Industry Report - Energy stocks level out but pricing is still attractive
Tuesday, January 4, 2021
Energy Industry Report
Energy stocks level out but pricing is still attractive
Michael Heim, CFA, Senior Research Analyst, Noble Capital Markets, Inc.
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- Energy stocks, as measured by the XLE Energy Index, began the quarter on a high note outperforming the overall market. As we entered the second half of the quarter, however, energy stocks leveled off while the overall market continued to rise. For the quarter ended December 31, 2021, the XLE rose almost 6% while the S&P 500 Index rose some 10%.
- Oil prices have been on a tear this year including a sharp increase in October reaching a peak price of $84.65/bbl on October 21. Prices cooled off a bit since then, but remain above $75/bbl. OPEC has been somewhat quiet this quarter. More surprisingly, domestic production has also been slow to respond to higher prices. 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.
- Natural gas prices have also been exceptionally strong early in the quarter climbing above $6/mcf. entering the heating season. Mild weather in November and December have tempered the sharp rise but prices remain above $3.50/mcf, a very profitable level for natural gas producers. Storage levels, which were running high most of 2020, have returned to historical levels.
- Energy industry fundamentals remain strong. Energy prices are high and show no sign of decreasing. Past 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.
Energy stocks, as measured by the XLE Energy Index, began the quarter on a high note outperforming the overall market. As we entered the second half of the quarter, however, energy stocks leveled off while the overall market continued to rise. For the quarter ended December 31, 2021, the XLE rose almost 6% while the S&P 500 Index rose some 10%. The chart below shows the performance of energy stocks in comparison to the S&P Composite Index over the last three months.
As is usually the case, the XLE tracked the movement in oil prices. WTI oil prices have been on a tear this year including a sharp increase in October reaching a peak price of $84.65/bbl on October 21. Prices cooled off a bit since then, but remain above $75/bbl., which is near a five-year high (excluding the October run up). Brent oil prices continue to track a few dollars above WTI prices and ended the quarter at $78/bbl. Futures prices are fairly flat holding in the mid seventies for several months implying that the market believes supply and demand have reached a point of equilibrium.
OPEC has been somewhat quiet this quarter refusing to open the spigot in response to higher prices perhaps out of concern that the spread of COVID could lead to another global economic slowdown. More surprisingly, domestic production has also been slow to respond to higher prices. Active rigs have doubled since bottoming out in the spring of 2020 but remain at levels only half that of 2018, the last time oil prices were at this level.
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.
Natural Gas Prices
Natural gas prices have also been exceptionally strong early in the quarter climbing above $6/mcf. entering the heating season. Mild weather in November and December have tempered the sharp rise but prices remain above $3.50/mcf, a very profitable level for natural gas producers.
Storage levels, which were running high most of 2020, have returned to historical levels. Drilling activity remains steady. As is the case with oil, we believe the lack of a supply response could mean that natural gas prices remain at elevated levels for several quarters.
Energy industry fundamentals remain strong. Energy prices are high and show no sign of decreasing. Past 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. Managements seem cautious due to concerns that demand could collapse with another COVID outburst or perhaps that OPEC would punish any expansion by flooding the market. 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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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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Report ID: 24362