We keep receiving questions from readers that boil down to the following:
Can you explain the conundrum: a powerful recovery in oil prices is underway but Oil & Gas stocks are still lagging the broader market?
To determine if there is any disconnect between equity prices and commodity prices, it might be helpful to get some facts on the table first.
Stocks In The Oil & Gas Sector Have Indeed Lagged Year-To-Date
Keeping track of stock price moves in this volatile sector can be a challenge. Therefore, we thought it might be helpful to provide a quick performance scorecard for various segments, with particular focus on North American Oil & Gas. (We recognize that our stock selections and the choice of the starting date are ad hoc but hope the comparison vs. commodity prices would still be helpful to readers.)
As one can see from the tables below, despite the recent spectacular recovery from the mid-summer lows, the vast majority of our segment samples are still trading in the negative territory year-to-date. With few exceptions, the groups are lagging the S&P 500 by a very wide margin – in many cases, by as much as 30%-40%.
The performance summary above suggests that many of the investors who started the year with an overweight position in Oil and Gas may be feeling bitterly disappointed today, even if they persevered and avoided cutting their positions at much lower levels this summer.
We must note the importance of stock picking, given the wide range of performance across each segment. For example, among Oil Majors, Exxon Mobil (XOM) has been a disappointment, lagging the S&P 500 by a hefty 22% (see our recent discussion). On the other hand, Royal Dutch Shell (RDS.A) (NYSE:RDS.B) outperformed the S&P by 4%. Another example would be Rice Energy (RICE), one of OIL ANALYTICS’ “best ideas” in 2017, which was up 37%, while its peer Southwestern Energy (SWN) declined 38% during the same period.
Bloggers’ Favorite Breaking News: “Brent Is Breaking Out!”
The poor year-to-date performance by many stocks in the sector must look particularly puzzling to those investors who source their fundamental intuitions from historical price graphs for crude oil.
The price graph for Brent has been particularly popular with some financial bloggers (with titles like “Crude Oil Is Breaking Out!”, “The Breakout Is Confirmed!”, “Crude Oil To Go Higher!” inundating financial sites).
Indeed, the graph above may help to solidify the sentiment that the fundamental environment for oil producer stocks has improved dramatically year to date. Not only is the current price for Brent significantly higher than a year ago, it also comes off a 12-month period when prices were quite firm, for a change – as compared to the very challenged 2016. The price action in crude appears to be telling us that the oil cycle has turned and the lagging stock prices should catch up any minute.
Or does it?
The historical price graph above does not tell the entire story. We invite readers to look at a different graph – below. The graph compares the current futures curve for WTI versus the curve at the very beginning of this year. The comparison reveals several important nuances that are concealed by the spot price graph above.
On Friday, November 10, the 2018 WTI strip settled at a respectable $57 per barrel. The historical comparison shows, however, that this price level is almost identical to what the market was expecting at the very beginning of this year.
Looking further out on the curve, one would notice – and this may come as a surprise to some readers – that the commodities market is now a lot less optimistic about the longer-term sustainability of the higher oil prices than it appeared to be at the beginning of this year. The 2021 strip is now trading at just $51 per barrel, significantly below the $56 per barrel that the market was prepared to pay for the same deliveries on December 30 last year. For an oil producer in the U.S., this makes a big difference in terms of expected drilling economics and value creation.
When comparing the two curves, it is also important to note that 2017 was another year of poor cash flow generation for oil producers. WTI prices have averaged just $49.65 year to date, significantly less than what the futures market predicted at the start of the year. At those prices, few operators were equipped to generate adequate fully-loaded returns.
Even if the futures curve were in the exactly same position today as it was at the beginning of the year, the weaker than anticipated cash flows in 2017 likely account for several percentage points of the observed underperformance by the stocks, everything else being equal.
U.S. Oil Producers Are Paid Mostly In WTI, Not Brent
The improvement in Brent prices has been indeed very inspiring, as Brent is arguably a better indicator of the global supply/demand balance than WTI is at the moment. Brent set a new recent high watermark last week, settling above $64 per barrel. However, the Brent curve is in an even steeper backwardation than WTI (which reflects hurricane effects), trading below $58 per barrel for 2021 deliveries.
For those oil producers who benchmark their price realizations off Brent or other waterborne grades, the improvement in oil prices is indeed quite material. It is no surprise that Oil Majors have outperformed U.S. E&P stocks.
However, quite often those producers who are paid off Brent are also the producers who have been losing their market share to U.S. shales and low-cost OPEC exporters. Their upside from the big upward move in Brent is often diluted by the effect of the production sharing contracts. At the same time, the perception of those producers’ competitive challenges has been reinforced by the continued success of the U.S. shale industry demonstrated over the last year.
Costs Are Higher
The list of factors that are likely contributing to the lag by U.S. Oil & Gas equities would be incomplete without two important ones that appear to be often overlooked: costs and hedging.
With the massive acceleration in the pace of activity in the U.S. Land, the cost of bringing new wells online for U.S. shale operators has increased dramatically since a year ago. In our assessment, cost inflation in 2017 exceeded the pace of productivity gains. As a result, higher oil prices are required going forward to achieve the same drilling returns.
On the revenue side, hedges can become a headwind for the industry going into 2018. Many operators have swapped a portion of their 2018 volumes at prices significantly below the current futures curve. While hedging provides certainty to business plans, should commodity prices sustain strength in 2018, hedges will be a drag on near-term cash flows and production growth.
In our continued assessment that we have discussed extensively with our subscribers, the improvement in global oil fundamentals has been detectable since March 2017. This improvement is finally bearing fruit in the form of stronger commodity prices. Moreover, the U.S. Shale Oil industry has been in a solid upcycle for more than a year.
We must note, however, that the current futures curves for oil appear to signal the market’s increased belief that the shales will steadily grow supply as long as WTI price remains above $55 per barrel and grow it even faster if WTI prices climb above $60 per barrel. This appears to be one of the causes for more conservative valuations reflected in the current stock prices. The valuation optimism seen a year ago – in some cases, euphoria, as we discussed on multiple occasions – has visibly subsided.
When assessing fundamental drivers for equities, it is also important to take into account the “pains of the upcycle.” Thanks to the rapid expansion of U.S. shales’ core footprint, higher prices will inevitably give rise to a wave of short-cycle drilling activity, which will program higher production volumes for the near term. The upcycle also impacts the industry’s cost structure. The increase in commodity prices often suffers many big dents by the time it trickles down to the company’s bottom line. From an equity perspective, these factors contribute to pressure on future margins and, therefore, valuation.
That said, we believe in general that the fundamental outlook for Oil & Gas equities looks the most favorable it has in three years and the lag versus the S&P 500 in some specific situations is too wide to ignore. While stocks in the sector are risky, we see multiple intriguing risk/reward opportunities, which we continuously discuss with our subscribers.
About OIL ANALYTICS
OIL ANALYTICS remains one of the most active offerings on Seeking Alpha’s Marketplace, with 450+ exclusive materials posted for its members since the beginning of this year alone (a total of over 1,300 non-public materials available to members).
Our macro and company-specific views are continuously illustrated in our Model Portfolio and Best Stock Ideas modules.
To illustrate some additional aspects of our work, through our analyses OIL ANALYTICS more than once accurately anticipated technical corrections in crude oil and technical corrections in natural gas, as well as several subsequent “bounces” and corrections.
Disclaimer: Opinions expressed by the author in materials included in Zeits OIL ANALYTICS subscription service or posted on Seeking Alpha’s public site are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned or commodities and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies’ SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author’s best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.