Tuesday, July 5, 2022
Energy Industry Report
The outlook for energy stocks remains favorable
Michael Heim, CFA, Senior Research Analyst, Noble Capital Markets, Inc.
Refer to end of report for Analyst Certification & Disclosures
- Energy stocks finally cooled off after five consecutive quarters of gains. The energy stock index declined 6.4% in the June quarter due to weakness in the overall market. The S&P Composite Index declined 16.4% during the quarter.
- Oil prices continued the climb begun in the spring of 2020 rising 5.5% in the quarter. The climb may have come to an end, however, with WTI prices peaking at $120 per barrel in the first week of June before settling at current levels near $108 per barrel. Supply concerns associated with the Ukraine conflict have been replaced by worries that economic tightening will lead to a slowdown in the world economy. OPEC announced production increases right at the end of the quarter, further putting pressure on prices. Active rigs have almost tripled in the last two years but remain below pre-pandemic levels and are only one-third of peak levels in 2015.
- Like oil prices, natural gas prices were strong in April and May but fell sharply in June. For the quarter, spot gas prices declined 3.9%. Gas in storage remains near the bottom of historical levels as the industry begins to refill storage fields
- Energy industry fundamentals remain strong. The recent drop in oil and gas prices does not concern us as prices are still well above the levels assumed in our financial and valuation models. Companies able to expand drilling efforts are doing so at a very high return on equity. Cash flow generation is high, and companies are facing the envious situation of trying to decide what to do with the cash. We maintain our positive bias on the group and favor small cap energy stocks with the ability to expand operations.
Energy Stocks
Energy stocks, as measured by the XLE Energy Index, finally cooled off after five consecutive quarters of gains. The XLE declined 6.4% in the June quarter. The decline was largely due to weakness in the overall market as oil and natural gas prices were largely unchanged. The S&P Composite Index declined 16.4% during the quarter. Looking at the XLE performance, it is interesting to note that the index’s performance was up sharply until hitting a peak on June 8th and then declining 15% in the last three weeks of the quarter.
Oil Prices
Oil prices continued the climb begun in the spring of 2020. The climb may have come to an end with WTI prices peaking at $120 per barrel in the first week of June before settling at current levels near $108 per barrel. Supply concerns associated with the Ukraine conflict have been replaced by worries that economic tightening will lead to a slowdown in the world economy. OPEC announced production increases right at the end of the quarter, further putting pressure on prices. The gap between Brent and WTI pricing has grown with Brent oil prices now commanding a $7/bbl. premium. Oil future prices are currently backward declining a few dollars each month and falling below $100 by yearend. Drillers are beginning to react to higher oil prices, but the response has been slow. Active rigs have almost tripled in the last two years 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.
Figure #1
Source: Baker-Hughes
Natural Gas Prices
Like oil prices, natural gas prices were strong in April and May but fell sharply in June. For the quarter, spot gas prices declined 3.9%. Gas in storage remains near the bottom of historical levels as the industry begins to refill storage fields. Gas storage is about 300 billion cubic feet or 12% below the trailing five-year average. This will most likely keep natural gas prices at elevated levels until the injections season ends in November.
Figure #2
Outlook
Energy industry fundamentals remain strong. The recent drop in oil and gas prices does not concern us as prices are still well above the levels assumed in our financial and valuation models. Companies able to expand drilling efforts are doing so at a very high return on equity. Cash flow generation is high, and companies are facing the envious situation of trying to decide what to do with the cash. Debt levels have been pared down and managements are reluctant to initiate/raise above in case the industry goes into a down cycle forcing them to reverse course. Share repurchase remains a viable option especially if energy stocks continue to be weak alongside the overall market. We maintain our positive bias on the group and favor small cap energy stocks with the ability to expand operations.
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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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Report ID: 24648
