a very good year.

December was an OK finish to a very good year. While the S&P500 gained +4.4%, Diversified Energy gained +2.8% (S&P 1500 Energy, S15ENRS), with the following energy subsector performance – Upstream/E&P -1.6% (XOP), Midstream +3.6% (AMZ) and oilfield services +3.6% (OIH). WTI oil rallied nicely +13.6% (~$75.20/bbl) and Henry Hub natural gas declined -18.3% (~$3.70/mcf).

Oil markets fought their way back from a string of negative data points and overhangs. Covid’s Omicron variant has driven a record number of cases, but fewer deaths and hospitalizations. The release/swap of barrels from the US Strategic Petroleum has moved ahead. As indicated in its December meeting, OPEC+ has continued to bring incremental barrels back to the market. Despite these issues, oil prices are holding nicely. After WTI’s Omicron dip in late November into the mid$60s/bbl, oil rallied back to the low $70s. It took another short trip into the $60s with the negative market reaction to impending Fed tightening and the failure to achieve passage of the Build Back Better plan. And once again WTI bounced back into the $70s along with the overall end-of-year stock market rally. We’re encouraged by what feels to be a strong floor in the $65/bbl range.

Fundamentally, it is worth noting that 2021 oil and gas discoveries (new reserves added via drilling) are likely to be the lowest in decades. This is not surprising given the low levels of reinvestment from the upstream players, but it is a reminder that hydrocarbon production is a capital-intensive process that requires drilling to offset natural declines. OPEC+ barrels can meet incremental demand during 2022, but 2023 is certainly feeling tighter on the supply side.

On the natural gas front, cold weather in Europe drove fresh new highs for European natural gas prices (near $200/bbl equivalent) and has pulled LNG cargoes toward that continent like moths to a flame. Price is rationing and allocating supply as it usually does when fundamentals are tight. Meanwhile, warm US weather moderated near-term Henry Hub prices to the $3.60/mcf level before the first meaningful cold snap popped them back above $4/mcf to finish the year. We would take the under on the current ~$3.70/mcf NYMEX futures strip for 2022, but still expect a decent year after spending the last few in the doghouse.

Turning to energy transition, Senator Manchin’s opposition to the Build Back Better plan was a psychological and financial hit to vehicle electrification and charging. Some of the expected support/subsidies must now wait for a revised bill or other legislation. However, electrification remains a juggernaut. The Biden administration issued an executive order which mandates, by 2035, all government vehicles purchased will be zero-emission. We haven’t changed our view that decarbonization is a megatrend. A lower carbon future is coming, but the path will be choppy and volatile. Highlighting this volatility, after jumping +140% in 2020, the Ishares Global Clean Energy ETF (ICLN) dropped -25% in 2021. We are searching for public equity opportunities within this (relative performance) wreckage, as well as for good risk-reward decarbonization private equity investments.

Despite coming off a stellar year with performance of +48.6% for the S&P1500 Energy benchmark, we feel good about the prospects for continued absolute and relative performance for energy stocks in 2022. Oil price is likely to trade in a $65-$85/bbl range, while the equities currently discount closer to $55/bbl and are trading at 4-5x cash flow and 10%+ free cash yields. Although a commodity price uptick probably won’t be a catalyst in 2022, the duration of capital discipline creates the very real potential for energy stock re-rating. Investors spent much of 2021 being skeptical the oil and gas industry could adjust its business model to capital discipline and returning cash to shareholders. Quarter after quarter after quarter of energy companies holding the line will eventually convert the skeptics. There’s another double in many energy stocks when they begin to discount $65/bbl long-term oil (current 2025 NYMEX futures strip is ~$60/bbl) and trade closer to 5-7x cash flow (still well below historical averages). Unless/until the fundamental outlook changes for either the energy or economic macro, we’re along for that ride!

The end of the year is always a good time to reflect on the past and think about the future. Even though it was choppy and difficult, 2021 was traditional energy’s best in quite a while. 2022 feels like more of the same. It will be a hard-fought, wall-of-worry year that is likely to be nicely profitable. Energy transition and decarbonization emerged as a Megatrend (our opinion) during 2021. Finding ways to make money in this expensive arena remains the key challenge and opportunity for clean energy investors. For the foreseeable future, the biggest overarching energy theme, which is non-consensus, will be “all-of-the-above”. Hydrocarbons, renewables and new energy technologies can and must co-exist in order for the world to have accessible, reliable, reasonably priced and lower-carbon energy. We look forward to navigating these unique times alongside you – our friends and clients.

As always, we appreciate your interest and welcome your questions. Wishing you the best in 2022!