February 2022 - Commentary From Dan Pickering

February was a good month for energy stocks, but most importantly, it will wind up being viewed as strategically significant for energy markets and energy investors.

February was a good month for energy stocks, but most importantly, it will wind up being viewed as strategically significant for energy markets and energy investors. 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.

During the month of February, the S&P500 fell -3.1% while Diversified Energy gained +6.5% (S&P 1500 Energy, S15ENRS), with the following energy subsector performance – Upstream/E&P +9.7% (XOP), Midstream +3.9% (AMZ) and oilfield services +9.9% (OIH). WTI closed the month at ~$95.72/bbl, +8.6% and natural gas gave back -9.7% to $4.40 after its +31% January run.

Things in Russia went many steps further than expected. The outright invasion of the entire country of Ukraine changed the game from political cat-and-mouse to unified opposition and fierce economic reprisals. In our opinion, what has happened and what hasn’t happened are forming the basis of a strategic shift in the global perception of oil and gas. We encapsulated this view in a short February 25th missive (see that HERE).

The key concept is one of Trustworthy Barrels. In times of peace and harmony, consuming nations aren’t necessarily concerned about the source of their energy – just give them the inexpensive, easy solution. Peace and harmony ended in February. Now it matters that Russia exports 7mmbbls/day to the global market and provides almost half of Europe’s natural gas. While those barrels and mcfs are currently available, they are no longer trustworthy. As such, consuming nations will have to develop other supply chains. Domestic barrels become the most valuable as they require no treaties or cross-border transportation to reach consumers. Western barrels become the next most valuable barrels as the rule of law should govern their access. Theoretically trustworthy allies like OPEC are the 3rd most valuable barrels in the new Cold War world. But those barrels have always held a tinge of angst. Then there are barrels from the bad guys like Iran, Venezuela and, now, Russia. They may have to be tolerated and purchased in the short term. But how can they be counted on for the intermediate to long term? Unless there is regime change and rapprochement, they can’t.

This is a massive and important shift which will come into focus over the remainder of the year – and of course be shaped by the ongoing developments in Russia/Ukraine. The structure will take years and years to fully implement. A few big picture thoughts to highlight:

  • The US government will support US production growth – While the administration has recently been far from a supporter of the US oil and gas industry, the game will change. Politicians will see domestic barrels as protecting our country and our Allies. We expect a change in tone from Washington, a call for more production (“do the right thing”) and perhaps even, eventually, explicit support in the form of incentives or tax credits. Yes, this flies in the face of stated Biden administration climate change goals. But these will become more balanced by the immediate concern of economy-killing high gasoline prices and the intermediate-term need to develop “trustworthy” energy supply chains. Necessity beats altruism for the next 5+ years.
  • Domestic production will go higher – We have been and remain vocal advocates for capital spending and production discipline from US shale producers. However, we have also talked about the inevitability of the sector’s cyclicality. Too much capital creates too much production, which creates lower prices, which reduces capital availability which rations production which supports prices and attracts more capital. February’s events are the catalyst for the next growth phase of US production. We hope and pray the growth phase comes slowly and grudgingly from the US E&P sector. But it will come. It always does.
  • These things take time – The new era of Oil & Gas Relevance and Trustworthy Barrels will unfold over years, not quarters. First, we have to see what the playing field actually looks like. The Russia situation could/will have many further developments and unintended consequences. Reading the tea leaves will take most of 2022. Then there are the practical implications of “trustworthy” supply chains. In the US, even after pushing the Go button, adding 20% to drilling activity will take at least a year – reactivating idle equipment and finding/training the people to staff. Ramping “trustworthy” international capacity will take longer as it requires investment in physical infrastructure.
  • Energy companies will make more money for a longer period of time than consensus expectations – Prior to the European gas wakeup call in Summer/Fall of 2021, oil and gas was being written off as unnecessary and having low/no terminal value as soon as the 2030 timeframe. While this was never going to be the case, recent events are reminding folks that fossil fuels remain incredibly relevant. Additionally, there will now be a combination of uncertainty/disruption premium (higher “equilibrium” price) and a need to develop redundancy in the energy supply chain. Excess/spare capacity will be required to safeguard against future dislocations. Higher price, more volumes mean more revenues and profits.
  • Renewables and lower carbon energy get a simultaneous boost – We take no position on the moral arguments for or against decarbonization, but a resurgence of strategic importance for oil and gas isn’t going to quiet the Net Zero push. Assuming hydrocarbons are going to be more expensive over the next five years, we should expect even louder calls to reduce hydrocarbon demand. Clean energy advocates can add the economic argument (“they’re expensive!”) to the climate change argument.

Can investors afford to remain on the sidelines with respect to energy stocks? The energy sector was an easy one to hate from 2014-2020. The returns were poor, the commodity price was weak, companies were undisciplined, hydrocarbons were “bad” and relative stock performance was dismal. Essentially, there was very little opportunity cost to being underweight/uninvolved. During 2021, energy company spending discipline became apparent, commodity prices improved and energy became the best sector in the market (almost doubling the S&P500). However, its weighting in the S&P500 was small (~2.5%) and hydrocarbons were still viewed as “bad”, so the hassle of owning the group kept hands in pockets for most investors.

For 2022+, the stigma of owning energy is decreasing, while the underlying profitability of the sector is increasing. Perhaps reluctantly, perhaps quietly, energy is going to be more owned and more highly valued. E&Ps currently trade at 3-5x cash flow. These multiples will expand. Big cap OFS currently trades at 13-15x P/E. These multiples will expand. Phase 1 of the Energy House Party involved the energy nerds and band geeks talking amongst themselves. Phase 2 of the Energy House Party started in late February 2022 and won’t finish until all the cool kids have arrived, the tequila is flowing like water and the pool is filled with drunken celebrants. Don’t miss the party!

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.