Weekly View: Big Dollar Energy - Get Used to Higher Energy Prices

SUMMARY

• OPEC’s supply constraints have allowed prices to more than double since November 2020.
• If shale drillers re-enter the market, we believe it’s unlikely they will overproduce.
• Thus, energy prices will remain elevated for the foreseeable future, in our opinion.

As society grows more comfortable incorporating Environmental, Social, and Governance (ESG) in portfolio decisions, the energy sector has been in the spotlight. Those responsible for making investment decisions no longer look solely at traditional energy sources that include petroleum, hydrocarbon gas liquid, natural gas, coal, and nuclear. Instead, renewables (solar, geothermal, wind, biomass, and hydropower) are considered as alternatives. However, despite the rise of ESG considerations in the energy space, oil is still at the top of the energy pyramid reflected by recent demand. The global pandemic slowed the demand for oil over the last 18 months but as the virus has waned, economies re-opened, and winter nears, demand is driving up the price of oil, in our opinion. The oil benchmarks Brent crude and the US West Texas Intermediate (WTI) both have seen their prices more than double in the last year since bottoming November 2, 2020. We believe that higher prices will be maintained as long supply constraints remain in place.

What is Behind Rising Prices?

Higher oil prices are the result of both reduced production by top oil suppliers and a demand rebound close to pre-pandemic levels. For example, OPEC responded to the sharp decline in global demand in 2020, by cutting production by 10 million barrels a day (approximately 11% of production). In an effort to stabilize prices over the last year, OPEC and its allies have increased production incrementally, with the goal of eliminating the production deficit by April 2022.

Prior to the pandemic, global oil demand reached nearly 100 million barrels per day but fell to 83 million barrels per day in June 2020. Fast forward a year and demand was 95 million barrels per day as of the end of June 2021, according to the International Energy Agency (IEA). As the global economy emerges from the pandemic, energy consumers are returning to work and traveling for leisure, creating additional demand for energy. Additionally, we are heading into winter months when historically stockpiles are drawn down thus helping to maintain current pricing until spring.

While OPEC and its allies were successful in propping up oil prices, shale drillers have forgone the opportunity to add supply to a constrained market largely due to reduced funding from private equity investors as they move to investments that are more climate change friendly. Thus far it does not appear that the shale industry is gearing up to join the party, as the number of drilled-but-uncompleted (DUC) wells has dropped from 8,934 wells in mid-2020 to 5,385 wells as of September. However, we believe that if prices continue to rise, currently above $80 for both Brent and WTI, shale drillers in the high-production areas of Texas and Oklahoma will be enticed to begin pumping oil again. The two charts below show that shale drillers in these areas have a breakeven of around $30 per barrel for existing wells and around $50 per barrel for new wells according to a 2021 survey done by the Dallas Federal Reserve, leaving plenty of room for profit at today’s elevated prices.

Profitability is even greater for shale drillers that can take advantage of today’s high natural gas prices since they can sell this natural by-product instead of flaring it (burning it off). Currently, natural gas prices are trading between $5 and $6 per Metric Million British Thermal Unit (MMBtu), which makes drilling more profitable if shale companies choose to sell the gas in addition to the oil.

Is Current Pricing Sustainable?

The question that investors are asking is whether current pricing levels are sustainable? The answer to this is complex but we will attempt to answer it in short order. First, we will look at OPEC’s production capacity which currently is estimated to be roughly 34.5 million barrels per day but as of September, the group was only producing slightly less than 27.5 million barrels per day. Given that there is spare capacity of approximately 7 million barrels per day, current pricing is sustainable if all members of OPEC stay in alignment, in our opinion. If any member decides not to comply and increases their production, current prices will come under pressure. In the US, there is a similar dynamic when we explore shale production. In 2019, the US shale producers were pumping just over 9.4 million barrels per day compared to slightly over 8.7 million barrels per day currently.

Conclusion:

The energy sector represents less than 3% of the S&P 500. However, it has a larger impact in our daily lives, from transportation and raw material costs for companies, to impacts on food, travel, and housing costs for consumers. Given the rise in oil prices, we believe shale drillers may re-enter the market. Additionally, in the near-term we believe the industry has learned from previous missteps and will not overproduce, keeping energy prices elevated for the foreseeable future. Currently, our portfolios are positioned broadly neutral to US energy, as we acknowledge that volatility could pick up in the sector if there are bad actors either amongst OPEC or the shale drillers.