RonFullHD
After seeing significant energy price increases from 2021 to early 2022, the market has been in a prolonged calm period over the past year. Crude oil and gasoline prices fell dramatically as releases from the Strategic Petroleum Reserve artificially fixed the shortage. As a result, inflation levels have declined, causing many investors to become more bullish on most stocks while avoiding energy companies. I was bullish on the energy market throughout the 2021 to early 2022 period but warned that government intervention would likely stop the rally last May. Today, fuel prices are generally much lower, but recent trends show a pattern that may proceed with a potentially more significant energy price rally. See below:
The bull market was effectively ended by immense intervention through a ~50% reduction in the SPR reserve. The US government’s SPR release program was supposed to end at the beginning of the year, but the supply has declined slightly. However, from now on, the SPR should not see its supply drop and could take oil out of the private market as the Biden administration looks to refill its lost reserves. While the government has purchased minimal refilling contracts, most analysts doubt their ability to replenish the reserve due to insufficient excess capacity.
I believe the SPR reserve release was like quantitative easing from the Federal Reserve. The effort certainly supports the economy and reduces price burdens, but it comes with significant long-term costs and is a temporary solution. Indeed, due to the decline in oil and gas prices, most producers are reducing their active rig count, implying that total US oil production levels will likely decline over the coming months. OPEC+ has also recently implemented more significant production cuts, indicating a general decline in global production levels in response to lower prices. Indeed, oil prices are starting to push against new well breakeven prices, which have been rising due to labor and materials shortages, so oil producers have little choice but to reduce drilling rates.
This situation sets solid conditions for a more significant breakout in oil, gasoline, and potentially natural gas. The primary energy ETF, Energy Select Sector SPDR Fund ETF (NYSEARCA:XLE) has begun to see positive performance, starting to push up against its May 2022 highs. That said, it remains possible that a recession causes a sufficiently significant demand decline to offset the negative production outlook. Additionally, the stocks in XLE may be overvalued today based on their immediate earnings potential. That said, chronic underinvestment in the energy market mixed with high and steady global demand appears likely to promote a large energy commodity price rally that may greatly benefit XLE.
Underinvestment Equals Reduced Production
Continental US oil production levels remain materially below pre-COVID levels despite moderate growth since the 2020 bottom. Future changes in production are dependent upon the oil rig count. Further, the oil rig count must maintain a certain level, likely around 400-600, for the total output level to be constant, as new wells must constantly be drilled to replace output declines in older wells.
Significantly, particularly with fracked shale wells (the most popular in the US), well output levels decline by ~70-80% in their first year and over 95% by year three. I emphasize that point in my energy-related articles because it illustrates how much the US oil supply depends on extremely short-term drilling activity. In 2020, a temporary significant decline in drilling led to massive long-term production shortages, which persist today because of the market’s increasingly short-term nature. To make the matter more extreme, US oil producers have used most of their “drilled but uncompleted” well inventory, meaning a higher rig count is necessary to maintain constant production. See the data below:
Today, the rig count falls with the drilled by uncompleted well count. Should this trend continue, total oil production levels should decline substantially. I do not expect total oil production to fall as quickly as it had in 2020, but potentially faster than in previous similar instances, such as 2016. Indeed, most of the production growth since the 2020 bottom is not due to increased drilling but the completion of drilled but uncompleted wells. That trend largely stems from the fact that oil companies are avoiding CapEx spending for various reasons. To illustrate, see the CapEx-to-sales levels of the most extensive stocks in XLE:
Most of these firms have reduced CapEx spending throughout the past decade following the rapid expansion of the US shale patch. CapEx levels have increased slightly for EOG (EOG), ConocoPhillips (COP), and Pioneer (PXD) but much less for the most prominent players, such as Chevron (CVX) and Exxon (XOM). The slight rise in capital investments over the past year mirrors the slight increase in the rig count. The declining rig count likely signals a decline in Capex spending over the Q3-Q4 timeframe.
Typically, high profits promote greater CapEx spending. While that remains true, the impact is much smaller today than over the 2010s period; energy companies are avoiding investments as much as possible. For one, most energy companies still have very high debt levels due to chronic losses during 2014-2019, so they’ve focused profits on reducing debt levels instead of drilling. Further, increased ESG efforts and incentives may play a role in reducing production and rising debt costs. Similar patterns are seen in ongoing executive branch efforts to expand drilling costs on Federal lands, decreasing ROIs from drilling. Of course, the energy and mining sectors also face massive labor shortages, making it impossible to drill and raising the cost of the materials required to drill (which are metal intensive). Lastly, key oil sources, such as shale, are simply running out of easy-to-drill reserves, with the “best sources” increasingly tapped out, further lowering drilling ROIs.
All of these factors are inherently long-term in nature and serve to maintain a sharp positive trend in breakeven drilling costs. As stated by Pioneer’s CEO, the US is unlikely to reach record oil production ever again. Higher drilling costs are not necessarily bullish for oil companies since their profits may decline if the commodity does not maintain an upbeat pace. Natural gas is a more significant issue since that commodity is trading below the breakeven price for most producers. Refineries and midstream companies are less exposed to these issues but may struggle with rising costs as capacity levels falter.
That said, to a large extent, ESG-related efforts and other limiting factors (labor shortages, etc.) may also benefit energy producers because they limit the total production levels. Individually, energy companies benefit from maximizing production. Collectively, energy companies benefit from minimizing production, unlike the OPEC cartel. Since ~2010, OPEC’s most significant strain has been the sharp rise in US production, limiting its efficiency to cartel the market. However, when US (and Canadian) oil output is limited for largely non-economic reasons, OPEC+ is increasingly powerful and could benefit more from reducing its supplies. The cartel is also looking to add new members, further increasing its market control.
Similarly, the BRICS nations’ efforts to diminish the international power of the US dollar could significantly increase US oil prices should the “Petrodollar” system wane. Many countries are making deals that begin to weaken the Petrodollar’s systemic value. I believe countries involved in this plan are unlikely to publish the full extent of those plans because most (like China) have significant US-dollar-denominated assets. China has been selling those assets but benefits from a strong dollar until its exposure is lower. While my outlook is speculative, I believe there is a high risk of a “black swan” bearish dollar-related event over the coming year as these nations become more public regarding their currency plans. A sharp decline in the US dollar, which is relatively expensive today, would be very bullish for oil and benefit US oil producers and exporters.
How Exposed is XLE To A Recession?
Assuming constant demand, I believe it is very likely that crude oil and gasoline prices will rise. Further, it appears likely that natural gas prices will increase, but I doubt they will return to 2022 peak levels anytime soon. XLE is allocated toward large vertically integrated energy companies, producers and explorers, midstream, and refineries. A sharp rise in energy commodity prices will benefit producers and explorers the most, potentially creating the best opportunity for relevant ETFs such as, SPDR S&P Oil & Gas Exploration & Production ETF (XOP). However, should energy commodities fail to rise, I expect that subindustry to decline since commodity prices are not currently high enough to support significant profits, such as in 2022. Thus, XLE may offer the best overall potential because it has the upside potential from E&P and the immediate high profits from refineries and midstream companies.
Refineries are probably the best immediate segment today due to the recent increase in the gasoline “crack spread,” or the difference between a gallon of gasoline and crude oil prices. See below:
The crack spread is chronically elevated from pre-COVID levels due to an immense shortage of refinery capacity and dilapidated refinery infrastructure. The overall trend in US refinery capacity will likely remain negative for this decade since they require enormous investments, which are unappealing due to the positive long-term outlook for electric vehicles. Accordingly, refineries are operating in an oligopolistic manner, ensuring high profits. However, as with the industry, they do not require collusion due to the many barriers to capital investments.
That said, the ongoing recession or prolonged economic stagnation/slowdown issue remains a headwind to all companies in the energy sector. In my view, as detailed in most of my articles over the past months, I expect the US economy to slow in a recessionary manner. That said, I do not expect a 2008-like crash but a slow burn, resulting in falling real incomes for companies and households over the years. Indeed, depending on the reality of inflation (if it is higher than stated), the US real GDP and real wages have been slowly falling since 2021. A sharp rise in fuel prices or a decline in the dollar will undoubtedly accelerate this trend, which I expect to persist until the US manufacturing base improves (potentially taking over a decade).
Still, US oil demand has remained very strong this year despite a massive slowdown in overall manufacturing growth. See below:
In my view, this data is an initial indication that oil and gas demand is not as sensitive to the economy as many believe. Fuel efficiency has improved dramatically over the past two decades (remember Hummers?), so households and companies lack easy options to reduce consumption and maintain mobility and operability. Electric vehicles should eventually result in lower demand. However, high prices, dependence on tax credits, dilapidated electrical grids, and materials shortages remain significant short-term and long-term barriers to growth. Thus, while an economic recession should lower demand, I doubt we will see the same trend as in 2008 since significant improvements in vehicle efficiency promoted that. Further, I expect demand only to decline in response to a sharp increase in fuel prices.
The Bottom Line
XLE trades at a lower “P/E” ratio of 7.75X on a TTM basis. Over most of the past twelve months, energy prices have been much lower than in 2021 to early 2022. That said, profits have remained elevated due to gains from hedging activity or long-term contracts created during the high-price period. The fund’s forward “P/E” is 11.75X, which implies an earnings decline due to lower commodity prices today. Additionally, XLE’s dividend yield is currently 3.4% after its expense ratio, which, although not high compared to interest rates, its dividend is much better than that seen in most other sectors.
Overall, I am very bullish on XLE today and believe its valuation is relatively low, particularly given a potential increase in commodity prices. In my view, there is a solid technical and fundamental setup for a potentially significant price increase for oil and gasoline over the coming months that may push XLE to much higher levels. Of course, XLE faces some economic risk and will still decline with stocks if the S&P 500 sells off again. However, contrary to the historical norm, I believe XLE is likely the least recession-exposed sector ETF because of the many secular trends benefiting the oil and gas market. Finally, speculative investors may see better results in E&P-focused ETFs like XOP. Still, I prefer XLE due to the high expected profit growth from refineries, giving XLE both positive commodity exposure and decent immediate value potential.
