Friday, April 1, 2022

Energy Industry Report

Energy Stocks Remain On A Tear

Michael Heim, CFA, Senior Research Analyst, Noble Capital Markets, Inc.

Refer to end of report for Analyst Certification & Disclosures

• Energy stocks, as measured by the XLE Energy Index rose 41% in the quarter. Investors are growingly accepting the fact that higher prices are not merely related to temporary factors. Investors no longer talk about domestic supply cost as the factor that sets prices instead concentrating on how rising demand will be met.
• Oil prices have doubled in the last twelve months. Prices have backed off of highs hit at the beginning of the Ukraine conflict but remain at levels well above that needed for energy companies to make large profits. We do not believe $100 oil prices are sustainable and expect increased drilling to eventually lower prices. Nevertheless, we have raised our long-term oil price assumption used in our valuation models to $60 from $50.
• Drillers are beginning to react to higher oil prices, but the response has been slow. Active rigs have doubled in the last twelve months but remain below pre-pandemic levels and are only one-third of peak levels in 2015. There has been a disconnect between the oil rig count and oil prices in recent years that has become only more exaggerated in recent months.
• Natural gas prices have also been strong. Much attention has been given to the role domestic gas producers might have in supplying natural gas to Europe to replace gas being received from Russia. The trend towards building liquified natural gas (LNG) export terminals (or reversing import terminals) began years ago. Still, the United States is several years away from increasing its LNG export capacity to a level that could offset Russian imports. Meanwhile, storage levels have become low due to cold weather.
• Energy industry fundamentals remain strong. Energy prices are high and show no sign of decreasing. We look for companies to continue reporting strong positive cash flow and to use cash flow to increase drilling and improve balance sheets. We believe small energy companies that can expand without drawing attention may be at an advantage.

Energy Stocks Performance

Energy stocks, as measured by the XLE Energy Index, continued their torrid pace rising 41% in the quarter and far outpacing the overall market. The increase reflects higher oil and gas prices during the quarter, much of which can be attributed to the conflict between Russia and Ukraine. That said, investors are growingly accepting the fact that higher prices are not merely related to temporary factors such as Ukraine, supply chain issues, a post-covid economic rebound, or OPEC supply tightening. Instead, there is growing belief that higher prices reflect a fundamental disconnect between the energy demand and supply. Investors no longer talk about domestic supply costs as the factors setting prices instead concentrating on how rising demand will be met until renewable energy is able to have a significant impact on energy demand.

Figure #1

 
Source: Yahoo Finance

 

Oil Prices

The run-up in oil prices has been extraordinary virtually doubling in price over the last twelve months. Prices have backed off of highs hit at the beginning of the Ukraine conflict but remain at levels well above that needed for energy companies to make large profits. Brent prices remain approximately $5/bbl. above WTI prices ending the quarter near $108/bbl. Futures prices remain relatively flat declining about a $1 each month going forward. We do not believe $100 oil prices are sustainable and expect increased drilling to eventually lower prices. Nevertheless, we have raised our long-term oil price assumption used in our valuation models to $60 from $50.

Figure #2

 
Source: Yahoo Finance

 

Drillers are beginning to react to higher oil prices, but the response has been slow. Active rigs have doubled in the last twelve months but remain below pre-pandemic levels and are only one-third of peak levels in 2015. As the chart below shows, there has been a disconnect between the oil rig count and oil prices in recent years that has become only more exaggerated in recent months with oil prices rising above $100. As indicated previously, we expect drilling activity to continue to increase as long as oil prices remain at current inflated levels. How quickly drilling will increase remains to be seen.

 Figure #3

Source: Baker-Hughes

 

Natural Gas Prices

Natural gas prices have also been exceptionally strong early in the quarter climbing approaching $6/mcf. Much attention has been given to the role domestic gas producers might have in supplying natural gas to Europe to replace gas being received from Russia. The trend towards building liquified natural gas (LNG) export terminals (or reversing import terminals) began years ago. Still, the United States is several years away from increasing its LNG export capacity to a level that could offset Russian imports. That said, the trend will most likely continue creating a favorable outlook for domestic natural gas producers. Interestingly, natural gas prices are higher at the Henry Hub pricing point than most of the country reflecting regional temperature disparities and perhaps a growing trend towards LNG exports.

Figure #4

 
Source: Yahoo Finance

 

Storage levels, which entered the winter heating season at high levels, exit the season near historically low levels. Temperatures in the lower 48 states have been colder than normal with the last two weeks in March being significantly colder than normal. As we enter the summer months, there is little to move storage levels back in line. We would expect to enter the next heating season at average to below average storage levels.

Figure #5

 

 

Outlook

Energy industry fundamentals remain strong. Energy prices are high and show no sign of decreasing. High oil prices, combined with improved operating efficiencies, mean that production companies are facing very favorable returns on their investment. We look for companies to continue reporting strong positive cash flow and to use cash flow to increase drilling and improve balance sheets. We do not expect companies to raise dividend payments given the cyclical nature of recent oil price trends but would not rule out share repurchases if stock prices do not rebound further. Concerns of industry-wide reductions in lifting costs or a fundamental shift away from carbon-based fuels have gone to the wayside due to a lack of supply response to higher prices. The drilling that is being done is very profitable and that should lead to higher company profits and improved company financials. We believe small energy companies that can expand without drawing attention may be at an advantage.

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ANALYST CREDENTIALS, PROFESSIONAL DESIGNATIONS, AND EXPERIENCE

Senior Equity Analyst focusing on energy and utility stocks. 24 years of experience as an analyst. Chartered Financial Analyst©. MBA from Washington University in St. Louis and BA in Economics from Carleton College in Minnesota. Named WSJ ‘Best on the Street’ Analyst four times. Named Forbes/StarMine’s “Best Brokerage Analyst” three times. FINRA licenses 7, 63, 86, 87.

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Outperform: potential return is >15% above the current price	94%	28%
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Underperform: potential return is >15% below the current price	1%	0%

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Report ID: 24648