Well-Positioned Energy Companies Stand to Benefit from a Rebound in Oil Prices
By Juliana Bogoricin
Capital Group Equity Analyst
Considering oil’s sheer size and importance to the global economy, the upheaval it has experienced over the past two years has been stunning. Demand for crude oil had been healthy for many years until a slowdown in China’s previously voracious appetite exposed a worldwide supply glut. Oil prices eventually lost about three-quarters of their value, before the market stabilized early this year and began a partial recovery. There’s little doubt that petroleum prices will continue to gyrate given the uncertainty hanging over the global economy. But I believe the current rebound is genuine and that prices are positioned to move higher.
The oil rally has been paced by significant production cuts among U.S.-based shale oil drillers. The number of rigs in operation has been dropping for more than a year, although actual production only began to taper off in January as output from older wells declined and cascading prices squeezed a growing number of companies out of the market. Even though crude prices have rebounded from their lows, it’s doubtful that production will ramp up meaningfully in the near future because of the time lag involved in securing investment capital, rehiring crews and relaunching production.
A few other factors have contributed to the budding recovery in oil. Inexpensive gasoline has prompted motorists to increase their driving and to buy more cars, especially larger vehicles with low fuel efficiency. Unexpected production outages in Canada and Nigeria have also had an effect of late.
Energy stocks often closely parallel oil prices, so continued improvement in the crude market could bode well, particularly for shares of large integrated energy companies. These businesses have the financial strength to weather the troubles roiling the industry. It’s critical for investors to be selective because some companies are better positioned than others to withstand long periods of uncertainty and benefit from changing market conditions. I favor those with good management teams, disciplined capital allocation, strong balance sheets, reliable dividends and attractive valuations.
The excess inventory that dominated the headlines in recent months has made it easy to overlook another factor going the industry’s way — demand has been strong in reaction to lower prices. The world’s appetite for oil is expected to grow a solid 1.4% this year and an additional 1.4% in 2017, according to the International Energy Agency. Although there is still a global surfeit of crude, the supply-demand equation will swing back into balance as steady demand gradually soaks up the oversupply. It could take about a year for inventory to return to historical levels. But as that happens, I expect that petroleum prices will edge up.
The long-term outlook for the oil industry is more uncertain.
Despite encouraging prospects in the near term, the industry is undergoing a fundamental transformation that poses a variety of longer-run risks. Some of these are well-established trends that have little or no relation to the current market tumult. For example, the industry is experiencing a fast rate of depletion, which intensifies the need for constant investment and discovery of new fields to offset the maturation of existing wells as they run dry. Similarly, global concerns about climate change, coupled with increasing strides in energy-efficient vehicles and consumer appliances, are sure to eat into oil demand over the next decade.
Other challenges confronting the oil sector are directly tied to the current upheaval. Most notable is the emergence of U.S. shale oil, which has upended some of the deeply ingrained dynamics that had long underpinned the industry. For decades, whenever recessionary conditions caused petroleum demand to slow, the Organization of Petroleum Exporting Countries cut production to prop up prices. In a sense, OPEC’s ability to act as a shock absorber meant that oil prices weren’t truly set by the free market. The new competition from shale producers has diminished OPEC’s ability to support prices. Even as crude prices skidded in the past two years, OPEC repeatedly refused to curb output because its members feared that slashing production would effectively cede market share to shale rivals.
The industry will have to spend wisely to discover new oil reserves.
The uncertain pricing environment will turn up pressure on oil companies to make smart decisions about capital allocation and operational efficiency. The nature of the business requires companies to make huge up-front expenditures to find and develop oil. It typically takes several years for those investments to be recouped and for individual projects to become profitable. Given demand growth and depletion, companies must work hard just to maintain production at current levels.
Historically, oil companies have spent heavily to discover and develop new reserves, sometimes with little concern for the realistic chances of turning up long-lasting and profitable projects. The mentality became “growth at any cost.” The companies that succeed going forward will have to exercise discipline in their exploration- and development-related outlays, carefully weighing the costs against the potential upside. Put simply, there’s less room for error and it will be more important than ever to avoid investing in projects that fail to justify their cost of capital.
Of course, it will take a number of years — and, in some cases, decades — for all of these dynamics to play out. In the meantime, the energy sector stands to benefit from worldwide population and economic growth, particularly in developing countries, where demand for crude will rise as more people reach the middle class. The energy sector has always been cyclical, but the decreased power of OPEC to control prices means that it may become increasingly volatile in the years ahead. There are likely to be long-term winners, but it will be essential to stay on top of which companies will be able to successfully navigate the shifting terrain.
Juliana Bogoricin is an equity analyst covering the U.S. and European energy sectors. Based in New York, she has five years of investment industry experience and joined Capital Group last year.