Earlier this month, we downgraded our rating on the Energy sector to “marketperform.” Although just two and a half months ago we expected the sector to outperform the broader stock market (as represented by the S&P 500® index), it hasn't performed as anticipated—even with higher oil prices—and new risks have emerged.
Despite a deal having been struck earlier this week, the recent breakdown in talks between OPEC+ members1 and a subsequent call for lower oil prices by the Biden administration are raising uncertainty—both in terms of the cohesion of the OPEC+ cartel and the increased politization of the energy market.
The rise in oil prices to well above the average breakeven level—even after the sell-off in the last couple of weeks—may threaten energy companies’ resolve to be more disciplined with expenses and investment. Meanwhile, the U.S. dollar has rallied—which is generally inconsistent with higher oil prices—and investor sentiment appears to have become too optimistic.
Together, these developments have diminished the risk/return tradeoff, in our view. However, it’s important to note that this is not a suggestion that investors should eliminate exposure to the Energy sector. There are still many positive attributes to the sector that could reassert themselves if some of the risks are resolved; and maintaining well-diversified exposure to sectors is generally a good idea, as nobody can predict with perfect accuracy how markets will move in the future.
Let’s look at some of the factors affecting the Energy sector.
OPEC cohesion is fractured. Recently, OPEC+ members had a falling-out, with negotiations on production limits breaking down. After cutting oil supplies last year during the COVID-19 crisis, the group has been gradually resuming production in response to the return in global demand for oil, as distribution of vaccines allows economies to reopen. At the center of the recent disagreement, the United Arab Emirates (UAE) claimed that, based on its increased capacity, it should be allowed to increase oil production more than what the proposed agreement specified. The cartel has since resolved the dispute, with the UAE granted a higher production quota. However, even with the resolution, the fallout reflects a less cohesive coalition, in our view.
Part of the agreement includes a provision that if Iranian oil sanctions were ended, the other cartel members would reduce their production accordingly. This might be untenable. The last call to reduce production—in March 2020—led to a price war between Russia and Saudi Arabia, during which Russia (one of the biggest OPEC+ producers) refused to slash production to the extent called for by the other OPEC members. In turn, Saudi Arabia pumped a record amount of oil, leading to global oil production to far outstrip collapsing global consumption. That drove the 2nd month crude oil futures to below $20 per barrel, from more than $60 per barrel prior to the COVID-19 crisis. While such a conflict is still unlikely, in our opinion, the increased risk of it could contribute to higher volatility for both the price of oil and the Energy sector.
Oil consumption dropped more sharply than production in 2020
Source: Federal Reserve Bank of Dallas, Energy Information Administration. As of 3/31/2021
The U.S. dollar and positive sentiment are creating headwinds. The recent increase in the value of the U.S. dollar is inconsistent with a sustained increase in oil prices. Because oil is priced in U.S. dollars, all things being equal a rise in the dollar is a headwind to the global price of oil. In addition, as it appears likely the Federal Reserve will be the first of the major global central banks to unwind accommodative monetary policies, the uncertainty surrounding the impact on growth—along with concerns over the spread of the COVID-19 delta variant—has boosted the dollar. In the coming months, the policies of global central banks and the path of the virus will provide a clearer picture on relative economic growth and interest rates—which can impact the dollar, as well as crude oil. In the meantime, the similar trends in oil prices and the dollar raises the risk of volatility in the oil market.
The value of the dollar and price of oil have been volatile
Source: Charles Schwab, Bloomberg, as of 7/16/2021. Charts reflects 12-week moving average of the Generic 2nd month WTI crude oil futures contract and 12-week moving average of the U.S. Dollar Spot Index. The last data point is not averaged. The arrows in the chart are intended to subjectively illustrate that the recent trends in the U.S. Dollar and the price of oil are in a similar direction, as opposed to the typical inverse relationship. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Meanwhile, measures of investor sentiment on oil have risen to an extremely optimistic level—a contrarian indicator that historically has been followed by weaker performance. A significant rise in the Delta variant of the coronavirus (which, if social distancing restrictions were renewed, could result in lower oil demand), and the risks noted above could lead to an unwinding of optimistic sentiment—which may be starting to happen now.
Overly optimistic sentiment can be bearish
Source: ©Copyright 2021 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/, as of 7/16/2021. Yellow dotted lines represent Crowd Sentiment Index readings of above 63.2 and below 42.3. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly Past performance is no guarantee of future results.
U.S. oil production uncertainty has a silver lining. The potential for a rapid rise in U.S. oil production also raises uncertainty on the supply side of the oil price equation. Given the current high price of oil, U.S. production could return faster than expected. It is now profitable enough for even the higher-cost shale producers to come back on line—which could happen quickly—as the current rig count is still well below pre-crisis levels. According to the Dallas Federal Reserve Bank’s survey of energy companies, the average breakeven price of oil is between $46 and $58 per barrel (depending on extraction methods and region)—above those levels, we’re more likely to see new oil wells drilled.
The number of oil drilling rigs is well below the pre-crisis level
Source: Charles Schwab, Bloomberg, as of 7/16/2021. A rotary rig rotates the drill pipe from surface to drill a new well (or sidetracking an existing one) to explore for, develop and produce oil. Value includes both land and offshore rigs.
The swift rise in oil prices is a two-edged sword for energy companies and investors’ views of the sector. Higher prices, of course, translate into higher revenues. However, one of the arguments for our previous outperform rating was that companies were exhibiting more discipline with investments and expenses. The quick rise in oil prices could entice producers to abandon their newfound self-control in favor of short-term gains.
Despite the spike higher in the price of oil the last several months, energy shares fell. It likely reflects that investors are pricing in lower oil prices due to the prospects of higher supply by OPEC+ and U.S. producers alike, as well as a potential for deteriorating fiscal discipline that contributed to sub-par stock returns in past years. The silver lining is that fiscal discipline by energy companies has persisted. Even with the sharp rise in oil, companies haven't ramped up capital expenditures as they have done historically. Therefore, if there is a significant decline in oil, they are less exposed to stranded assets (investments that becomes obsolete).
Energy companies’ capital spending has remained low despite oil price rise
Source: Charles Schwab, Bloomberg. As of 7/19/2021. Generic 2nd month WTI crude oil futures contract. Bloomberg’s estimated capital expenditures for the S&P 500 Energy sector. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.
The Energy sector still has other positives, as well. Since the low point of the COVID-19 crisis in 2020, the Energy sector has lagged the sharp rise in the price of oil and is well below the historical average of that relationship—though the clean energy movement may have loosened the relationship somewhat. This is still likely an intermediate-term tailwind for the sector, as it could provide a buffer for energy stocks if the price of oil were to weaken.
Energy stock prices have lagged the oil price rise
Source: Charles Schwab, Bloomberg as of 7/19/2021. S&P 500 Energy Sector Index; Generic 2nd month WTI crude oil futures contract. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Valuations in the Energy sector—though above the historical average—are attractive relative to other sectors. Despite the strong gains in energy stocks since the market lows in 2020, they have not kept up with rapidly rising earnings expectations. This is not surprising, as investors have remained wary of this boom/bust sector, while equity analysts found optimism amid the combination of rising oil prices boosting revenues and restrained expense growth.
Energy sector earnings expectations are outpacing other sectors
Source: Charles Schwab, Bloomberg. As of 7/16/2021. Percent change in Bloomberg’s blended 12-month earnings per share estimates.
Finally, oil inventories have declined. With the reopening of the global economy, the recovery in demand for oil has outstripped supply by cautious producers—OPEC+ and U.S. producers alike. One measure of inventories—days of supply for crude oil—is back to the pre-crisis five-year average. A continued decline in inventories against the backdrop of higher demand is inherently supportive for oil and potentially energy companies.
Drop in oil inventories may be a support for oil prices
Source: Charles Schwab, Bloomberg as of 7/7/2021. DOE Crude Oil Total Inventory Data (excluding Strategic Petroleum Reserve). Generic 2nd month WTI crude oil futures contract.
We believe that the recent increase in risks diminishes the risk/reward tradeoff for the Energy sector. Tensions within OPEC+, the higher U.S. dollar, overly optimistic investor sentiment on oil, and the risk that U.S. producer discipline fades, all raise uncertainty for the energy market. Some of these issues could be resolved in the coming months, but even renewed cooperation within OPEC+ would leave open the question as to whether the cartel is fracturing.
There are still many positive attributes of the sector that could spur renewed outperformance. But until the risks are alleviated and the positives reassert themselves, we think that market-weight exposure to the energy sector is appropriate at this time.
1 The Organization of the Petroleum Exporting Countries Plus (OPEC+) is an affiliation of the 13 OPEC members (Algeria, Angola, Congo, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Saudi Arabia, the United Arab Emirates, and Venezuela) and 10 of the world’s major non-OPEC oil-exporting nations (Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russia, South Sudan, and Sudan).
What do the ratings mean?
The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:
- Outperform: likely to perform better than the broader stock market*
- Underperform: likely to perform worse than the broader stock market
- Marketperform: likely to track the broader stock market
* As represented by the S&P 500 index
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