There’s no question that energy stocks have had a rough ride over the past year. After reaching a peak of just over $105 in the middle of last year, the Energy SPDR (XLE) plunged to a belly-scraping low of $63.56 last Wednesday. The decline has easily made energy the worst performing segment since the bull market began in March 2009, after outperforming considerably over the last decade.
The reason for the decline is simple: the plunge in oil prices from over $100 a barrel to just above $40 currently. The downside began due to greatly increased supply of U.S. oil production, as hydraulic fracturing (more commonly known as fracking) was able to retrieve oil from previously hard to get at locations, thanks to improved drilling technology. High prices along with lower interest rates made such projects economical.
U.S. oil production increased 80% from 2008 through 2014. Crude oil inventories in storage at Cushing, Oklahoma, the largest storage hub in the country, increased from 20,000 million barrels in the middle of last year to just under 60 million currently.
In addition, slower growth in demand from China played a significant role in declining prices (the thought that Chinese economic growth would continue indefinitely at close to double digit rates had driven oil up sharply in the last decade).
Finally, there was quite a bit of feeling that the high price of oil merely reflected trading and speculation, and that the whole situation was a house of cards that would fall apart at some point as fundamentals declined. In this case, the catalyst was OPEC failing to reach an agreement in production cuts last November.
So what’s next for oil? While it’s difficult to predict the timing, a recovery in oil prices should begin as supply and demand comes back into balance. Oil demand tends to go up over time, with global numbers increasing from 75.9 million barrels per day in 2000 to 92.6 million barrels per day last year.
According to the International Energy Association (IEA), further gains are expected to 94.2 million this year and 95.6 million next year. And although oil demand is widely regarded as cyclical, it’s worth noting that in the recession year of 2009, global demand fell to just 84.9 million from 86.2 million in 2008, then quickly recovered to 88.3 million in 2010.
On the supply side, U.S. drilling activity is slowing, with the Baker-Hughes rig count currently at 877 (down from 1,914 a year ago). There will be a lag effect to reduce supply, as the remaining wells still being drilled are very efficient. In addition, given the high fixed cost in oil drilling, once a well is operating at peak capacity, it is very profitable even at lower commodity prices.
However, with the lack of new wells being drilled, supply will fall at some point, and given the steady rise in demand, equilibrium will eventually be reached. Supply would then tighten and prices should rise.
How Natural Gas Fits In
Natural gas is a bit of a different market than oil, largely domestic and seasonal in nature, though prices of the two commodities tend to move in tandem. Gas is generally injected into storage from May to September, when little is used for home heating, and then withdrawn from storage in the months when homes are operating their heaters. Prices thus can be volatile through the winter, as an extended snap of very cold weather could have a negative impact on inventories.
Through the middle part of the previous decade, there were concerns that natural gas was in permanent shortage in the United States and that it would become too expensive for industrial use. Two times – first in 2005 following fears of supply disruption due to Hurricane Katrina, and again in 2008 when oil rose to $130 a barrel – the price of natural gas spiked to over $12 a thousand cubic feet (mcf).
However, the growth of fracking eliminated all of the supply problems, and the price of natural gas hasn’t reached $6 again since the end of the financial crisis. It currently stands at $2.70, but I think we will see periods where it trades closer to $4 over the next two years, as supply is cut and storage levels decline from their current ample status.
I believe we are close to a bottom for oil, although we have had a few false bottoms already so the exact timing of a rally is hard to project. I also believe that given the difference fracking has made in increasing available supply to the United States, we will not see $100 a barrel for a long time — perhaps never again as we begin a slow but likely definite transition to cleaner fuels.
As we see a more definitive bottom reached in this sector, watch for fresh buying opportunities to emerge in once beaten-down stocks.
