- The energy sector has recently re-emerged into the spotlight as a confluence of events have driven a shake-up in prices and profitability.
- The S&P 500 Energy Sector posted a 7.4% gain in July and outperformed all sector peers.
- Major integrated oil and gas companies are posting sharp declines in year-over-year profits.
Company Profits and Fundamentals
Major oil companies have recently reported plunging second quarter profits. Weaker fossil fuel prices compared to a year ago have significantly eaten into bottom lines. Despite these second quarter results, stock prices have not faltered in a commensurate manner. In July, the energy sector of the S&P 500 posted its highest monthly return of the year. The 7.4% return was top among all S&P sectors.
Companies have emphasized returning shareholder value by raising dividends and implementing share buybacks. Additionally, a renewed focus on stricter cost measures has begun to shore up balance sheets and improve fundamentals. We’ve seen both free cash flow yield and cash flow return on invested capital, measures of valuation and profitability, turn positive this year as industry management teams—with pressure from Wall Street—have focused less on production volumes and more on profitability.
Global Supplies Have Been Shocked
Crude oil prices (as measured by West Texas Intermediate, or WTI) leapt higher and finished July at $81.80/bbl, up almost 16% from the previous month. This was due, in part, to voluntary production cuts by OPEC+ members in April, along with an additional 1 million barrel-per-day cut by Saudi Arabia starting in July.
Meanwhile, in the U.S., stocks of crude oil fell by 17.05 million barrels for the week ended July 28. That marks the largest single-week decrease since 1982 when the Energy Information Administration (EIA) started reporting data. The week’s drawdown was entirely from private reserves, as the Strategic Petroleum Reserve remained static, albeit at a 40-year low of 347 million barrels.
The chart below shows the decline in U.S. ending stocks of crude oil, including both the private and strategic petroleum reserves.
The Demand Picture is Muddied
While supply is being constrained, the outlook on demand is less clear. The waning of summer-heightened demand will shift the seasonality factor, the U.S. economy may contract slightly later this year or early next, Europe is currently teetering on the edge of recession, and higher oil prices could curb demand and limit the industry’s profit potential. On the other hand, Chinese economic officials have recently pledged to “restore and expand” consumption which could further spur demand from the world’s second-largest economy. However, the effects and success of these policies are yet to be seen.
LPL Research holds a ‘neutral’ view on the energy sector but maintains a positive bias. Current fundamentals are showing signs of strength and valuations are attractive, but the geopolitical backdrop and recession fears amid an expected slowdown in growth, are creating cause for concern. We continue to maintain a watchful eye on the sector and assess the landscape through a technical and fundamental lens.
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