July 2022 – Commentary from Dan Pickering

Better. July saw a bounce in risk assets with the S&P500 jumping +9.1% and energy generally outperforming. There were no particular fundamental epiphanies in the crude oil markets during July. The commodity traded in line with other risk assets, gene

Better.  July saw a bounce in risk assets with the S&P500 jumping +9.1% and energy generally outperforming.  For the month, Diversified Energy gained +10.1% (S&P 1500 Energy, S15ENRS) with subsector performance as follows – Upstream/E&P +14.7% (XOP), Midstream +11.6% (AMZ) and oilfield services +3.9% (OIH).  Crude oil was a laggard, notching a second consecutive down month at -6.8% (~$98.60/bbl).  In sympathy with strong European prices, US Henry Hub natural gas roared back +51.7% (~$8.20/mcf)(1).

There were no particular fundamental epiphanies in the crude oil markets during July.  The commodity traded in-line with other risk assets, generally rising on up days for the stock market and falling on down days.  The -6% decline for the month felt mostly about the shape of the curve (backwardated) and lingering recession-trade drift.  Falling US gasoline prices reduced the negative political rhetoric…for now.  President Biden’s trip to the Middle East netted essentially nothing in terms of incremental supply.  Price action in longer-dated crude futures tells an interesting story.  From the recent high on June 8th, front month WTI is off -19%, but 2025 WTI is off only -3% (~$74.50/bbl). 1  Near-term recession worries may be high, but there is clearly confidence in oil demand over the intermediate term.

Gas markets are, justifiably, insane.  On-again, off-again volumes from Russia to Europe have elevated the impending risk of a winter crisis.  European TTF prices have moved from €84/MWh in mid-June to €195/MWh at the end of July(1).  That’s roughly $58/mcf!! (for those wishing to convert European prices to US equivalents, with the dollar and euro near parity, simply multiply by ~0.3).  Understandably, Europe is scrambling.  The EU agreed to (voluntary) 15% reductions in gas usage and demand for stockpiles of all forms of energy has jumped.  Orders for wood-burning stoves have doubled in Germany while industrial gas consumers are scaling back activity.  Rising prices are already forcing government intervention in the utility sector and it isn’t even cold yet.

When thinking about the cat-and-mouse game Russia is playing, we place a low likelihood (10-20%) of a shut-off of gas to Europe in the winter.  Why poke the bear?  Right now, Europe is outraged by the Ukrainian invasion, but reliant on Russian gas supplies.  Right now, Russia is getting meaningful cash from gas sales, while the Nordstream flow games remind the Europeans of Russia’s supply leverage.  Alternatively, turning off supplies this winter and freezing many Europeans would likely be a tipping point for more dramatic actions against Russia.  Thus, we expect high prices to continue, but don’t expect the powder keg to explode.

Turning to the industry, cash flows are dramatic.  Exxon and Chevron reported monster free cash generation during Q2.  Refiners are printing money.  The big oilfield service companies see a strong upcycle.  There is no indication of any meaningful pivot from the capital discipline model toward a volume growth model.  The economic outlook is too uncertain.  Investors are not clamoring for growth.  In the face of a recession, they are happy to clip fat dividend payouts and wait for economic clarity.  This type of status quo is a good thing for energy shareholders.

Clean energy received a boost with the surprise late July announcement of the Inflation Reduction Act.  When/if passed later this year, over $300B pours toward the energy sector with boosts for wind, solar, hydrogen, geothermal, battery storage, EVs and other green initiatives.  Carbon capture, utilization and storage (CCUS) probably sees the biggest inflection in economics, with the legislation increasing 45Q tax credits from $50/ton to $85/ton and allowing simplified financing structures.  Battery storage also benefits meaningfully as the legislation provides for Investment Tax Credits (ITCs) regardless of how a project’s power is generated (previously ITCs were only available for storage tied to renewable generation).  For traditional energy, the Act mandates lease sales, bumps royalty rates for new leases and establishes a fee on excess methane emissions.  More sticks than carrots, but manageable.  This legislation is another example that the push for energy transition is not going to be slowed by economic uncertainty or the need for Energy Security.  The freight train toward NetZero continues.

It was a volatile July for energy stocks.  The S&P1500 Energy Index fell as much as -6% during the month, before closing +10% higher.  The S&P500 rallied out of the gates in July and never looked back.  Energy stocks are behaving as if a recession will damage energy fundamentals and financial results more than the overall market.  We strongly disagree with this premise.  Energy demand has proven to be quite resilient in past recessions and economic slowdowns.  We expect that to be the case over the next 18 months. Additionally, energy supply is restrained and there are Energy Security dynamics to consider.  Those trading energy as a relative loser in a recession are in for a rude surprise.

Our expectation has been that strong Q2 (and beyond) earnings and cash flow generation would force investors to open their eyes to the value in the sector.  As such, we were a bit spooked when refiners had blowout Q2 numbers and their stocks underperformed both the S&P and energy indices.  Faith in the thesis was restored when Chevron and Exxon both rallied strongly after impressive Q2 results.  Next up – upstream E&P results in early August.  We’ll be listening closely for the interplay between cost inflation, capital spending, growth forecasts and capital return strategies.  We expect good news and maintain conviction in an upcycle that has continued momentum despite economic headwinds.

Of course, we can’t forget to include and reiterate 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.