Fundamentals of the Oil & Gas industry are improving from the depths of the Covid-19 sell-off

Summary

  • Fundamentals are improving from the initial COVID-19 sell-off.  Near term, the trajectory is closely tied to the pace of economic activity affecting oil demand.  The Conference Board’s December 9, 2020 base-case US GDP forecast calls for second-half weighted 3.6% annual growth in 2021.
  • OPEC estimates that oil demand will not return to 2019 levels until 2022 at the earliest.  Long term, the organization estimates that oil demand will rise 9.4 MMb/d to 109.1 MMb/d in 2045 from 99.7 MMb/d in 2019.  Non-OECD economies, especially India, are expected to grow demand offsetting contraction in the OECD economies. 
  • In their December 2020 report, EIA estimates WTI oil prices will average $45.78 in 2021, compared to $38.96 in 2020.  EIA estimates that monthly spot natural gas prices will average $3.01 in 2021, compared to $2.07MMBtu in 2020. 
  • The shale revolution, which allowed the US to become the largest oil producer in the world, is maturing.  Producers are focused on improving capital efficiencies through cost control and development plans focused on improving the net present value of projects.   
  • The structural shift in oil prices that began during the second half of 2014 and the wave of bankruptcies that followed exposed the dangers of high financial leverage in a cyclical industry.  Producers are responding by shifting to a more sustainable model geared toward spending 60% to 80% of cash flow on exploration and development and dedicating the remainder to balance sheet improvement and/or return to shareholders. 
  • Corporate consolidation has picked up in 2020.  The strategic rationale behind most recent announcements has been to gain scale and high-grade capital allocations options, to reduce overlapping costs, and to increase free cash flow generation potential.  Enhancing Permian Basin asset positions has been the focus of many of the recent combinations. 
  • Many institutional investors are incorporating an ESG framework in their portfolio construction.  For now, much of the industry’s ESG reporting has concentrated on CO2 and methane emissions along with water usage.  Companies are evaluating ways to decrease the carbon intensity of their operations to appeal to a broader investor universe.
  • Energy shares, as represented by the XLE Sector Spyder, have underperformed the S&P 500 by about 125% over the past five years. The XLE has posted substantial gains since the COVID-19 collapse in March/April 2021.  The industry faces obstacles in the form of an uncertain demand outlook related to the economic impacts of COVID-19 in the near term and competing for attention in a world transitioning toward lower carbon intensity in the long term.  The energy transition will occur over decades, during which oil and natural gas will continue to serve as vital fuel sources and chemical feedstocks.