Why oil, gas stocks deserve a rethink

Oil and gas stocks were undervalued and under-owned even before the pandemic, but they have been even more unloved since the collapse in global demand in 2020. We have previously explored the case for energy infrastructure and pipelines in particular, but, as always, our recommendation is not just built on today’s valuations, but on the larger macro environment of this theme.

The COVID-19 pandemic caused significant interruptions in the production and storage of oil, as we saw last April when the price per barrel of u.s. crude briefly went negative. but it also resulted in a drastic sector cutback in capital expenditures, given the demand detonation globally and uncertainty around the virus’s trajectory and economic recovery.

Indeed, the International energy Agency has estimated that upstream oil and gas investments — meaning those in the exploration and production of oil — fell 28 per cent globally in 2020. by comparison, during the severe oil market downturn in 2015 that decimated many producers (particularly in the u.s. and Canada), these investments fell only 12 per cent. On top of that, producers looked for ways to economize and increase efficiency during the last downturn and now have fewer options available to mitigate the current shock to their balance sheets.

These kinds of distortions take time to make their way through the market and will no doubt act as a tailwind behind oil prices in 2021 — we’ve already seen the price of a barrel of WTI surge 24 per cent so far this year. Of course, this week’s historic winter storms in Texas haven’t helped the situation for the u.s., either: whole segments of the industry, from pipelines to refineries, have been forced to shutter due to frozen equipment and rolling blackouts.

Overall, u.s. supply is expected to remain subdued with the energy Information Administration (EIA) reference case outlook forecasting that domestic crude production will not return to 2019 levels until 2023. On a global level, Saudi Arabia had previously signalled a desire to continue supporting prices as well, though with the recent announcement that the kingdom will start increasing production by one million barrels per day after March, there remains significant uncertainty around the global supply.

but this uncertainty is nothing compared to the lack of clarity on the demand-side. Given the tepid recovery in economic activity, u.s. demand for oil remains eight per cent below where it sat in February last year. We know that demand will eventually come back. The question is how quickly this happens: will a second-half surge in spending and travel materialize and, if so, what will the Saudi reaction be to the upward pressure that puts on prices?

Though our outlook tends to favour only a short-term bump in pent-up demand later this year, it is possible that even a small recovery in the face of supply constraints could lead to a short-term swell in oil prices in the back half of 2021. And we can’t rule out a soaring recovery in road travel and gasoline demand as the economy comes back to life, given that travel abroad will no doubt be the last to come back.

Longer term, there are significant headwinds to oil and gas from the shift towards renewables, but peak oil is likely still years away. Again, looking at EIA forecasts, u.s. production is expected to increase until 2030 and then plateau, rather than crater over the subsequent two decades.

Granted, if President Joe biden’s plan to reach “net-zero” emissions by 2050 gains steam, the baseline forecast could be drastically cut within the next few years. However, we also have to remember that it’s not necessarily a zero-sum game: many of the traditional oil and gas companies have also been investing heavily in renewables (solar, in particular) to hedge against the risks of a future with less oil-dependency.

The bottom line is that while the conventional energy space has been valued for extinction, absent significant leaps forward in alternative energy sources and the widespread adoption of electric vehicles (which have their own environmental issues related to mining and e-waste from batteries), the future is one in which petroleum products will continue to play a major role. In the meantime, amid the current market backdrop where value and yield are scarce, the energy players offer low-cost access to an income stream in a sector in which the bad news is likely already priced in.