Recently an interesting divergence has developed with oil prices rallying since the start of the year and Energy stocks lagging relative to the market. This is a noticeable change from the historically tight correlation between Energy stocks and oil prices. A possible explanation is that higher oil prices are rising due to temporary geopolitical concerns while Energy stocks are pricing a soft oil price environment in the long term. Additionally, Energy stocks are leveraged to Natural Gas prices which have remained low. Below are nine charts that provide context about the divergence and highlight trends in the Energy sector.
(1) Oil prices and Energy sector relative performance have diverged
Oil prices have disconnected from Energy relative performance since 2016. Oil is up from the lows in 2016, but the Energy sector has made new lows vs. the S&P 500. It’s tempting to look at the chart and conclude that the two assets have to converge through a combination of lower oil prices or higher relative equity prices. However, a closer inspection of the dynamics in the market suggests that the divergence may remain open, and is unlikely to be resolved by Energy stocks rallying.
(2) The rally in oil prices reflects geopolitical issues impacting the front end of the oil curve, but the backend remains anchored
The benchmark oil price represents the front end of the oil curve, which has rallied since the start of 2019. Oil has had its biggest January-March price increase in 10 years, up 32% due to geopolitical concerns in Iran and Venezuela. U.S. refineries were already cutting back on Venezuelan crude over the past 5-10 years, but Venezuelan crude was still the cheapest option as of about 3 months ago, when sanctions essentially shut the U.S. off from Venezuelan imports (NY Times).
The back-end of the oil curve has stayed anchored since January, causing the Brent futures curve to go into backwardation. The back-end of the oil curve is less impacted by short term factors and represents market participants’ long-term view of oil prices. Energy company intrinsic value is leveraged to the back-end of the oil curve since equities represent future earnings.
(3) Oil price has increased since the start of 2019, but Natural Gas is near lows
Energy equities are leveraged to oil prices as well as natural gas prices. Even though oil has rallied, natural gas prices have stayed low. Natural gas front-month futures are at $2.48, which is the lowest level since 2016. Natural gas is not impacted by the same geopolitical tensions that have caused the front of the oil curve to rally.
(4) Supply of oil has remained robust due to increased U.S. production
The price of oil has limited upside in the near term without lasting geopolitical supply issues. The ability of OPEC to prop up prices by controlling demand has diminished significantly as non-OPEC countries have increased oil production. The U.S. in particular has dramatically changed the supply dynamics with increased production from shale. The U.S. is now the largest producer of oil in the world.
(5) OPEC countries control the bulk of oil reserves
In the long run, OPEC countries control the largest oil reserves. The U.S. Energy Information Administration forecasts that supply of oil will increase over the next 5 years in part driven by U.S. production. Beyond that, supply growth 10 years and out will be tied to OPEC production.
(6) Energy equities that depend on capital expenditures like Oil Services have underperformed the Energy sector
On a thematic level, there are several notable trends that are worth highlighting. From a performance perspective, the companies with the most leverage to oil and natural gas production have underperformed. The most clear example is the underperformance of Oil Services vs. the overall Energy sector. Oil producers have focused on profitability instead of expanding production, and that’s taken a toll on the Oil Services stocks that rely on capex from exploration and servicing.
(7) Defensive stocks like Refiners and MLPs have outperformed since oil prices peaked in 2014
Refining companies have weathered the prolonged downturn much better than other Energy stocks. Since 2014 when oil prices peaked, the best performing stocks in the XLE are refining stocks (VLO, MPC, PSX), along with one MLP (OKE) and one E&P (FANG).
(8) Companies with shale portfolios are acquisition candidates as the sector consolidates
The slump in oil prices has driven consolidation in the sector. The recent $50B announcement by Chevron (CVX) to acquire Anadarko (APC) underscores the trend of companies looking to leverage economies of scale to navigate the new paradigm of lower oil prices. If the acquisition closes as expected, Chevron will extend its lead as the largest owner of shale in the U.S., with shale assets worth about $100B. This shift in Big Oil’s favor has already been occurring with momentum over the past 5 years, with Big Oil responsible for 78% of mega-project investment decision since 2014, an increase from its 49% in the previous 10 years, according to Goldman Sachs.
(9) After Chevron announced its acquisition of Anadarko, midcap stocks with attractive shale assets have rallied
Medium-sized E&P companies with significant exposure to shale gapped up on the Anadarko takeover announcement and have continued to trade higher since. Investors are evidently expecting further acquisitions of strategically attractive companies.
Oil prices will likely remain capped in the medium term due to robust supply from non-OPEC producers and tepid demand stemming from soft global growth. The Energy sector as a whole is unlikely to outperform the market in such an environment. On a stock level, focus on large-cap stocks with healthy balance sheets (XOM, CVX) that can navigate the prolonged oil price downturn. For higher beta exposure, focus on stocks that may be acquired like the mid-cap shale plays (EOG, PXD, CXO & FANG).
Special thanks for Evelyn Donatelli for helping to research this post