Energy stocks (XLE) have retraced all of their gains since Russia's invasion of Ukraine, are down ~15% from recent highs and still well below all-time highs reached in 2014. Yet oil prices (USO) remain elevated in the face of historic reserve releases and a lockdown of the Chinese economy. Natural gas prices in the US are at decade+ highs, while seaborne natural gas is at its highest sustained level in history. Though performance of oil and gas commodities pales in comparison to coal and refining margins, with both trading several hundred percent above historic average levels. To boot, nearly every US, Canadian and European energy company has provided a shareholder return framework. Frameworks which are likely to result in record dividend and buyback announcements in coming quarters.
Conversely, energy stocks (XLE) have outperformed the broader market by almost 70% year to date, after outperforming in 2021 as well. Recession risk remains elevated, with the Atlanta Federal Reserve now forecasting 0.0% GDP growth in Q2, after a negative print in Q1. And the ire of politicians from Brazil, to the UK and the US is raining down on energy investors and management teams alike.
In two weeks, Exxon (XOM) and Shell (SHEL) will provide a quarter-end summary of results, setting the tone for the sector. Oil prices (USO) rising ~15% from Q1 will boost results, while oil-linked contracts for LNG with their embedded price lag will also show through this quarter. Exxon's (XOM) exposure to US natural gas prices, up ~70% quarter on quarter, should materially lift earnings. As will refining margins, up ~30% from Q1 average levels. While most US coal producers are contracted for 2022, seaborne prices rose ~30% in Q2, and will lift earnings for those able to supply the export market.
From a valuation perspective, its not clear that blockbuster results alone will carry stocks higher. Vermillion (VET) for example, posted a 30%+ annualized free cash flow yield in Q1, the strategic case for their European gas acquisitions has improved, oil is up, and shares are trading where they were the day following Q1 results. Shell (SHEL) generated more free cash flow than Exxon (XOM) and Chevron (CVX) combined in Q1, on RBC's numbers, yet shares are lower than they were when Q1 results were released. Great results are sure to be seen across energy subsectors and geographies, but are likely to be considered "table stakes," with companies posting mixed results being sold, rather than companies posting strong results being bid up.
If earnings are not enough to drive shares higher, management teams will need to make the case for higher multiples. In the shale patch, the conversation is likely to focus on capital allocation. With most producers committing to shareholder return frameworks very recently, the market will want to see commitments honored. Following Russia's invasion of Ukraine, several shale CEO's offered to work in coordination with Washington to increase production at the expense of shareholder returns. However, Washington countered the offer with windfall taxes, which could make it more challenging for boards to justify capital spending in the current environment.
In Canada and Europe shareholders will also want to see strong shareholder commitments. With European majors largely clear of Russian exposure, the market will want to see how management teams fill gaps in the portfolio. BP (BP) and Total (TTE) will be the center of attention. In Canada, Cenovus (CVE) has now provided a shareholder return framework, so the Street will zero in on net debt reduction progress in anticipation of higher payouts. Cenovus (CVE) will also see the company's Conoco (COP) earn out expire in Q2, which should lift earnings. Management will also have a chance to showcase newly-acquired downstream assets, with exposure to increased benchmark refining margins and wider Canadian oil discounts. Suncor (SU) has aggressively repurchased shares following Elliot's activist campaign. And Imperial (IMO) will benefit from a much reduced share count following its tender during the quarter.
Gas companies (UNG) could be at risk of increasing capital investment at the expense of shareholder returns, given the ~300% rally in US natural gas prices. However, Thursday RBC wrote that Repsol (OTCQX:REPYY) had dropped plans to pick up a rig in the Marcellus, on account of rising costs and labor availability. Paired with setbacks on the MVP pipeline, and an outage at Freeport LNG, gas names too could be preparing to announce record shareholder returns. A move that could lead to multiple expansion for equities trading at historically discounted valuations.
Coal stocks are perhaps best positioned to make the case for a higher multiple. After years of declining production, the Department of Energy expects to see thermal coal production grow in 2022. US producers have hopefully made progress getting spot tons to seaborne markets, where margins are more than 10x higher than domestic markets. Perhaps most importantly, a tripling of natural gas prices has lifted in-basin coal pricing. Domestic producers now have a window to lock in long-term contracts at materially higher prices. Locking in even a small portion of domestic production with contracts at $100+ should send coal stocks higher. Though it's unclear which management team is best positioned to capitalize, after several disappointing results in Q1 (BTU).
Refiners too are in the spotlight. In recent history, the world has never experienced a shortage of refining capacity the likes of which is being experienced currently. Margins are sky high, and following missteps in Q1, earnings should be very strong across the board. With most investors looking to Valero (VLO) CEO Joe Gorder for context on the macro environment, his comments could make or break returns for the sector. If Mr. Gorder confirms the market's view that demand has been unimpacted by high prices, and that industry is unable to respond with more capacity in the near term, shares for all US refiners should trade well through results. Conversely, Philips (PSX) and Marathon (MPC) could walk away from proposed refinery conversions, as the bio-fuel projects are set to further reduce US refining capacity.
Setting aside performance into quarterly results, energy stocks (XLE) are better positioned than they've been in decades. Balance sheets are much improved. Net zero targets have scared most boards away from major projects, and as a result shareholder returns are increasing. Most western politicians remain focused on excluding the world's largest energy producer from global markets, and OPEC+ appears unable to respond to higher prices. Assuming a major recession does not materially reduce demand, the outlook for energy stocks has never been brighter. Into results, institutional investors may use the recent selloff to position for record earnings and shareholder returns.