How will energy companies fare in 2024?
Energy stocks, are we at the end of the bearish phase? Analysis by Shinwoo Kim Portfolio Manager, Global Natural Resources Equity Strategy, T. Rowe Price
The bear market in oil and natural gas that has lasted for more than a decade appears to be coming to an end. This scenario would create a more favorable context for energy investments in the coming years. What is driving this change? There is growing evidence that US shale oil and gas productivity is likely reaching a peak.
The importance of productivity
Many factors can influence energy prices in the short term, from geopolitics, weather conditions, to the health of the global economy. Our approach to investing in energy and other commodities focuses primarily on structural changes in productivity that drive prices over the long term.
These cycles typically last 10 to 20 years and reflect the ups and downs of two waves: First, rising productivity: Disruptive technologies allow oil and gas companies to extract greater quantities of raw materials from the ground at a lower cost. inferior. This surge in productivity puts downward pressure on break-even costs prevailing in the industry, reducing commodity prices, a much-needed incentive for operators to pursue new projects. This is a bearish setup for commodities. Second, productivity declines: the incremental gains in raw material production generated by these innovations slow, eventually reversing as the technology is exploited to its full potential and the underlying assets mature. New resources become harder to source or more expensive to develop, increasing prevailing break-even costs. This scenario tends to increase the prices of raw materials, which are essential for encouraging investments in new supplies with a view to rebalancing the market. This is a generally bullish setup for raw materials.
The shale oil and gas revolution in the US has produced a surge in productivity, which has fundamentally changed the global energy landscape. But, it seems, this wave is peaking.
Implications for oil and gas prices
The challenge is not that the US is running out of oil and gas. Rather, it appears, the industry is running out of supplies of cheap oil and gas that have driven the prolonged bear market in energy.
To the extent that shale productivity slows, it would cost the sector more to maintain production levels, requiring higher energy prices to incentivize new supplies.
While U.S. shale productivity appears to be peaking, near-term uncertainties justify two reservations: Question marks remain over the timing, magnitude, and speed of deterioration in U.S. shale productivity and oil and gas prices still exhibit a cyclical pattern, or are sensitive to economic fluctuations. Energy prices could still come under pressure if economic weakness impacts demand.
The sustained productivity gains that US shale has enjoyed during the energy bear market have also reduced demand for services and equipment in two ways. As shale operators have pumped more oil and gas into each rig, the number of active rigs has plummeted and the need for other oilfield services has dropped. On the other hand, the resulting overcapacity has affected the prices of services and equipment. Furthermore, the rapid growth and cost competitiveness of US shale has led to a reduction in spending on exploration for new resources and development of offshore fields. Both activities tend to carry greater risks and costs than drilling in established U.S. shale fields. In response to these pressures, oilfield services and equipment companies have cut expenses and reduced excess capacity. Declining U.S. shale productivity would increase demand for oilfield services and equipment, making it more expensive for the oil and gas sector to produce the incremental supply needed to create market equilibrium.
We see greater potential use of international and offshore projects to fill this gap. However, it will be a challenge to grow an industry, where staff numbers and capabilities have been significantly reduced.
Active deepwater drilling rigs, for example, have dropped by about half over the past decade; the reactivation of disused plants or the construction of new plants would entail significant expenses.
There has also been significant consolidation, suggesting that companies involved in oilfield services and equipment may be more disciplined in terms of increasing capacity and improving pricing power than in the past. Ultimately, oilfield service cost inflation could also contribute to higher oil prices. Following a prolonged oil and gas bear market, energy stocks still appear underrepresented in portfolios and undervalued.
In recent years, the sector's weighting in the S&P 500 Index has generally been less than 5%. This is a far cry from the numbers posted from 2007 to mid-2014, when energy consistently represented more than 10% of the large-cap index.
Where to find opportunities?
We find opportunities in oilfield services: as shale productivity peaks, the combination of increased service intensity (after years of capacity reductions) and consolidation could lay the foundation for a favorable multi-year outlook.
And in oil and gas producers. Here we favor companies with a higher mix of quality reserves and a thoughtful approach to developing these assets. Such companies would benefit from low-cost production growth in an era of higher energy prices.
Selection ability will be fundamental. Well-resourced portfolio managers who have followed the energy sector closely throughout the bear market may be well positioned to add value.
What about electric vehicles and oil demand?
We are closely monitoring the growing adoption of electric vehicles and its implications for oil demand. Gasoline accounts for about a quarter of global oil consumption. By our estimates, sales of electric vehicles and electric vehicles equipped with hybrid batteries would need to make up more than about half of global new car sales for oil demand to peak before 2030.
Heavy transportation – planes, freight trucks and ships, for example – poses a greater challenge because this category represents approximately 40% of global oil demand. Decarbonizing these sectors will be much more difficult due to costs and the need for significant innovation. We understand that concerns about peak oil demand could impact energy stock valuations. At the same time, anticipating this risk could limit investment in oil and gas development, even if a peak in oil demand takes longer to materialize. This scenario would push energy prices and inflation higher.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/energia/come-andranno-le-societa-energetiche-nel-2024/ on Mon, 01 Jan 2024 06:53:07 +0000.