An unprecedented level of demand destruction –equivalent to roughly one‑third of global crude consumption thus far – has decimated oil prices, briefly driving them into negative territory. Energy stocks have also been pummelled.
The question for investors is whether this carnage creates compelling investment opportunities in energy stocks, or whether it is a sector to avoid.
We see the potential for a powerful, countercyclical rally in crude prices and energy stocks that could last between 12 and 24 months. However, longer‑term, the outlook for oil and the energy sector remains less sanguine. Ongoing productivity gains from automation and improved reservoir management techniques in US shale fields, among other factors, should continue to make hydrocarbons easier and less expensive to extract, likely ensuring crude oil remains mired in a secular bear market.
Successful investing in the energy sector requires balancing near and long‑term views for oil, while focusing on the names able to provide meaningful leverage to the recovery rally – without making concessions to quality. Selectivity will be critical. Some energy companies will not make it to the other side of this crisis, while some survivors could find themselves in too weakened a state to compete effectively.
Industry will take drastic action
Negative oil prices signal a need for the industry to take dramatic actions to align supply with demand. We believe producers are likely to over‑cut output, which would stop storage tanks from filling and then start to drain the glut. The lifting of quarantines implemented to restrict the spread of the coronavirus would also help to draw down oil inventories by boosting demand.
We envision a scenario where a lack of capital expenditures in the oil and gas industry accelerates the fall in hydrocarbon production – especially in US shale, where wells tend to exhibit steeper decline rates – prompting crude prices to rise to levels incentivising operators to invest in new wells. In fact, we are of the view West Texas Intermediate crude oil could hit $45-50 a barrel by next year.
The pain suffered by investors and management teams should lead to greater discipline in how energy companies allocate capital. For the remainder of the secular bear market in crude, outspending operating cash flow should be a thing of the past for oil field services and exploration and production (E&P) companies.
In the case of E&Ps, this shift should translate into a more balanced mix of production and free cash flow. Share buybacks, which make less sense for a cyclical commodity producer, likely will stop, though special dividends could emerge as a more appropriate alternative.
Industry consolidation could also be in the cards, with the major integrated oil companies interested in expanding presence in US shale likely to pursue strategic acquisitions in the Permian Basin. The shale oil plays have reached a stage where the major oil companies’ technical sophistication and experience with project management are needed to unlock value and boost recovery rates from shale formations.
Investors should be cyclically optimistic
Our outlook for the energy sector is ‘cyclically optimistic’ for the next one to two years, but ‘structurally bearish’ over the long term. We are finding some opportunities in the major integrated oil companies, as well as E&Ps and oil field services firms, where undemanding valuations and the potential for a countercyclical rally in oil prices create a compelling risk/reward profile for high‑quality names.
Among E&Ps, we continue to focus on low‑cost operators boasting good balance sheets and sizable inventories of quality locations to drill wells. Although we like the strong balance sheets of many oil majors, we have become more selective in this space, avoiding names where strategic shifts could result in identity crises that distract management teams and dilute returns.
We are also finding select investment opportunities among oil field services companies and believe the likelihood of a wave of bankruptcies in the space, coupled with the flight of labour from the industry, could enable the survivors to raise prices for the first time in a long while. Moreover, with E&Ps slashing capital expenditures in response to crashing oil prices, there is the potential for a snapback in spending on services, as crude prices and activity levels recover.
Shawn Driscoll is portfolio manager of the T. Rowe Price Global Natural Resources Equity fund. The views expressed above are his own and should not be taken as investment advice.