May 2022 – Commentary from Dan Pickering

If it ain’t broke, don’t fix it. May 2022 was another excellent month for energy. The S&P 500 was dead flat for the month (+0.0%), while Diversified Energy added +14.8% (S&P 1500 Energy, S15ENRS).

If it ain’t broke, don’t fix it.  May 2022 was another excellent month for energy.  The S&P500 was dead flat for the month (+0.0%), while Diversified Energy added +14.8% (S&P 1500 Energy, S15ENRS), with the following energy subsector performance – Upstream/E&P +17.3% (XOP), oilfield services +11.3% (OIH) and Midstream +6.8% (AMZ). WTI closed the month at ~$114.70/bbl, +9.5% and natural gas continued its relentless march upward, closing +12.4% at ~$8.15/mcf.(1)

No better way to start this month’s writeup than with the promised reiteration of the mantra we adopted in February 2022:

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.

As US upstream companies and OPEC+ continue to exhibit capital/supply discipline, the macro story, both for energy and the global economy, remains the story.  We leave our readers to develop their own conclusion about the severity of an economic slowdown.  Energy prices have the ability to make economic conditions better (moderation from current levels)…or worse (continuation of current levels or another move higher).  With China coming out of covid and US driving/vacation season ramping up, we have little expectation of pricing relief in the near future.  Ironically, as energy bulls, we are hoping for a breather/pullback on the current oil/gasoline price momentum.  Prices are already great, they don’t need to be “more great”.  Additional upside price moves from here merely jab a dagger deeper into the heart of consumption and risk truncating the sector’s cycle longevity.  For those scoring at home, at the end of May, WTI oil futures for 2023/2024/2025 respectively were $92/bbl, $82/bbl and $75/bbl, respectively.

The Biden Administration’s upcoming “hat-in-hand” trip to Saudi Arabia highlights how nervous politicians are about high gasoline prices and demand destruction.  With some of the globe’s last excess capacity, Saudi is in the catbird’s seat.  We’d expect platitudes but no real meaningful acceleration of barrels into the marketplace.  They can lay back in the weeds, enjoy strong prices and let Russia’s production decline, gradually stepping in with more volumes when it is clear how the Energy Security situation and the global economic slowdown are playing out.

During May, the European Union developed a sanctions plan for Russian crude with teeth that start to bite in 6-9 months, while China and India continued to purchase discounted Russian barrels.  Russia flexed its energy muscles by cutting off Finland’s gas exports – a shot across the bow for other European countries where Russian gas is a significantly higher proportion of the energy supply.  The cancellation of some Russian barrels and molecules seems inevitable.  However, the absolute magnitude remains unknown (2mmbbls/day? 4mmbbls/day? 6mmbbls/day?) and won’t become more clear until late 2022 and into 2023.  Energy Security dynamics have the ability for the current energy upcycle to last 5+ years (with oil trading $80+/bbl or better the entire time) or to simply be another 2-3 year upswing.  We lean toward the former given the history of pariah regimes in the oilpatch (they linger in power and their production inexorably declines – see Iran, Iraq, Venezuela).

US natural gas continues to impress.  Front-month Henry Hub closed May at $8.15/mcf, but is trading over $9/mcf as this commentary goes to print. Calendar 2023 NYMEX futures are ~$6.50/mcf.  Drivers include warm weather, low inventory and the pull of LNG to international markets attempting to displace Russian gas.  Natural gas consumption in the US is about 1/3 residential/commercial, 1/3 power, 1/3 industrial. (2)  The historical relief valve for high natty prices has been power sector fuel switching – turning off expensive natural gas, turning on cheaper coal.  However, coal is now much more expensive and coal-fired power capacity has been consistently shrinking due to ESG pressures.  Thus, there is simply no relief valve other than natural gas prices rising high enough to shut-in industrial buyers or forcing residential consumers to turn up their thermostats.  While our instinct is to fade $9/mcf prices, even after the ongoing rally, US gas is still just half the price of gas in Europe.

The US energy industry is like a coiled spring.  With both oil prices and natural gas prices at decade highs, the cash flow generation is dramatic.  But uncertainty about the future is high.  Which way will the spring uncoil?  Will the economy tank and drag oil/gas prices down with it?  Will the government enact some sort of punishing legislation in a misguided effort to provide relief to consumers?  Or will the cycle last for years and make current profitability look commonplace?  While waiting for clarity, US E&P companies are staying disciplined on drilling activity and looking to opportunistically build inventory and/or build scale through acquisitions.  Conoco did several great deals in hindsight with its purchase of Concho Resources (announced October 2020) and Shell’s Permian assets (announced September 2021).  Cabot combined with Cimarex (announced May 2021) to create Coterra. Pioneer acquired Permian private DoublePoint (announced April 2021).  Civitas was the result of a merger between Bonanza Creek and Extraction Oil & Gas (announced May 2021).  More recently, Oasis Petroleum and Whiting are combining (announced in early March 2022) and May 2022 saw the announcement of Centennial Resources merging with large Permian private Colgate Energy.  While the thunder rolls, the industry is methodically consolidating.  Duration will bring more.

Duration of strong performance in energy land will also bring financial investors back to the sector.  Every day we see evidence of expanding institutional interest.  Whether it is the amount of time allotted on CNBC or Bloomberg, the number of Twitter followers for popular energy accounts or the inbound requests for PEP’s research commentary, more people care about the sector.  At the end of May, energy had clawed its way to 4.8% of the S&P500.  Still much too low for a sector that is now much more strategically relevant (Energy Security) and much more profitable and disciplined.  Stay the course!

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.