November 2022 – Commentary from Dan Pickering

November was a generally sidewise month for energy while the S&P500 enjoyed a bear market rally...

November was a generally sidewise month for energy while the S&P500 enjoyed a bear market rally. The S&P500 gained +5.6% (-13.1% YTD). Energy lagged across the board. Diversified Energy gained +1.2% (S&P 1500 Energy, S15ENRS) with subsector performance as follows – Midstream +1.1% (AMZ), Upstream/E&P +0.5% (XOP) and oilfield services +1.8% (OIH). Clean energy had a big bounce at +12.0% (ICLN). Crude oil fell -6.9% (~$80.55/bbl). US Henry Hub natural gas popped +9.0% (~$6.95/mcf)(1).

We are embarrassingly late with this writeup as it goes to print a few days before Christmas. Thus, our November commentary will really be a mix of November and December, with a sprinkling of year ahead musings.

  • Oil markets finding a way to rip your heart out – December was supposed to be healthy market for crude oil. SPR releases ended, reducing supply by ~1mmbpd. OPEC cuts announced in November have begun to take effect. European sanctions on Russian crude were implemented. With all these items stacking up on the bullish side of the ledger, sentiment entering December was clearly leaning positively. Boom – WTI crude dropped $10/bbl in the first nine days of December and felt perilously close to breaking $70/bbl (lowest closing price was ~$71/bbl). This was a good reminder that predicting commodity prices is very hard and risk appetite (recession fears) can clearly dominate short-term price action.
  • Still forecasting a long/strong cycle – During November, global oil/product inventories hit their lowest levels since 2004. Organic supply additions are anemic with absolutely no signals from oil and gas companies that capital spending will accelerate in 2023. OPEC is defending $80/bbl. China has moved away from its CovidZero policy. The world’s second biggest producer (Russia) is a pariah with likely dwindling productive capacity over time. Global supply chains are being reworked to find new Trustworthy Barrels. Demand remains a short-term wildcard but should enjoy intermediate term growth. We reiterate our forecast of a 5-year cycle with oil averaging $80/bbl or better. We know the WTI futures strip is ~$76/bbl for 2023, ~$71.50/bbl for 2024 and ~$67.60/bbl for 2025. We are taking the over!
  • Europe’s energy crisis solved…for now – Nothing like a good old-fashioned crisis to create action and solutions. When Europe realized it was facing a winter without Russian gas supplies, the ensuing panic generated results. Europe became the world’s most aggressive buyer of LNG, paying record-high prices to pull in cargoes destined for other markets. Meanwhile, high prices and active government conservation campaigns pushed businesses and households to reduce demand. The result was above average inventory levels and below average consumption. Problem solved, albeit with great financial pain/strain. We caution against complacency. While prices have come down dramatically (from over €300/MWh to under €100/MWh), the intermediate supply situation is still very constrained for the next several years. Europe will be groping for supplies for the foreseeable future.
  • Natural gas – the 2023 vs. longer term debate – US natural gas doesn’t look great for 2023. Supply is ample and incremental LNG takeaway capacity is still more than a year away. This dynamic has become consensus across Wall Street and is also evident in the NYMEX futures market where the 2023 calendar contract is trading at ~$4.60/mcf, well down from the $6.50+/mcf levels of late summer. Looking further out, the US gas story is compelling. Europe wants our LNG, new takeaway capacity is underway and natural gas is the bridge fuel to a lower carbon future. Gassy equities are cheap but the near-term outlook is challenged. Right now, we’re Switzerland on this short-term vs. long-term battleground, prepared to watch the fireworks with no position and a tub of popcorn.
  • “All-of-the-above” beginning to gain mindshare – There are ongoing examples of an “expanding middle” where previously polarized “hydrocarbons are evil” and “energy transition is stupid” factions are coming together to realize that the globe’s energy future must encompass both lower carbon and fossil fuels. Examples include conventional energy company’s interest/investments in CCUS, hydrogen, RNG and low carbon fuels as well as the expansion of the COP27 invite list to include oil and gas companies for the first time. We see no slowing of energy transition momentum, nor any ability to dramatically lower fossil fuel consumption in the intermediate term. Thus, this uneasy détente seems both appropriate and necessary.
  • The Russian die is cast – Our base case assumption is for a lingering of the Russia/Ukraine conflict. We have no geopolitical edge, but status quo seems realistic given the lack of active superpower intervention and no clear military edge being evidenced by either the Russians or the Ukrainians. But what if peace breaks out? From an energy perspective, we’d expect an immediate and violent knee-jerk downdraft in crude and gas markets on the fear of increased supply. That initial reaction is probably the wrong one. Russia has proven itself to be a bad actor. How can consumers rely on Russian volumes in the future? Supply chains will continue to be reworked and Russian supply will be deemphasized over time. It will take many, many years before Western players will feel comfortable with Russian supply/investment. It will eventually happen, just like it does every 10-15 years in Venezuela. Like Venezuela, we suspect Russia is an oil and gas value trap for many decades.
  • More active deal market in 2023 both public and private – 2022 was a year of volatility and uncertainty. Within months of each other, oil traded at $70/bbl and at $125/bbl. In relatively close proximity, gas was both $4/mcf and $9+/mcf. Greed kicked in, making energy deals hard to execute, quite similar to the pandemic-influenced 2021. As we enter 2023, buyer and seller expectations are coming back together. Consensus agrees on an economic slowdown. Consensus agrees energy has a good future, but $150/bbl forecasts have been washed away. Meanwhile, industry balance sheets have improved. Spending for aggressive growth is off the table. Investors have made money for several years in energy stocks and are willing to entertain the idea of financing asset acquisitions and consolidation. IPOs are in the queue for the first time in years. It should be a busy M&A and capital markets year for energy.
  • Energy stocks – a three peat for 2023 outperformance seems reasonable – If it ain’t broke, don’t fix it. Despite being the best group in the market and outperforming the S&P for the past two years, the odds favor a repeat in 2023. Energy earnings will be 10% of the S&P500 but garner barely 5% of the S&P500 weighting. Company capital discipline is excellent and energy stocks are not expensive. Given overall market dynamics, beating the S&P500 may not be a difficult task, but we’d expect energy outperformance in either a bearish or bullish overall tape in 2023.

After a 10th consecutive month of including this in our commentary, we are retiring the mantra given the risk of being pelted with garbage for overuse of cut-and-paste. Please keep in mind, this concept holds for the foreseeable future!

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.

1Source: Bloomberg