February 2023 – Commentary from Dan Pickering

Two years into Value over Volume, most US upstream players have adopted similar mantras which de-emphasize production growth and have a strong commitment to returning capital to shareholders…

February was a retrenchment month across the board as the S&P500 fell -2.4%, the Nasdaq Composite gave back -1.0% and energy indices generally lagged.  Diversified Energy (S&P 1500 Energy, S15ENRS) fell -7.1%, with subsector performance as follows - Midstream -1.2% (AMZ), Upstream/E&P -5.7% (XOP), and Oilfield Services -5.8% (OIH). Clean energy dropped -7.4% (ICLN).  Crude oil corrected -2.3% (~$77.05/bbl) while natural gas stabilized with a +2.3% gain (~$2.75/mcf).(1)

Items of note during February:

1.  Capital efficiency in focus. Two years into Value over Volume, most US upstream players have adopted similar mantras which de-emphasize production growth and have a strong commitment to returning capital to shareholders.  However, Q4 results showed that not all invested dollars are having the same impact.  Notably, Devon Energy’s stock fell -10% on the day of earnings as guidance on capital efficiency disappointed investors.  Likewise, EOG Resources took a -4.4% hit on earnings day on higher spending guidance than expected.  The E&P business is getting tougher via a combination of rising well costs and falling well productivity.  Consequently, we expect more differentiation in companies/stocks as we get deeper into this upcycle.  It should be a good environment for stockpickers.

2.  Shale inventory – an increasingly relevant topic.   During the course of the past few months, we’ve seen various signals and comments regarding the inventory depth and inventory quality of shale plays.  Chevron and Pioneer Resources both indicated they would upspace their drilling activity in the Permian.  Upspacing should improve the productivity/reserves of the future wells, but means there are fewer remaining wells to drill within their current acreage.  The CEO’s of both Pioneer and Conoco recently indicated US production would soon peak.  Meanwhile, Diamondback Energy, Devon Energy, Marathon Oil and Pioneer have all made multi-billon dollar acquisitions (building future inventory).  On multiple fronts, actions and words imply a plateauing of shale prospectivity.  This suggests Tier 2 rock today is going to be the future’s Tier 1 (or perhaps Tier 1.5).

3.  The circularity of the impact of a potential shale plateau –

  • Less productive shale inventory is not currently modeled by the bulk of Wall Street analysts.  This is a hard problem to evaluate even if investors have access to detailed production and reservoir data, which they don’t.  Instead, we sift through the entrails of quarterly results, SEC reserve filings and investor presentations, trying to assess which company has the most good rock that will last the longest.
  • As inventory becomes a bigger issue, there could easily be downward pressure on values and valuations for shale-related companies.  However, if US shale is a critical component of world oil production, the rising costs/declining productivity of shale should support/bolster overall oil prices, which should in turn result in upward pressure on values and valuations of oil-producing companies.  The circularity is challenging.  Will stocks fall on inventory fears, then rally on comfort in the oil macro?  Or will investors simply look through declining well productivity in anticipation of rising oil prices?
  • Rather than a complete exit from shale names, we are choosing to invest in companies we feel will differentiate on the inventory front.  This should allow us to win twice – first through the micro (company-specific performance) and second through the macro (supportive commodity pricing).  Easy to say, hard to do.

4.  Natural gas temporarily breaches $2/mcf.   We’ve devoted a lot of ink in the past few months to US and global gas markets.  The one sentence recap – a price rip driven by war-induced European panic to fill storage, followed by a warm winter and unwinding of high prices.  The unwind crescendo saw US Henry Hub price dip briefly below $2/mcf.  Gas-related rigcount has begun to slow, with several public companies lowering capex and dropping activity.  So far, fewer than 10 gas rigs have been idled (there will be more).  Meanwhile, optimism remains regarding LNG-driven support to the longer-term gas markets, evidenced by 2025 futures at almost $4/mcf.  To us, 2023 feels very sloppy and will likely chop around until at least Fall.

5.  Interest rates, interest rates and interest rates.   Have we mentioned interest rates?  One Fed Governor talks about a potential pause in Fed hikes and stocks rip.  Another discusses the need to stay vigilant and stocks tank.  Energy stocks and commodities are being buffeted by these sentiments.  In theory, oil and gas should benefit from (or cause) an inflationary environment.  Yet oil frequently trades down on risk-off behavior associated with inflation fears and higher rates.  Schizophrenic to say the least.  We’re sticking to our view that energy stocks are headed for a ThreePeat of outperformance during 2023.

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