Crude Oil in a Bear Market
After an impressive recovery in 2016, crude oil pricing is facing adverse conditions again so far in 2017. With spot prices for Brent (the global standard) and West Texas Intermediate crude (the benchmark grade for domestic production) down more than 20% for 2017 through mid-June, crude is back in bear-market territory (figure 1).1
Crude Oil Price Per Barrel (USD)
Sources: Thomas Reuters Datastream, Fathom Consulting, as of 6/22/17.
U.S. Oil Rotary Rig Count
Source: Thomas Reuters Datastream, as of 6/22/17.
Following the collapse in oil prices that began in mid-2014, the active rig count in the U.S. plummeted through the first half of 2016 (figure 2).1 That, coupled with an agreement amongst a critical set of OPEC (Organization of Petroleum Exporting Countries) and non-OPEC petro states to curb production, helped fuel a year-long rally in the crude prices. However, a renewed expansion in U.S. production since then, coupled with a persistent inventory glut, has reawakened investor anxiety. The failure of a few participants to abide by the terms of the agreement (compliance has always been an issue for OPEC) and increased output by a handful of states not subject to the agreement, notably Libya and Nigeria, have added to those concerns.
Predictably, investors have reassessed prospects for energy companies. The S&P 500 Energy sector is down almost 14% in 20171, while the broader market is up almost 10%. We see opportunity.
Prospects are not nearly as bleak as reflected in markets at the moment, and we believe the current price action has created an attractive entry point. The state of the industry for the upstream and midstream players in the U.S. is much healthier now than was the case two or three years ago. These companies were previously exposed to over-levered balance sheets, high distribution expectations, and external funding challenges. This time around, with many of the weaker players having already been culled, balance sheets are more robust, distributions have already been curtailed, and capital has already been raised for the current slate of projects. Further, with the crude oil futures curve now in contango (meaning that oil prices for future delivery are higher than in the current cash market), E&P (Exploration & Production) companies are able to hedge future production at better price levels. Perhaps most importantly, technological advances continue to drive down tight energy extraction costs, resulting in ever lower breakeven prices for shale producers. Many can continue to operate and be profitable with oil priced below today’s levels.
Hydrofracturing (“fracking”) and related technologies have turned the energy industry on its head. U.S. producers have cemented their role in the vanguard of this revolution and are poised to become the world’s largest producer over the next few years (currently number three, a short distance behind Russia and Saudia Arabia) (figure 3).
Crude Oil Production
Source: Thomas Reuters Datastream, as of 6/22/17.
We believe that even with oil trapped in the $40-$50 range, the current drawdown may present an interesting opportunity to investors who are willing to stomach short-term volatility. Should oil rebound and stabilize at a $50+ level, which we think is likely as high cost producers are gradually driven out of the business and global inventories rebalance, oil may have attractive upside potential.
1. Bloomberg, 6/22/17.
Past performance is not indicative of future results. An investment cannot be made in an index. All investments are subject to market risk, including possible loss of principal.
BBL is an abbreviation for an oil barrel.
Brent Crude is a major trading classification of sweet light crude oil that serves as a major benchmark price for purchases of oil worldwide.
Commodities reference investments in instruments and companies that are susceptible to fluctuations in certain commodity markets. Any negative changes in commodity markets (that may be due to changes in supply and demand for commodities, market S-4 events, regulatory developments or other factors) could have an adverse impact on those companies.
The downstream sector is the refining of petroleum crude oil and the processing and purifying of raw natural gas, as well as the marketing and distribution of products derived from crude oil and natural gas.
An exploration & production (E&P) company is in a specific sector within the oil and gas industry — companies involved in the high-risk/high-reward area of exploration and production focus on finding, augmenting, producing and merchandising different types of oil and gas.
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The S&P 500® Energy Index comprises those companies included in the S&P 500 that are classified as members of the GICS® energy sector.
The upstream sector includes searching for potential underground or underwater crude oil and natural gas fields, drilling exploratory wells, and subsequently drilling and operating the wells that recover and bring the crude oil or raw natural gas to the surface.
West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a domestic benchmark in oil pricing.
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