A two-year rally in US oil and gas stocks is coming to a halt as falling crude prices and fears of a slowdown in the world’s biggest economy threaten producers’ ability to maintain bumper shareholder payouts.
The S&P 500’s energy sector — consisting of oil and gas groups — was the market’s best performer in 2021 and 2022, rising more than 50 per cent last year as Russia’s full-scale invasion of Ukraine pushed up crude prices and operators used the windfall to repair balance sheets and shower shareholders with cash.
The mood has changed, with the energy sector down 5 per cent since the start of the year compared with a rise of 8 per cent for the wider market and a 24 per cent surge in the tech sector.
Investors are bracing themselves for recession and are worried about a weak “macro backdrop” that could trigger further oil price falls, said Matt Portillo, head of research at advisory firm TPH&Co. “It doesn’t engender a lot of confidence in the near-term future of cash flows.”
US oil settled at $71.34 a barrel on Friday, well above its long-term average price but still 7 per cent down this year, as turmoil in the US banking sector has roiled markets.
The equities sell-off has come despite companies reporting another strong quarter of cash flows and shareholder payouts in recent days, part of a new operating model in a sector that became notorious in the previous decade for burning investor cash in headlong drilling sprees.
“These companies had high share prices when they were losing money,” said Trisha Curtis, chief executive of consultancy PetroNerds. “Now they are making money hand over fist and not being rewarded.”
Wall Street’s lingering scepticism remains visible in the pricing of the S&P 500 energy sector’s dividend yields — still double those in the financial sector and fourfold those in tech.
Some investors say shale companies are suffering the after-effect of a two-year stock price rally when big shale operators such as Devon Energy and Pioneer Natural Resources began paying “variable” dividends, including a base dividend and extra payment depending on cash flows.
“Equities tend to be rate-of-change stories and last year, with rising commodity prices, you had a positive rate of change when it came to free cash flow generation and return of capital,” said Mark Viviano, a portfolio manager at Kimmeridge, an activist private equity group.
But falling commodity prices this year have triggered a “reverse effect”, Viviano said, prompting investor anxiety about cuts to the variable dividend.
Devon was the first shale producer to introduce a variable dividend in 2021 when a near-doubling of its share prices made it the S&P 500’s best performer. Since it began cutting the variable part of its dividend in November, the stock has lost almost 40 per cent of its value. The company is expected to report another strong quarter of earnings on Tuesday.
Weaker operating conditions, including rampant inflation in oilfield services costs and falling productivity, were also weighing on companies as crude prices fall, said Portillo.
Even in the prolific Permian Basin of Texas and New Mexico output from each new well drilled has fallen almost 30 per cent in the past two years, according to the Energy Information Administration.
“An estimated 30 to 40 per cent cost increase in field operations, increased interest charges on borrowed money, a drastic collapse in natural gas prices combined with lower crude oil prices produced a noticeable lower cash flow,” said one anonymous executive in the Dallas Federal Reserve’s most recent quarterly survey of the US oil patch.
Analysts say the environmental, social and governance movement also continues to influence Wall Street’s view of fossil fuel producers — and their long-term value, given government efforts to accelerate an energy transition.
“The market and investors are still uncomfortable with oil and gas,” said Curtis. “The companies are not being valued to their assets or what they’re producing.”
Other analysts say capital markets’ scepticism will continue to deter upstream spending, thereby contributing to a forthcoming surge in oil prices as supplies fall short of fast-rising demand — the so-called supercycle thesis that predicts the onset of a multiyear oil bull market.
The International Energy Agency said last month that global oil production would increase in 2023 far more slowly than demand, which will hit another record later this year.
But analysts say equity investors are for now more focused on bearish signals of a slowdown in the US economy, where diesel consumption — often a leading indicator of industrial activity — has dropped 20 per cent since February last year, according to the EIA.
Only when the clouds over the world’s biggest economy clear and global oil markets begin to tighten will energy stocks come into favour again, say analysts.
“We need to get past the recession fears — next week, next month, or whenever — and then [global oil] inventories need to draw down,” said Christyan Malek, global head of energy strategy at JPMorgan.
“The supercycle thesis over the medium term remains intact. But demand is king of the energy complex at the moment,” he added.