May 2023 – Commentary from Dan Pickering

May 2023 was another ugly month for the energy sector on an absolute and relative basis.  The S&P500 gained +0.4%, while energy indices fell.  Diversified Energy (S&P 1500 Energy, S15ENRS) dropped -9.6% with subsector performance as follows - Midstream -0.5% (AMZ), Upstream/E&P -7.1% (XOP), and Oilfield Services -10.0% (OIH). Clean energy declined -2.0% (ICLN). Crude oil flopped -11.3% (~$68.10/bbl) while natural gas fell -6.0% (~$2.30/mcf).⁽¹⁾

A lot happened in May and early June:

Energy sector consolidation continues and broadens

The drumbeat of deals continued as May saw the announcement of a Midstream transaction (ONEOK buying Magellan Midstream for ~$19B EV) and several Upstream transactions involving majors (Chevron acquiring PDC Energy for ~$8B EV; Chord Energy buying Bakken assets from Exxon for ~$400MM).  The midstream deal traded at over 10x EV/EBITDA, while both Upstream deals were <4x EV/EBITDA.  Scale continues to be a goal, even for a company the size of Chevron, particularly when it can be done accretively at low absolute valuations.

Consolidation will keep going

It’s always about growth.  Companies love to grow.  It’s simply more fun to expand the enterprise than to preside over a shrinking or status quo business.  However, whether it’s barrels, mcf’s, rigs or steel, energy companies have now promised investors they won’t organically boost capacity.  This mindset is entrenched in C-suites across the energy sector.  Which means it competes with the inherent desire to grow.  So if you can’t grow organically, what do you do?  You grow inorganically.  You buy somebody else.  Investors are welcoming this type of growth as it lowers operating costs, eliminates G&A costs and reduces the number of players that can spoil the current disciplined regime.  At current valuations and structures, everybody wins.  Decent growth at the company-specific level, but low growth at the macro level.

Oil markets in Show Me mode

• After rallying on OPEC’s April announcement of a 2mmbopd production cut, oil gave up its gains in May and traded below the pre-announcement price.  Blame was placed on rising rates, fears of economic weakness, significant short interest by financial traders, ongoing high levels of Russian production and a China demand recovery that was behind schedule.
• As OPEC+ prepared to convene its early June meeting, the Saudi oil minister told speculators to “watch out”.
• The result of the meeting was an extension of existing OPEC+ production cuts through the end of 2024 plus an incremental 1mmbopd month-to-month cut from Saudi.  Additionally, Saudi indicated it would do what was necessary to support the oil markets.  
• After initially rallying a paltry $2/bbl, WTI oil closed the day after the OPEC+ announcement at an even more paltry +40c/bbl or $72.15/bbl.  A nothing burger.  As of June 15^th, oil is ~$70.62/bbl, once again lower than the pre-OPEC+ announcement. What gives?
• At this point, the empirical evidence unequivocally points to an oil market that simply refuses to anticipate tightening conditions.  Even with a rallying stock market signaling higher odds of an economic soft landing, crude won’t budge.  Market participants will whistle past the recession graveyard and buy Nvidia and Microsoft, but they won’t give crude the same soft landing optionality.
• The idiosyncratic oil market risks remain a) Russian production (much higher than expected), b) potential for Iran sanctions to be lifted (we are skeptical) and c) the risk of OPEC+ cohesion breaking down and resulting in market share battles similar to 2020.
• OPEC+ recent actions are supportive, but there is more than meets the eye.  Russia is producing well above its quotas – they aren’t cutting production like they’ve promised.  Right now the Saudi’s are turning a blind eye.  Will this continue? The United Arab Emirates got a higher quota and could produce +200kbopd in 2024.  Meanwhile, African countries squawkingly took a cut in their baseline production levels, but there is no actual production decrease.  Finally, Saudi’s 1mmbopd incremental cut feels somewhat weak given they acted alone (never a good sign in a theoretically collaborative cartel).
• Ultimately, the proof is in the inventory.  Global inventories should start to decline given all the production that is coming offline and the ongoing demand recovery.  If inventory doesn’t decline, there is a problem somewhere and oil deserves to be $60-$70/bbl.  If inventories decline, prices will likely improve.  Until there is evidence, status quo seems firmly entrenched.
• We’ve talked repeatedly about our forecast of $80/bbl WTI for the next 3-5 years.  No change to this viewpoint.  Nobody said it was going to be easy along the way.

The stock market is rallying and it matters to energy

• Since our last update (published 5/11/2023), stock market sentiment has improved markedly.  The focus has shifted from nothing-but-interest-rates to fear-of-missing-out.  Excitement about artificial intelligence (AI) and earnings results from big technology stocks, particularly Nvidia, were enough to catapult the S&P500 out of its recent trading range.  We recently talked about liking oil markets more than the stock market.  This is still true, but the stock market is working and oil markets are not.
• After the past few years, we have developed a healthy respect for technicals, momentum and money flow.  These now favor “the market” (aka tech) and not the oilpatch.  The current party has a whiff of the dot-com bubble of 1999/2000.  That celebration went longer and louder/higher than most expected.  Maybe this will too.  Even though we are energy-centric, we can’t ignore the market because it competes for investor mindshare and portfolio allocations.  Until oil prices can move out of their malaise, energy stocks will probably underperform.  But….when oil prices join the party, energy stocks could see amazing catch-up moves after lagging significantly YTD (S&P1500 Energy -11.7% through May 31^st vs. S&P500 +9.6% and Nasdaq Composite +24.1%).  And oil prices will join the party.

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

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