Demand doubts dampen investor sentiment
Concerns over the long-term future of oil exercise US investors’ thinking
The European financial community has harboured growing concern over the longer-term prospects for oil demand for a few years. But the collapse in US oil and gas (O&G) share prices is testament to a shift there too, with investors no longer bullish on robust long-term demand—particularly given the increasing prominence of the transition to lower carbon energy.
This change in sentiment implies relatively less US oil development activity and threatens to shrink the industry permanently.
Investor confidence in the US O&G industry, both in E&P and the offshore services and equipment (OFSE) sector, has eroded gradually since the start of the last downturn in late 2014. But this had stemmed mainly from the inability of, or lack of prioritisation by, both the E&P and OFSE sectors in generating adequate financial returns.
Investors also grew concerned that the industry would be a victim of its own success—that is, that the US oil industry’s ability to grow its productive capacity through the shale revolution threatened to keep oil prices lower for longer and thus constrain earnings. US O&G equities significantly underperformed the broader stock market as a result—equity indices representing the E&P and OFSE sectors underperformed the S&P 500 index by 136 and 140 percentage points, respectively, from mid-2014 through to 2019.
But, even with this underperformance, the valuation of these sectors’ shares, even as late as 2019, still suggested that investors expected robust global oil demand for oil and continued growth of US production. It was only in 2020 that share prices, as they collapsed further, began to point to a loss of that longer-term conviction, even if much of the weakness early in 2020 can be attributed to indications of both E&P production growth in 2020 and slowing near-term demand growth for oil.
In the first two months of the year, the S&P oil & gas exploration & production select industry (SPSIOP) index and the Philadelphia oilfield services (OSX) index fell by 35pc and 33pc respectively versus an S&P 500 down by 9pc and the WTI benchmark crude price, which was down by 27pc. Declines accelerated dramatically in March as the oil industry confronted the risks of unprecedented demand loss for oil related to the Covid-19 pandemic and the breakdown of Opec+ cooperation that resulted in higher production, although the E&P sector then posted dramatic trading gains in April, far outpacing the stock market recovery and WTI.
A global focus on lowering the carbon intensity of energy—and ESG investing more generally—is finally becoming a more relevant investment consideration in the US
Nonetheless, by 6 May, the SPSIOP and OSX had fallen by 47pc and 65pc respectively year-to-date versus an S&P 500 down by just 12pc.
Two points are useful to explore the sector’s weakness in 2020 further. The first is anecdotal: conversations with investors support that a global focus on lowering the carbon intensity of energy—and ESG investing more generally—is finally becoming a more relevant investment consideration in the US.
The second, as is described in a little more detail, involves multi-year forecasting of companies’ cash flow generation. From these forecasts, one can derive that current equity share prices are consistent with a long-term oil price that is below the cost of production for much of US tight oil. This can reflect doubt that the US will be able to, broadly, economically produce oil to current capacity over the medium-to-long term. Instead, lower global oil demand will be satisfied largely by lower-cost oil sources.
It is important to note some caveats to this narrative. The idea of asking “What are the stocks telling us?” is predicated on the view that the stock market is adept at guessing the future, certainly more so than any individual. There is plenty of evidence to support this in the long-term, but it can take time for the market to incorporate big macro shifts, such as in the current oil supply-demand picture.
Smoothing the volatility created by aggressive selling and/or buying—with the last two months a perfect example as investors chased after E&P shares in April that were “beaten up” in March—can also take time. In addition, company financial forecasting includes scores of assumptions, so, at best, it yields directional interpretation, as opposed to precise predictions.
Acknowledging such caveats, financial modelling conducted by US financial services firm Simmons Energy, a division of Piper Sandler, suggests that E&P share prices relatively early in March reflected a long-term US oil price expectation of under $40/bl, compared with a current US all-in production cost of closer to $50/bl.
47pc - SPSIOP year-to-date fall by early May
For E&Ps, the financial modelling includes detailing both a company’s existing portfolio (of existing wells and evaluated prospects, known as proved developed reserves) and potential opportunities (undeveloped and non-proved developed reserves) to estimate the company’s future hydrocarbon production. Thus, one can infer the price of oil and natural gas over time that the share price of an E&P company is reflecting—because the share price should reflect the present value of expected future cash flows.
The exercise can be repeated for US OFSE firms, although the financial exercise is much less straightforward. But current share prices appear to incorporate a view that a so-called ‘normalised’ level of earnings/cash flow is likely to decline over the long-term (known as a negative terminal growth rate)—again consistent with the idea that not as much US oil will be required and therefore oil firms will not spend as much to develop it.
A bias about long term shrinkage in the US oil industry is pernicious because it may be self-fulfilling. If sources of capital do not believe in the industry’s prospects, they will not provide adequate levels of finance.
The US O&G industry can help itself by showing its commitment to delivering financial returns and lowering its costs structurally. But, if investor and creditor concerns about declining demand are too great, the only path forward for the industry includes getting much smaller.
Professor Morgan Bazilian is the director of, and Brad Handler is a non-resident fellow of, the Payne Institute for Public Policy at the Colorado School of Mines