The energy sector has sold off sharply, with the index now down approximately 30% from its June high (it certainly feels worse than that!). While some of the weakness can be attributed to the lack of loss of Russian barrels from the market, the largest release from oil strategic stockpiles in history, and an on-again/off-again status of the Iranian nuclear negotiations threating the return of ~1MM Bb/d of lost production, most of the weakness in my mind is attributable to growing recessionary fears and consequent concerns of oil demand destruction.
What makes this vicious sell-off all the more frustrating is that it is largely not on fears of “what is” but rather fears of “what could be.” We can measure global oil inventories, the nexus of supply and demand, and witness that global oil inventories continue to fall indicating a still undersupplied market:
This, despite China remaining under lockdown suppressing oil demand by roughly 0.5MM Bbl/d and the largest release from oil stockpiles in history, despite no meaningful losses of Russian production.
We have spoken on several occasions that recessions do not necessarily mean negative oil demand, but rather a moderation in the rate of demand growth. Respected oil analyst Energy Aspects is modelling recession in both Europe and the US next year, yet still estimates that oil demand will grow by about 1MM Bbl/d (partially owing to gas-to-oil switching and a rebound in Chinese demand as they emerge from very unpopular COVID lockdowns).
Is it possible to believe that we are heading into a recession yet still be bullish oil and energy stocks? Yes! The market has recently, and may in the short-term, continue to ignore that what sets the price of a commodity is not just demand but supply. US shale producers are beginning to plan for 2023. With inflation in service costs, massive pressure to continue to prioritize share buybacks and variable dividends, and now nausea inducing volatility in the oil price, it is a safe bet that any growth aspirations for 2023 have largely evaporated. What of OPEC? All of the “haves” of OPEC had already approached what we estimate to be maximum productive capacity. While Saudi and the UAE are adding capacity it will not come online until 2027/2025 respectively.
In short, the market was and remains undersupplied despite the largest marginal consumer remaining under lockdown impacting oil demand by ~0.5MM Bbl/d and the release to-date of 150+ million barrels from strategic stockpiles. What happens when the SPR ends in November and China emerges from lockdown (with some encouraging signs coming out over the weekend)? With US shale growth likely disappearing, OPEC tapped out, the stagnation from the supermajors continuing, and the pressure to talk down the oil price easing once we get past the US mid-term election, we continue to believe in an ongoing state of undersupply, despite a likely recession, putting further upwards pressure on the oil price. Our work continues to point to a “fundamental” price of over $100/bbl and others like Energy Aspects and Cornerstone Analytics agree.
We believe there is a major break between the physical demand for oil and the financial demand for oil, and that the tail is wagging the dog. Massive policy uncertainty, such as a EU embargo on Russian oil in December and the torturous rumor-filled Iranian negotiations, paired with increased margin requirements have led to a lack of willingness to take on risk leading to the lowest net speculative interest in oil since early 2020, exacerbating volatility. Energy Aspects this morning summarized it as such:
Are we still bullish? The major 4 tenets of our multi-year bull market thesis remain unchanged: persistent demand growth for at least the next decade, the end of US shale hyper-growth, the exhaustion of OPEC spare capacity, and the end of growth from the global supermajors owing to too many years of insufficient investment. With the US midterm election approaching and coincidentally the end of the biggest SPR release in history, it should become much more apparent to the masses in the weekly data that the oil market remains undersupplied. Secondly, should oil continue to fall, we would expect a production CUT from OPEC, as foreshadowed a few weeks ago, as a means of restoring some balance between the physical and financial oil markets. China too is critical to the oil trade, and we remain impressed that inventories have continued to fall despite China demand being impacted by approximately 0.5MM Bbl/d (along with SPR releases), and further signs of restriction easing could materially improve sentiment.
What of energy stocks? Even with the rally earlier this year, energy stocks remained inexpensive and failed to even moderately embed an oil price above $100. We believe today our average holding is discounting an oil price of about $50 (or lower). With the average company approaching “debt free” status by early 2023 their ability to increase shareholder returns in the form of dividends and buybacks may be much greater.
This is not 2009 or 2020. Stocks are discounting a nightmare oil demand scenario (essentially another Great Financial Crisis), are near debt-free status and able to weather whatever storm comes, are gushing with free cashflow even at $60WTI, and are committed to low-to-no growth an instead rewarding shareholders finally in the form of meaningful share buybacks (all the more attractive given the sell off) and dividends.
While the drawdown is nausea inducing and can serve to shake conviction in the absence of data, it is we believe only temporary. We have learned that the best opportunities come when fear is rampant yet fundamentals are strong. That is our assessment of things today. With the SPR ending, China signaling the potential slow return to normal, US shale growth stalling, and OPEC ready to cut production should the oil price sell off, we view valuations today as extremely attractive and potential outsized returns compensating for the additional volatility that the sector carries.
With our average holding trading at an estimated 2.5X EV/CF at $80 (1.9X at $100WTI), down 37% from June highs, global oil inventories continuing to draw, and several potentially positive catalysts in the months ahead, we remain bullish.
Senior Portfolio Manager
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