Newton’s First Law of Motion says an object in motion tends to stay in motion, unless acted on by a force. There were many forces in the energy markets during March 2022, but energy stocks clearly stayed in motion. The S&P500 finished March +3.6%, while Diversified Energy gained +9.5% (S&P 1500 Energy, S15ENRS), with the following energy subsector performance – Upstream/E&P +15.1% (XOP), Midstream +2.0% (AMZ) and oilfield services +13.9% (OIH). WTI closed the month at ~$100.30/bbl, +4.8% and natural gas ripped +28.2% to ~$5.65/mcf.
On February 24th when Russia invaded Ukraine, we knew energy markets were going to be volatile. March lived up to that expectation. WTI crude entered the month at roughly $96/bbl, trading as high as $130/bbl (intraday March 7th), falling back to $94 (intraday March 16th), before closing right at a Benjamin (~$100/bbl). Natural gas also traded in a 30% range, between $4.45/mcf and $5.80/mcf. The President of the United States did an entire speech about energy. Much of the world banded together to sanction Russian energy supplies. The world scrambled to find new, trustworthy sources of energy. We said it last month, but readers of this monthly commentary should expect to see it every month for at least the next several quarters.
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.
The restructuring of the global oil and gas supply chain got underway in earnest during March. The US banned imports of Russian oil, as did other countries. Europe set a goal to reduce its dependence on Russian natural gas by 85%. The United States vowed to help the United Kingdom with incremental cargoes of LNG. When dramatic discounts emerged for Russian crude, India stepped up to buy cheap cargoes. China appears to remain a customer for Russian barrels. Perhaps China will become an even bigger buyer as others seek to “cancel” Russian exports. Meanwhile, the Russia/Ukraine conflict continues, with few signs there will be a quick resolution or regime change.
The magnitude to which Russian production is replaced is a critical variable in the multivariate beast known as the energy market. Let’s use the phrase Energy Security as a shortcut to describe the process of energy buyers looking to replace their Russian supplies with Trustworthy Barrels, enhancing their own supply chains and punishing Russia for its Ukraine invasion. Looking at oil, according to the US Energy Information Administration (EIA), Russia exports ~4.7mmbbls/day of crude/condensate and ~2.8mmbbls/day of products. On the oil side, China takes 1.6mmbbls/day, leaving 3.1mmbbls/day being purchased by customers who are probably aiming for Energy Security (remember – that’s our code word for replacing Russia). Assuming China/India step up for 1mmbbls/day of incremental oil, this still leaves ~2mmbls/day of homeless Russian crude. These barrels will first be purchased by Bargain Hunters willing to endure the wrath of the Energy Security crowd. The remainder will rapidly fill every Russian storage facility, tanker, nook, cranny, swimming pool and trash can available. Finally, when tank tops are full and there is nowhere for the oil to go, Russian field-level production will be shut-in. History shows that reviving sanction-driven production shut-ins is difficult – prime examples are Iran (1987, 1995, 2006), Iraq (1990 post Kuwait invasion) and Venezuela (2014, 2019). The next several quarters will illuminate the success of the Energy Security crowd versus the Bargain Hunters.
How long does Energy Security take? Years. Remember, folks in search of Energy Security have made the strategic decision to develop more politically stable energy supply chains. Additionally, it won’t be palatable to have “just enough”. Energy Security implies having insurance against unforeseen circumstances. Spare capacity is now more than a theoretical concept, it is what will keep the boogeyman away. Finally, recall that energy demand is not a static animal. For now, demand is growing. Therefore, Energy Security requires replacing Russian barrels, while also chasing the upward slope of demand (more absolute production required).
OPEC will certainly bring more oil to the market over time, but probably not enough to provide Energy Security. Literally no other (non-Iran, non-OPEC) sources have any easy valves to turn. This means new drilling projects will have to be part of the solution – in US shale, in Canada, in offshore Guyana and other Latin American countries, even in Africa. But new drilling takes time. Years. The shortest cycle drilling projects in the world are onshore US shale wells, but even these are a year away at the earliest given logistical considerations. What was likely to be a 2-3 year cyclical recovery has turned into a 5+ year cyclical and structural story. We believe US production, currently around 11.5mmbls/day, will exit 2022 in the +/- 12mmbbls/day range from projects/spending already in place before the Russian invasion of Ukraine. We expect US production will need to grow to 14-15mmbbls/day by the 2025/2026 time frame as the Energy Security theme plays out.
In the short-to-intermediate term, we view demand destruction as a much more significant risk to the bull thesis than oversupply. Demand could fall due to high prices (haven’t seen it yet even with US gasoline prices averaging $4.20/gallon recently), economic contraction (a growing concern given rising interest rates, inflation and Russia/Ukraine conflict) or further covid challenges (like we are seeing in China currently). The Energy Security dynamic will provide a demand buffer, but if the world contracts/melts, so does an underlying component of the energy upcycle. This argues for being a wide-eyed, finger-on-the-trigger, looking-over-your-shoulder bull, not a canape-popping, fanned-by-palm-fronds, NetJet-contemplating bull.
The story is similar in the global gas markets. Russia exports 26bcf/day, of which 20bcf/day goes to Europe. To frame the challenge, the US recently pledged 15bcm of LNG to the UK to help offset rising prices and supply difficulties. 15bcm is roughly 1.5bcf/day. Europe needs 13x that amount to wean off Russian imports. European Energy Security solutions include consumption efficiency, incremental coal-fired power (unpalatable), increased nuclear power and/or increased LNG imports. LNG will take time (measured in years), but ample global natural gas reserves do exist.. Vlad and his Russian pals have handed global gas players a fabulous growth opportunity. The LNG boom will last for a decade and is likely to see US capacity increase by 50-100% (currently 12bcf/day).
During March, there were a number of high-profile US political announcements and discussions that highlighted energy’s move to center stage. The issues and our analysis below:
The Biden Administration is in a complicated strategic vice. High gasoline prices are hurting approval ratings and Democratic prospects for the midterm election. Publicly tongue-lashing oil companies and pushing down oil and gasoline prices by any means possible appears to be a priority. At the same time, enhancing Energy Security requires the cooperation of the very same companies being flogged, as well as supporting increased fossil fuel production despite a vocal green agenda. We suspect the proverbial stick currently being used on the energy industry will turn into a carrot. Whether it is a price-floor repurchase agreement with US producers for SPR refill, tax incentives or some other measures, we think Energy Security is too important to leave to chance. Tough times create strange bedfellows and we expect a grudging, uneasy partnership will form between Washington DC and the energy industry during the remainder of 2022 and beyond. This partnership will last 5+ years until Energy Security is achieved, at which point a return to loggerheads is likely.
Last month, we predicted decarbonization would get a boost from high fossil fuel prices. This feels accurate as expensive gasoline, expensive natural gas and geopolitical dynamics are driving calls from many corners to accelerate renewable and net zero initiatives to wean the globe off destabilizing and inflationary hydrocarbons. While the current oil and gas cycle has been strengthened and lengthened by the Russia/Ukraine conflict, the long-term viability has probably been shortened (although still measured in many decades).
Turning to the stock market, energy remains the S&P500’s best sector over the past year and YTD. For those lamenting an underexposed portfolio or wondering if the excellent run is nearing an end, we’d highlight one statistic. Energy is only ~4% of the S&P500. Sure, this is a double from the trough of ~1.9%. But it is mind-bogglingly too low for a subsector that has become strategically important for the world. We believe energy is headed to a double-digit weighting of the S&P500. This makes it a relative no-brainer and a great risk/reward bet on an absolute basis. Although tantalizing, we suggest against watching front-month oil prices to inform a bullish or bearish view on the energy sector. The tail wags this dog. During March, as front-month WTI fell -23% from $130 intraday to close at ~$100.30/bbl, calendar 2025 crude rose +4.8% (~$69.50/bbl to ~$72.85/bbl) and the S&P1500 Energy Index rose ~8%. This market is thinking beyond just today….and it likes what it sees. So do we.