From Well To Pump: Opportunities Within The Energy Sector

|
Includes: FILL, IEO, IEZ, IXC, IYE
by: Christopher Dhanraj

Summary

The price of crude oil has risen sharply over the last 12 months, outpacing shares of energy companies.

In energy equities, we like exploration and production firms and midstream companies. We see the favorable backdrop for crude persisting.

We acknowledge that investing in the energy sector has been deeply unprofitable for much of the post-crisis period until recently.

Crude oil has been one of the best performing assets of over the last 12 months, rising by more than 30%, albeit from a low base.1 Over this time horizon, the asset has benefited from various economic and geopolitical tailwinds.

  • The price of crude oil has risen sharply over the last 12 months, outpacing shares of energy companies. Equities have just started to catch up on the back of the supportive commodity backdrop and earnings picture. We believe there is currently a stronger case for considering energy equities than crude itself over the short term.
  • In energy equities, we like exploration and production firms and midstream companies. We see the favorable backdrop for crude persisting.
  • We acknowledge that investing in the energy sector has been deeply unprofitable for much of the post-crisis period until recently. We also identify several risks to this trade, including a slowdown in global growth, increasing U.S. production levels, and a fast appreciation of the U.S. dollar.

Supply and demand dynamics

Synchronized global growth has increased demand for energy, while on the supply side high compliance levels with Organization of Petroleum Exporting Countries (OPEC) production cuts have aided in the balancing of global oil inventories. This dynamic has allowed global crude oil inventories to balance toward a deficit, which has led to expectations of surplus crude oil demand, the first time this has occurred since 2014 and a trend that is expected to continue into 2019 (Figure 1).

Geopolitical risk premium

Geopolitical events have also supported the commodity's increase in price. According to the New York Federal Reserve's Oil Price Dynamics Report, the level of oil price changes that are driven by non-supply factors-which can be inferred as "noise" surrounding geopolitical developments-is at its highest level since 2014. This suggests that perceptions of geopolitical developments have impacted oil before they have materially affected supply. For example, the U.S. departure from the Iranian deal, plus the threat of sanctions, did not immediately hinder Iranian supply lines, but the market reacted as if it did.

Figure 1: World oil demand is expected to outpace supply through 2019

Source: Thomson Reuters, as of 5/15/18. There is no guarantee that the forecast will come to pass.

Figure 2: Crude oil price change due to "noise" is at its highest level since the 2014 crude sell-off

Source: New York Federal Reserve, Oil Price Dynamics Report, Haver Analytics, Thomson Reuters, Bloomberg, as of 5/15/18. Residual reflects price movements unexplained by supply and demand factors. Supply, demand and residual sum to Brent crude price.

Reasons to consider energy equities

We find that a favorable economic backdrop for crude oil will likely persist, but note that crude oil prices have run well ahead of energy stocks this year.2 At the same time, we find confidence in energy firms' capital discipline, evident in first-quarter earnings results.

Unlike in some past oil market rallies, companies are not making huge investments in future production. Instead, they are using free cash flow to return capital to shareholders via increased buybacks and dividends. Figure 3 highlights how capital expenditure has fallen in S&P 500 energy names.

Additionally, current oil prices offer potential upside for energy companies' earnings and stock prices. Most energy companies have budgeted for mid-$50s oil prices in 2018, with this conservative outlook reflected in share prices today. This points to valuation upside should current levels of oil prices be sustained.

Figure 3: Capital expenditure has fallen, helping support free cash flow (NYSE:FCF) growth

Capital expenditure

Source: Thomson Reuters, as of 5/15/18. Notes: The figures are amalgamations of individual free cash flow and capital expenditure within the S&P 500 Energy Sector. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Overview of energy sub-sectors

Not all energy exposures are created equal. The various operations of energy firms can create differing sensitivity to crude oil prices. The major categories of operational functions within the energy sector are:

  • Upstream: Firms involved in upstream operations find and produce crude oil. Major sub-sectors within this space include exploration and production firms (E&Ps), and firms that provide equipment and services for exploration and extraction. Shares of these tend to be most sensitive to oil prices.
  • Midstream: The midstream function is involved in the transportation and storage of crude oil and natural gas. This includes pipelines and secondary logistics (trucking, rails, and barges).
  • Downstream: The downstream function of the industry refers to the preparation of crude oil for retail use, including oil refiners, petroleum products distributors, and retailers. Certain downstream firms (i.e. refiners) may be relatively insulated if crude prices were to fall as crude oil is an input cost for their output (gasoline or other distillates). For example, refiners benefit from a wide crack spread-the difference between the input cost of crude oil and the selling price of gasoline-and can therefore perform well in periods of low oil prices if retail gasoline prices remain elevated.

Our view: The divergence of operational exposure to crude drives different sensitivities to changes in raw crude prices. Figure 4 identifies the beta of different energy exposures to changes in West Texas Intermediate (NYSE:WTI) crude oil, a commonly used benchmark oil price, since 2012, capturing the highs of 2013 to the lows of 2016. Oil equipment and services firms and E&Ps have the highest sensitivity.

However, we note a recent dislocation between oil prices and energy equities. Energy equities have persistently underperformed crude prices over the past two years (Figure 5). Now, the stronger crude oil environment and diminished capital expenditures have found their way into U.S. energy sector earnings. Forward earnings growth for the MSCI USA Energy Sector has outpaced all other U.S. sectors. As oil prices established technical support around $50 in mid to late 2017, the performance of energy equity subsectors diverged (Figure 5). Going forward in energy equities, we like exploration and production firms and midstream companies because of their exposure to crude and capital discipline.

Figure 4: Upstream exposures have the highest sensitivity to changes in crude prices

Upstream exposures

Source: Bloomberg, as of 5/15/18. Beta of weekly returns since 1/1/12. Beta is a measure of how much an asset or security moves relative to the rest of the market. A beta of 1 indicates assets move in synch. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Figure 5: Energy equities have underperformed crude oil amid the oil price rally

Source: Thomson Reuters, as of 5/15/18. Relevant indexes are the Dow Jones U.S. Oil & Gas Index, the Dow Jones U.S. Select Oil Exploration & Production Index, and the Dow Jones U.S. Select Oil Equipment & Services Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Risks:

Investing in the energy sector over the past decade has been a difficult task. E&Ps and oil equipment services firms have had three times the volatility than that of the S&P 500 over the last three years3. We encourage investors to evaluate the risks to both energy equities and crude oil:

  • A slowdown in global growth: Global growth has remained elevated over the past two years. However, recent PMI data has been choppy the last couple of months, against a backdrop of trade uncertainty. Trade wars have the potential to slow economic growth both through the actual physical trade of goods and services and impacting investment and business confidence.
  • Increasing global production levels: Global production levels will be crucial to monitor going forward. One of the major factors that drove energy prices lower in 2014 was the increase of U.S. production levels. Efficiencies achieved by U.S. shale producers challenged OPEC crude market share, a pivotal catalyst in OPEC's decision to oversupply the crude market in 2015 (Figure 6). Constructively, the price impact of high U.S. levels of production has been balanced by record high levels of U.S. exports against a backdrop of surging demand. However, the potential elimination of OPEC production cuts in the longer term also provides a downside risk.
  • A rising U.S. dollar environment: 2017's dollar weakness supported risk assets broadly. A particular beneficiary have been commodities, which tend to be priced internationally in U.S. dollars. However, the dollar is up over 5% since the multi-year lows experienced in mid-February4. Further upside could challenge commodities.

Figure 6: Key risks to monitor - U.S. production levels

U.S. production levels

Source: Thomson Reuters, as of 5/15/18.

This post originally appeared on the iShares blog.

© 2018 BlackRock, Inc. All rights reserved.

1Source: Thomson Reuters, Oxford Economics, as of June 5, 2018. The bars represent Oxford Economics' forecasts for global supply and demand. 2Source: Thomson Reuters as of June 5, 2018. This is a year to date analysis. Crude oil is being tracked by the WTI benchmark and energy stocks by the S&P 500 Energy Sector Index. 3Source: BlackRock, Thomson Reuters as of May 15, 2018 using the Dow Jones U.S. Select Oil Exploration & Production Index and Dow Jones U.S. Select Oil Equipment & Services Index. Volatility is defined as the annualized standard deviation of daily returns over the last three years. 4Source: Thomson Reuters, as of June 5, 2018.


Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds' prospectuses or, if available, the summary prospectuses, which may be obtained by visiting the iShares Fund and BlackRock Fund prospectus pages. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets or in concentrations of single countries.

This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

This document contains general information only and does not take into account an individual's financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, "BlackRock").

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Barclays, Bloomberg Finance L.P., BlackRock Index Services, LLC, Cohen & Steers Capital Management, Inc., European Public Real Estate Association ("EPRA® "), FTSE International Limited ("FTSE"), ICE Data Services, LLC, India Index Services & Products Limited, JPMorgan Chase & Co., Japan Exchange Group, MSCI Inc., Markit Indices Limited, Morningstar, Inc., The NASDAQ OMX Group, Inc., National Association of Real Estate Investment Trusts ("NAREIT"), New York Stock Exchange, Inc., Russell or S&P Dow Jones Indices LLC. None of these companies make any representation regarding the advisability of investing in the Funds. With the exception of BlackRock Index Services, LLC, who is an affiliate, BlackRock Investments, LLC is not affiliated with the companies listed above.

Neither FTSE nor NAREIT makes any warranty regarding the FTSE NAREIT Equity REITS Index, FTSE NAREIT All Residential Capped Index or FTSE NAREIT All Mortgage Capped Index; all rights vest in NAREIT. Neither FTSE nor NAREIT makes any warranty regarding the FTSE EPRA/NAREIT Developed Real Estate ex-U.S. Index, FTSE EPRA/NAREIT Developed Europe Index or FTSE EPRA/NAREIT Global REIT Index; all rights vest in FTSE, NAREIT and EPRA."FTSE®" is a trademark of London Stock Exchange Group companies and is used by FTSE under license.

©2018 BlackRock, Inc. All rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, BUILD ON BLACKROCK, ALADDIN, iSHARES, iBONDS, iSHARES CONNECT, FUND FRENZY, LIFEPATH, SO WHAT DO I DO WITH MY MONEY, INVESTING FOR A NEW WORLD, BUILT FOR THESE TIMES, the iShares Core Graphic, CoRI and the CoRI logo are registered and unregistered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

This post originally appeared on the iShares blog.