Monday, October 4, 2021
Energy Industry Report
Energy Sector Remains Hot
Michael Heim, CFA, Senior Research Analyst, Noble Capital Markets, Inc.
Refer to end of report for Analyst Certification & Disclosures
- Energy stocks started off weak but finished strong. Energy stocks, as measured by the XLE Energy Index, declined sharply in the first half of the quarter falling as much as 16%. The second half of the quarter was a different story with the index regaining lost ground and finishing within 0.04 points, or 0.01% of where it began.
- Stock performance followed oil prices. WTI oil prices began the quarter at $75.23/bbl., fell to as low as $62.32/bbl., and then shot up sharply to $75.88/bbl. One would have to go back to 2014 to find higher oil prices. What’s more, oil prices show no signs of letting up. Drilling rig count has started to increase, but not at a level one would expect for this oil price level. The WTI oil futures curve shows oil prices declining on the out months but staying above $74/bbl. through December.
- The rise in oil prices is impressive, but it pales in comparison to the jump in natural gas prices. Henry Hub gas prices rose 53% during the quarter and are now trading at a level of $5.619/mcf. One would have to go back to 2008 to find natural gas prices this high. Interestingly, the rise has come during the normally quiet summer months. The race to refill storage units that began in March has been negatively impacted by tepid drilling activity combined with high gas demand due to hot weather this summer. Natural gas future prices rise through the high-demand months of winter. The January contract, for example, trades at $5.85/mcf.
- The rebound in oil and natural gas prices came faster than expected and is staying higher than we would have expected. We have been adjusting our models to reflect higher prices but are maintaining our long-term oil price forecast of $50 per barrel and $2.50 per mcf. Energy companies should start reporting positive cash flow at these prices and increasing drilling budgets. Our near-term outlook for energy stocks remains positive. Wells being drilled today at current prices are generating cash flow to repay drilling costs in a matter of months, not years. We expect companies to report favorable results for the next few quarters. We recommend investor shift their attention to companies with active drilling programs and a plethora of drilling options.
Energy Stocks Performance
Energy stocks, as measured by the XLE Energy Index, declined sharply in the first half of the quarter falling as much as 16%. The second half of the quarter was a different story with the index regaining lost ground and finishing within 0.04 points, or 0.01% of where it began. This is in direct contrast to the S&P 500 Index which rose steadily in July and August before giving back much of its outperformance in September and ending the quarter up a modest 0.85%
Oil Prices
As one might expect, the XLE Index largely mirrored oil prices. WTI oil prices began the quarter at $75.23/bbl., fell to as low as $62.32/bbl., and then shot up sharply to $75.88/bbl. Prices have surpassed peak levels reached in 2018. One would have to go back to 2014 to find higher oil prices. What’s more, oil prices show no signs of letting up. Drilling rig count has started to increase, but not at a level one would expect for this oil price level. Brent oil prices have also been strong and are close to crossing $80/bbl. The spread between Brent and WTI prices has widened but remain below the traditional spread of around $5/bbl. The WTI oil futures curve shows oil prices declining on the out months but staying above $74/bbl. through December.
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 start 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.
Natural Gas Prices
The rise in oil prices is impressive, but it pales in comparison to the jump in natural gas prices. Henry Hub gas prices rose 53% during the quarter and are now trading at a level of $5.619/mcf. One would have to go back to 2008 to find natural gas prices this high. Interestingly, the rise has come during the normally quiet summer months. The race to refill storage units that began in March has been negatively impacted by tepid drilling activity combined with high gas demand due to hot weather this summer. Natural gas future prices rise through the high-demand months of winter. The January contract, for example, trades at $5.85/mcf.
Longer-term energy trends
Energy sources in the United States are undergoing a significant transformation away from carbon-based fuels. While this should not be a surprise to anyone, it is worth taking a long-term view of energy consumption to highlight how the transformation has accelerated in recent years. Coal consumption has been replaced by renewable, nuclear, and natural gas. Worth noting, petroleum consumption, which grew dramatically in the last 50 years, has maintained the levels reached at the end of the century. We believe this trend will continue with petroleum providing a smaller portion of the overall energy picture, but not necessarily declining in absolute value.
Outlook
The rebound in oil and natural gas prices came faster than expected and is staying higher than we would have expected. We have been adjusting our models to reflect higher prices but are maintaining our long-term oil price forecast of $50 per barrel and $2.50 per mcf. Energy companies should start reporting positive cash flow at these prices and increasing drilling budgets.
Our near-term outlook for energy stocks remains positive. Wells being drilled today at current prices are generating cash flow to repay drilling costs in a matter of months, not years. We expect companies to report favorable results for the next few quarters. Longer-term, we have concern that oil demand will be constrained by power generation competition from renewable energy and decreased demand for gasoline and diesel due to a growth in electric vehicles. At the same time, increased supply from OPEC and continued drilling productivity will eventually mean lower energy prices. However, the near-term returns are so favorable, we believe investors will be amply rewarded before such a time arrives. We recommend investor shift their attention to companies with active drilling programs and a plethora of drilling options.
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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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RESEARCH ANALYST CERTIFICATION
Independence Of View
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Ownership and Material Conflicts of Interest
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| Outperform: potential return is >15% above the current price | 84% | 30% |
| Market Perform: potential return is -15% to 15% of the current price | 3% | 1% |
| Underperform: potential return is >15% below the current price | 0% | 0% |
NOTE: On August 20, 2018, Noble Capital Markets, Inc. changed the terminology of its ratings (as shown above) from “Buy” to “Outperform”, from “Hold” to “Market Perform” and from “Sell” to “Underperform.” The percentage relationships, as compared to current price (definitions), have remained the same.
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Report ID: 24083
Energy | October 4, 2021