The Oil And Gas Industry Likely Heading For A Long-Term Downfall

Summary

• OECD liquids production continues to rise quarter on quarter, putting downward pressure on the price of oil.
• Significant share repurchase programs led by Exxon Mobil and Chevron Corporation keep the share price of these companies from falling.
• In August 2022, India's crude oil imports fell to a ten-month low reaching 4.1 million barrels per day, down 13.8% from the previous month.
• India's economic indicators, including industrial production, continue to deteriorate from year to year, which leads to a slowdown in the country's GDP growth.
• The Chinese government continues its zero-tolerance COVID-19 policy, which leads to a weakening of economic and social activity and thus negatively affects domestic demand for gas and oil.

mysticenergy

Since the publication of my article “OPEC+ Decision Won't Keep Oil Prices High”, Brent and WTI crude futures (CL1:COM) have fallen by more than 7.6%, but at the same time, oil and gas stock prices have remained stable. This indicates a significant deviation between the two asset classes and signals that the shares of such industry mastodons as Exxon Mobil (XOM) and Chevron Corporation (CVX) are overbought.

Source: Author's elaboration, based on Investing.com

Before proceeding to the description of the reasons explaining the persistence of negative dynamics in oil prices, I would like to highlight two main factors that contribute to the preservation of oil stock prices near multi-year highs. The first of these factors is the multibillion-dollar buybacks that are conducted by BP (NYSE:BP), Shell (NYSE:SHEL), TotalEnergies (NYSE:TTE), etc. As you can see in the table below, there is a clear relationship between the amount of money allocated for this purpose and the percentage change in the company's share price over the past year. That is, the larger the share buyback program, the stronger the company's shares have grown over the past 12 months, and vice versa, in the absence of such stimulation, the share price of PetroChina (PTRCY) and Saudi Aramco (ARMCO) have dropped significantly from multi-year highs.

Source: Author's elaboration, based on quarterly securities reports

Let's take a look at the impact of the share buyback program on Exxon Mobil with a 22.87% weight in the Energy Select Sector SPDR ETF (NYSEARCA:XLE), and then move on to Chevron Corporation, which has a slightly lower weight in this index fund at 19.11%.

Source: State Street Global Advisors

With relatively strong performance in the fourth quarter of 2022, Exxon Mobil has authorized a share buyback program worth up to $10 billion over the next 24 months. However, due to a significant increase in oil prices in the first half of 2022, which was caused by the war in Eastern Europe, the company's management decided to increase the buyback program to $30 billion until 2023. As a result, Exxon Mobil's share price continues to remain near multi-year highs and has been in the range of $85-102 per share for the past two months. A similar situation was observed from 2011 to 2015 when high commodity prices contributed to maintaining high investment interest in the oil and gas industry and an aggressive share buyback policy.

Source: YCharts

However, as soon as Exxon Mobil began to reduce the volume of quarterly buybacks of the company's shares, this foreshadowed the formation of a peak in the price of the company's shares in the next 2-3 months, and the trend will change from bullish to bearish. In the first half of 2022, Exxon Mobil bought back the company's shares for a total of $5,986 million, leaving the company's management with about $24 billion left to spend on these purposes. At first glance, this is a significant amount, but it is not so. In addition to the fundamental changes taking place in the energy market at the moment, when referring to historical trends observed from 2011 to 2013, Exxon Mobil bought back the company's shares for more significant amounts, but this did not lead to an aggressive increase in their price. A similar situation was observed with Chevron Corporation when the company's management pursued an active share buyback program from 2011 to 2015, thereby creating upward pressure on the energy giant's share price. However, in the past two years, Michael Wirth, who is the CEO of the company, has not resorted to this type of stimulation. Instead, he used a multibillion-dollar net income to pay off debt, which in my opinion is a more justified decision in a period of rising interest rates and macroeconomic uncertainties. Overall, Chevron Corporation's management still has an ace up its sleeve, which is the share buyback program, which was increased from $10 billion to $15 billion in Q2 2022.

Source: YCharts

The second reason that supports the price of Exxon Mobil and Chevron Corporation shares is the "Warren Buffett effect", which has been actively buying Occidental Petroleum shares since March 2022. These transactions had a positive effect on the growth of investment interest in the entire oil and gas industry and the increase in cash inflows into various ETFs, such as United States Brent Oil Fund (NYSEARCA:BNO), ProShares Ultra Bloomberg Crude Oil (NYSEARCA:UCO), Invesco DB Oil ETF (NYSEARCA:DBO), etc. In the first quarter of 2022, the Warren Buffett-led conglomerate bought about 106.6 million shares of Occidental Petroleum (NYSE:OXY), but the pace has slowed down since then. On August 19, 2022, the U.S. energy regulator granted permission to Berkshire Hathaway (NYSE:BRK.B, NYSE:BRK.A) to purchase up to 50% of the common stock of Occidental Petroleum. Many investors expected that the Oracle of Omaha would then restore the pace of increase in Occidental Petroleum, but Berkshire Hathaway only purchased 5,985,190 shares of the oil company, and that was only five weeks later. Moreover, Warren Buffett's conglomerate didn’t buy a single Occidental Petroleum share in Q4 2022. This situation only increases the uncertainty regarding the prospects for the development of the oil and gas industry in a period of declining commodity prices.

Source: Author's elaboration, based on quarterly securities reports

The significant rise in the value of oil assets in the first half of 2022 is reminiscent of the situation that occurred in 2021 when the shares of pharmaceutical companies rose by hundreds of percent during the massive fear of the COVID-19 pandemic, which supported the investment attractiveness of the sector. Moreover, most retail investors continued to believe in the prospect of bloated companies with product candidates in phase 1/2 clinical trials even after the number of COVID-19 cases began to decline at a substantial pace. As a result, I believe that the shares of companies from the oil and gas industry are near their peak values, and the situation will soon change dramatically, mainly due to falling prices for petroleum products. The first factor that will put downward pressure on oil prices is the increase in its production by non-OPEC+ countries. OECD liquids production was 30.22 million barrels per day for the 2nd quarter of 2022, an increase of 1.09 barrels per day compared to last year. In my estimation, the positive dynamics of oil production will continue in the coming quarters due to a significant increase in the number of oil and gas drilling rigs and lower inflationary pressures in the US. Furthermore, a relatively calm start to the Atlantic hurricane season will help keep refineries running and have little to no impact on oil and gas production in the Gulf of Mexico. The total number of active drilling rigs in the US was 765 at the end of September, an increase of 237 units from the previous year. While, according to the OPEC report, the number of horizontal drilling rigs was 696 and thus showed an increase of 222 units compared to 2021, even despite the decrease in the price of Brent crude (CO1:COM).

Source: The OPEC Monthly Oil Market Report

According to my estimate, in the 4th quarter of 2022, the production of liquid hydrocarbons by OECD countries will increase by 0.55 barrels per day compared to the previous quarter. Given the current pace of drilling and improving the situation with the supply chain, I expect the growth rate of oil production to continue in 2023, which will reduce the price of petroleum products and also reduce inflation in the US.

Source: Created by author

The average price of WTI crude oil will fall from $84/bbl to $68/bbl by the end of Q1 2023 and will be under downward pressure throughout 2023 due to deteriorating economic conditions in India, Europe, and China.

Economic development of India and its impact on the oil and gas industry of the country

India is the third largest oil-consuming country in the world, and as a result, the pace of its economic development plays a significant role in the formation of market prices for oil and gas. On October 12, 2022, the Ministry of Statistics and Program Implementation of India released new data that not only turned out to be worse than expected but also hit multi-month lows. Industrial production in India decreased by 0.8% in August compared to the previous year due to lower output in manufacturing, electrical equipment, rubber, and plastic products.

Source: Author's elaboration, based on MOSPI

In my assessment, the continued dire situation in the supply chain and rising inflation in Southeast Asia will continue to weigh on India's sluggish industrial growth. Moreover, the trade deficit was $25.71 billion in September 2022, up 14.4 percent year-on-year, and this is mainly due to the slowdown in global economic growth. As a consequence, I expect India's economic recovery to slow down due to lower private sector activity, higher inflationary pressures, and monetary tightening. The policy of the Central Bank of India aimed at raising interest rates continues to dampen the country's growth prospects, as it reduces investment in various sectors, which will ultimately affect the slowdown in domestic sales of petroleum products and a decrease in investment interest in the iShares MSCI India ETF (BATS:INDA). OPEC has revised down its forecast for India's GDP growth and expects this figure to be 5.6% in 2023 and 6.5% in 2022.

Source: The OPEC Monthly Oil Market Report

In August 2022, India's crude oil imports fell to a ten-month low reaching 4.1 million barrels per day, down 13.8% from the previous month. On an annualized basis, this figure increased by just under 1%, thus indicating the absence of any positive dynamics despite the easing of restrictive measures related to COVID-19.

Source: Author's elaboration, based on the OPEC Monthly Oil Market Report

On the other hand, I expect a modest recovery in oil demand in Q4 2022 due to the ongoing Kharif harvest season and increased construction activity. Demand for diesel fuel, the production of which takes 34.2% of the consumed oil, shows mixed dynamics due to a decrease in the production of ferrous metallurgy and light industry products in recent months.

Source: Author's elaboration, based on the OPEC Monthly Oil Market Report

In addition, the Indian civil aviation market is recovering after the end of the COVID-19 wave in February 2022.

Source: Author's elaboration, based on the OPEC Monthly Oil Market Report

As a result, jet kerosene demand will continue to increase by double-digit percentages until at least Q1 2023, when I estimate that a new wave of coronavirus will begin due to the rapid spread of new BQ.1 and BQ.1.1. variants and which will lead to quarantine measures. In addition to a decrease in demand for petroleum products, this will lead to a decrease in revenue for Indian airlines, whose fleet mainly consists of Airbus (OTCPK:EADSF, OTCPK:EADSY) and Boeing (BA) aircraft.

Economic development of China and its impact on the oil and gas industry of the country

The Chinese government continues its zero-tolerance COVID-19 policy, which is undermining business confidence and weakening economic and social activity, thereby negatively impacting domestic demand for gas and oil. In August 2022, oil demand was 12.65 million barrels per day, showing a decline both quarterly and year on year.

Source: Author's elaboration, based on the OPEC Monthly Oil Market Report

The only petroleum product that uses more than 15% of China's total oil consumption and has seen production growth both year-on-year and quarterly has been naphtha, a mixture of liquid hydrocarbons whose molecular weight is greater than those used in gasoline production. The reasons for this are the growing demand from the petrochemical industry. Positive dynamics were also noted in the production of aviation kerosene, whose oil requirements amounted to 0.53 million barrels per day in August 2022, an increase of 82.8% from the previous month due to the ongoing recovery in the passenger transportation industry. At the same time, demand for gasoline and diesel continues to decline month on month despite the easing of restrictive measures in southwest China. The worst dynamics were demonstrated by liquefied petroleum gas and fuel oil, the demand for which continues to fall. In my opinion, this trend will continue in the coming months due to a slowdown in the country's GDP growth.

Source: Author's elaboration, based on the OPEC Monthly Oil Market Report

On the other hand, a surge in construction activity, which occurs almost every season from September to October, will help maintain the demand for diesel fuel. As well as the expected launch of the refining complex Shenghong Petrochemical with an estimated capacity of 320,000 barrels per day in October 2022, will support oil consumption in the 4th quarter of 2022. But overall, I don't think this will lead to a significant increase in demand for oil in the next six months, as planned maintenance work begins on refineries around the world, including Exxon Mobil and Chevron Corporation. As a result, refining volumes will decline during this period and oil prices will continue to experience downward pressure. Moreover, the situation in the Chinese commodity market could deteriorate dramatically due to the increase in cases of COVID-19 in recent days, which will lead to the reimposition of restrictive measures, including school closures and travel restrictions. The last wave of COVID-19 in China occurred in March-April 2022 and led to a significant decline in oil prices, and this situation may repeat itself in the near future. Since October, the number of cases of COVID-19 has continued to rise after the end of the Golden Week, which was accompanied by mass events and increased domestic tourism.

Source: Google Search

Given the relatively low efficacy of COVID-19 vaccines being massively used in China and the rapid rate of virus mutation, I expect new waves of coronavirus to emerge in 2023. At the moment, there are no prerequisites that would indicate mitigation of the zero-tolerance policy and, as a result, new outbreaks of COVID-19 will lead to a slowdown in the growth rate of the world's second economy and a deterioration in the situation in the overheated residential real estate market. The real estate sector, which accounts for about 25% of China's economy, has been in crisis since the summer of 2020 after regulators stepped in to cut over-leveraged developers. For the third month in a row, prices for new homes show a negative annual trend, and real estate sales are falling. A similar situation was observed in 2014-2015 when China's GDP growth showed the worst dynamics since 1990, and oil prices fell from $90 per barrel to $40 per barrel.

Source: Author's elaboration, based on Investing.com

As a result, economic data points to a high likelihood of a recession in China, which will fuel bearish sentiment in the commodity market, which I estimate will only intensify in 2023.

Conclusion

The euphoria from the Warren Buffett effect, which contributed to a significant increase in the investment attractiveness of the oil and gas industry in the first half of 2022, is beginning to fade, but many investors continue to believe in the prospects of such mastodons as Chevron Corporation and Exxon Mobil. In terms of technical analysis, I expect another upward movement in the shares of Exxon Mobil and Chevron Corporation in the area of ​​$105-108 per share and $172-176 per share, respectively. However, this will be followed by their 30% retracement to the strong support zone marked on the chart below.

Source: N_Aisenstadt — TradingView

In terms of fundamental analysis, the downward pressure on the share prices of these two companies will be due to the fall in oil prices, which will subsequently negatively affect the volumes of the share buyback programs of Exxon Mobil and Chevron Corporation from 2023. Declining US inflation is helping ease pressure on oil and gas prices as producers face lower costs ranging from workers' wages to transportation costs. As I noted in a previous article, cutting OPEC+ production quotas by 2 million barrels per day does not mean reducing oil production by the same amount. Moreover, last week Iraq announced its unwillingness to cut production by the agreed amount. Mohammed al-Sudani, the main contender for the post of Iraqi Prime Minister, spoke about his intention to achieve a revision of the country's production quota, which once again casts doubt on the durability of the OPEC+ deal. In the past, Iraq has repeatedly produced more oil than was stipulated by the agreements. The increase in OECD liquids production, the worsening performance of the Chinese and Indian economies, as well as the increase in the number of cases of COVID-19 due to the rapid rate of mutation of the virus, will significantly contribute to the fall in the price of Brent and WTI futures and the subsequent decrease in investment interest in the entire oil and gas industry.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.