Is the pessimism in the fossil fuel sector overdone? Can investing in oil and gas still pay off over the long term? After years of underperformance, the U.S. energy sector has been displaying flashes of brilliance that suggest that it’s still got some legs to run. The sector has just managed to trounce all other 10 sectors of the U.S. economy in the first quarter of the current year, bouncing back from historical lows set in 2020.
The Energy Select Sector SPDR ETF (XLE) has reeled off an impressive 30.8% return in Q1 2021, good for a 78% increase over the previous 12 months.
That marks a sharp turnaround from 2020 when the energy sector, yet again, emerged as the worst performer among the S&P 500 11 sector index funds after a 32.7% decline.
The XLE represents the stocks of large energy companies from integrated, oil production, and equipment services sub-sectors. It’s considered a good benchmark for conservative energy investors, with ExxonMobil, Chevron, ConocoPhillips, EOG Resources, and Schlumberger Ltd its top 5 components.
Virtually all segments of the energy sector stank the place out in 2020.
The average midstream company fell 31.9%. These are companies that transport and store oil and gas.
Integrated supermajors such as Exxon and Chevron declined 32.5%, while the largest upstream companies crashed 33.6% in 2020. Meanwhile, giant refiners such as Marathon Oil, Valero Corp., and Phillips 66 fell 32.2% over the timeframe.
However, all four sub-sectors have managed to turn things around, with midstream companies climbing 25.6% in Q1 2021; integrated supermajors gaining 35.7%, upstream companies gained 38.0%, while refiners returned 25.8%.
Can the sector maintain the strong momentum?
It’s hard to imagine the energy sector making another strong run unless oil and gas prices can continue their impressive climb.
Those stock gains have largely coincided with oil prices climbing from historical lows after prices crashed into negative territory in April 2020.
The good news for the bulls is that the oil outlook remains great.
The oil markets are in an upbeat mood once again, with oil futures trading sharply higher on Wednesday after the U.S. government reported a third-weekly drop in weekly inventories while the International Energy Agency (IEA) issued a bullish oil report for 2021.
On Tuesday, the American Petroleum Institute (API) reported a crude draw of 3.608 million barrels for the week ending April 9, considerably better than the consensus draw of 2.889 million barrels that analysts had predicted. The week prior, API reported a crude draw of 2.618 million barrels vs. expectations for a much smaller draw of 1.436-million barrels.
Meanwhile, Paris-based IEA has lifted its global demand outlook for 2021 and predicted strong oil demand growth, particularly during the latter half of the current year. After declining 8.7 mb/d last year, the IEA now expects world oil demand to expand by 5.7 mb/d in 2021 to 96.7 mb/d.
The IEA revised up global oil demand in 2021 by 230,000 b/d to 96.7 mb/d, good for a 5.7 mb/d increase from 2020 levels. The energy watchdog has based the upgrade on encouraging economic indicators. However, it says recovery remains fragile due to surging Covid-19 cases in key consumer regions.
For instance, in its April update of the World Economic Outlook, the IMF raised its forecast for global GDP growth for 2021 and 2022 to +6% and +4.4%, respectively.
The United States received the biggest upgrade thanks to its swift vaccine rollout and hefty stimulus packages. The United States has so far unveiled the world’s fastest vaccine rollout as per Bloomberg, placing itself in a good position for a full re-opening of the economy. The latest vaccination rate stands at 3,053,566 doses per day, meaning it could cover 75% of the population, or the so-called herd immunity number, in just three months.
The IEA says the biggest demand growth will come in the latter half of the current year, with strong demand growth requiring an additional 2 mb/d of extra crude to keep the markets well supplied. However, don’t rush to buy barrels of crude, hoping to flip when prices turn up because the IEA says a supply crunch is not going to happen.
According to the organization, by July, OPEC+ will still have close to 6 mb/d of effective spare production capacity, not counting 1.5 mb/d of Iranian crude currently shut in by U.S. sanctions. IEA reckons that OPEC’s monthly calibration of supply should be enough to quickly ramp up production or lower output depending on market dynamics.
In other words, the biggest beneficiary of the coming demand surge will be OPEC+ as it continues to bring more of its idle capacity online back again.
Global refineries recover
Meanwhile, margins at the pump–a good barometer of oil demand–have improved considerably.
Crack spreads have improved considerably over the past five months, nearly doubling over the timespan to the current $22.86 per barrel.
Indeed, the IEA says global crude inventories have been trending in the right direction, with refinery activity enjoying a fast recovery.
In February, OECD industry stocks fell by 55.8 mb or 2 mb/d, marking the 7th consecutive month of declines thanks to sharp draws in product inventories (-66.8 mb). By the end of February, OECD oil stocks clocked in at 2,977 mb, about 28.3 mb lower compared to the 2016-2020 average overhang. That was enough to offset a combined 15.3 mb industry stock build for the US, Europe and Japan.
The IEA says that global refinery throughput finally returned to year-ago levels in March, rising by 1 mb/d m-o-m on a strong recovery in the US aided by February’s Arctic freeze. However, at 75.9 mb/d, global refinery runs remain 4.4 mb/d below March 2019 levels. There’s a fair chance they could even surpass 2019 levels with crude throughput forecast to rise by 6.8 mb/d from April to August, resulting in average annual growth of 4.5 mb/d.
The positive refinery outlook is a big reason why refinery stocks have been on a tear with MRO) and VLO up 65.8% and 27.4% in the year-to-date, respectively.
Crude prices face pressure
And now the million-dollar question at the top of everyone’s mind: What does the rest of the year portend for oil prices?
Unfortunately, the IEA does not offer concrete price targets here. However, it does warn that prices could come under pressure later in the year as world oil supply ramps up and shifts the market from deficit towards balance.
But ultimately, Covid-19 will continue being the oil market’s biggest wildcard. Neil Beveridge, senior oil and gas analyst at Bernstein Research, says demand could potentially increase by 4 to 5 million barrels as we get into 3Q and 4Q if Covid-19 vaccine rollout progresses smoothly–a net positive for oil prices.
Over the long-term, however, the oil and gas sector still has to confront the renewable energy megatrend especially now that the Biden government is willing to commit massive sums of money into solar, wind, and EVs.