February 2024 – Commentary from Dan Pickering

A step in the right direction. For the month of February, all energy subsectors were higher and several beat the market.

A step in the right direction.  For the month of February, all energy subsectors were higher and several beat the market.  The S&P500 gained +5.3%, the Nasdaq jumped +6.2% and Diversified Energy gained +3.4% (S&P 1500 Energy, S15ENRS) with energy subsector performance as follows: Midstream +4.4% (AMZ), Upstream +5.5% (XOP), Oilfield Services +1.6% (OIH) and Clean Energy +0.7% (ICLN).  Front month WTI oil rallied +3.2% (~$78.25/bbl), while front month NYMEX natural gas was drubbed by -11.4% (~$1.85/mmbtu).(1)

February was remarkably quiet on the oil macro front.  There were no OPEC fireworks, there were no (new) demand scares and conflicts (both Russia/Ukraine and Middle East) were relatively status quo.   Venezuela’s potential threat to Guyana also quieted down - although we don’t think this is a particularly real threat anyway.

At almost $80/bbl, WTI is now sitting at what feels like the top end of a near-term trading range, helped by traders who are realizing that interest rates/inflation won’t be falling quite as fast as previously expected.  A breakout from here would be unexpected - which may be the strongest bull argument for the commodity in the near term.   Further strength toward $90/bbl would almost certainly result in headlines/discussions of increased production from OPEC.  The cartel has 3-4mmbbls/day of shut-in barrels (and more from a paper barrels/quota perspective).   Probably premature to be thinking about this, but worth noting in a world where $5-$10/bbl moves can happen in any given month.

Natural gas has gotten so bad that the outlook is actually improving.  With a front-month plunge down to the $1.50/mmbtu level, prices were so awful during February the industry can no longer ignore the near-term while waiting for the right-around-the-corner salvation of increased LNG exports.  Reflecting the weakened near-term cash flows and impaired near-term drilling economics, companies are lowering 2024 budgets and reducing rigcount to protect free cash generation.  Chesapeake alone is likely to reduce supply by ~1bcf/day and EQT added shut-in volumes of ~1bcf/day for March.  Meaningful for a market that is around 1-2bcf/day oversupplied.  Natural gas isn’t yet out of the woods – let’s keep watching LNG export timing – but the outlook is certainly more favorable.

For the gazillionth month in a row, the energy industry experienced consolidation.  February saw California players CRC and Aera combine, as well as Bakken players Chord and Enerplus and Permian players Diamondback and Endeavor.  Consolidation has moved from breathtaking to expected, so each of these deals received scrutiny on the merits of the individual transaction, rather than creating wonderment over the industry implications.  As the biggest of the deals, Diamondack+Endeavor has certainly captured the attention of investors.  Diamondback stock traded 2.4x normal volumes in the week following the transaction, while climbing +20% from announcement through the end of February (the XOP +6% over the same time period).  Post-deal, this $50B+ market cap company will be the jewel of the Permian and has almost certainly attracted investors from PXD and HES who want to own more upside juice than the Exxon and Chevron stock they will receive when their respective transactions close later this year.  As we said last month (and will keep saying), energy sector consolidation is about 1) inventory (for business longevity), 2) size (for investor relevancy), 3) scale (for increased efficiency and profitability) and 4) value (attractive financial metrics).  In our view, it will keep happening until some mix of these four components are no longer present.  Said another way, if investors won’t buy energy companies, they will buy each other.

For those that like to watch a schoolyard scuffle, cast your eyes toward the drama playing out with the Chevron/Hess merger.  From our perspective, the prize asset in the Hess portfolio is the 30% ownership in the massive, Exxon-operated Guyana complex.  A furor erupted during late February when Exxon stepped forward, asserting it has a right-of-first refusal (ROFR) on any sale of the Hess Guyana asset.  Chevron/Hess say this ROFR doesn’t apply in a corporate merger.  Exxon says it does.  There is a ton of nuance around this issue, which will likely be sorted out by lawyers, but it is a good reminder that when billions of dollars are at stake, the gloves come off.  We suspect the ultimate resolution is the merger of Chevron and Hess as planned, but with some sort of value extraction for Exxon.  With (future) partners like these, who needs enemies!

Energy stocks saw a spark of life in February.  The energy datapoints were decent – well-received mergers, improving oil prices and signs of hope for natural gas.  The main impediment for energy stocks isn’t about energy at all, but rather about the continued strength in technology earnings and the unrelenting momentum of technology stocks.  Is energy a S&P500 hedge?  Or is energy a beneficiary of markets making new highs?  At these valuations, perhaps both, in our opinion.  Most long-only investors are underweight or under-interested in the energy sector.  That could continue.  So, we wait patiently, with value on our side.