As expected, crude oil markets applauded the move, with the front month WTI contract +6% as of the time of the writing, which is roughly where it has been all day at a price/barrel of just over $80. What made OPEC act now (there was no scheduled meeting), and what impact will this have on energy markets longer-term?

Saudi Arabia is the primary producer and de facto leader of OPEC, responsible for 36% of the 13-member group’s February 2023 output of 28.9 MMbls/d. They have expressed recent frustration at the price of oil, namely, the seeming disconnect between the physical market (where traders buy/sell oil for immediate use/delivery) and the paper market (futures contracts, which include speculators and hedge positions). Though certainly weaker than last summer, the physical market has held up much better than the paper market, suggesting market participants are trying to get in front of an expected economic slowdown that could curtail oil demand. 

Separately, the Saudi’s have not appreciated the moves made by the Biden administration to use its excess supply to ease oil prices over the last couple years. The SPR (Strategic Petroleum Reserve), created in the wake of the 1970’s Arab oil embargo as a measure of national defense, was turned into a political lightning rod with the government releasing 221 MMbls over the course of 2022, drawing the inventory down to levels not seen since 1983.

To be fair, ingenuity and resilience shown by the domestic oil industry has positioned the US as an energy powerhouse, far less dependent on foreign imports when compared to the 1970/1980’s. A case could certainly be made that we don’t need 713.5 MMbls of oil (SPR capacity) sitting in salt caverns scattered along the gulf coast (for reference, the current inventory is 371.6 MMbls). Even so, in late 2022, the administration had hinted at partially refilling the SPR once prices reached the ~$70/bbl level. In the minds of many, including perhaps the Saudi’s, this would serve as a pseudo floor wherein the US could be counted on as a price supporter as opposed to the pressure they had applied over the preceding months.

Surely the Saudi’s might not have been thrilled when US Energy Secretary, Jennifer Granholm, came out two weeks ago saying plans to refill the SPR will take years, and likely won’t begin in 2023. Planned maintenance at two of the four storage sites and the fact that another 26 MMbls draw is scheduled between April-June (a Congressionally-mandated, federal budget-aiding measure passed years ago) makes a refill in the near-term simply impractical.   

So perhaps the Saudi’s (and OPEC) had the motivation to make a move, but will it make more than a short-term difference? Let’s first take a look at what is being done. Not all OPEC members are participating in this cut:

Source: OPEC, *non-OPEC countries participating in the cut

The voluntary nature of this move is somewhat unique. It is worth noting that of the participating members, many are cutting from a position of strength, meaning they have spare capacity. In comparison, take the October announced OPEC+ cut; it included several members (namely Nigeria and Angola) that were producing so far below their quota, they could continue to grow production without hitting the newly announced cut threshold (meaning the nameplate 2 MMbls/d cut would never reach that volume in practice). This time around, only Russia is producing materially below their quota (which is voluntary anyway, given Russia isn’t an OPEC member). Russia had previously announced its own 500,000 bls/d cut to begin last month, and coincident with this OPEC announcement, they extended that cut through 2023. It is yet to be seen whether or not they will comply with their self-imposed sanctions, but they appear resolved as they seek to hit back over western-imposed export price caps affecting their own energy sector. 

Source: BloombergNEF, as of 04.03.23

Ultimately, we believe this move will be more impactful in the short-term than the long-term. By cutting supply, OPEC is merely counteracting the negative demand sentiment surrounding crude. According to the US EIA (Energy Information Agency), implied domestic oil demand is still 8.7% below the high reached in July 2019. With many market commentators forecasting recession in the next 12 months, that deficit would only be expected to widen. This line of thinking is reflected in the paper markets referenced earlier; according to the CFTC’S (Commodity Futures Trading Commission) Commitment of Traders report as of March 28, large speculators were the least long crude going back to 2011 (which is another reason for the big price response in oil today – traders weren’t positioned for it). OPEC’s action sends a strong signal to the market that they intend to backstop the weakness typically witnessed in past economic contractions. 

Longer-term, we believe structural undersupply borne by chronic underinvestment will support oil prices. After all, as quickly as OPEC can support markets by cutting supply, they can also bring it back into strong demand. What can’t be so easily manipulated is the type of long-cycle investment that has eluded global commodity markets over the last several years. This is seen perhaps most clearly here in the US, where investment has taken a backseat to shareholder-friendly cash return policies. Even with rampant oil service cost inflation, nominal capital expenditures still haven’t retaken 2018/2019 levels, much less the early part of the decade. This has global implications, as the US is now the largest producer of crude oil and liquids products.

Source: Strategas, as of 03.16.23

Our view for crude oil and energy more broadly supports near-term frustration (recession narratives and risk-off fears overtaking even this impactful move from OPEC) eventually giving way to sustainable upside for the industry. With material energy transition likely to take years longer than originally believed, this should provide a nice runway for energy companies to produce resilient cash flows which they are now generally dividending out to shareholders. Having coordinated support from OPEC should help smooth what could be a bumpy forward 6-12 months.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

When a page is marked “Advisor Use Only” or “For Institutional Use”, the content is only intended for financial advisors, consultants, or existing and prospective institutional investors of Aptus. These materials have not been written or approved for a retail audience or use in mind and should not be distributed to retail investors.  Any distribution to retail investors by a registered investment adviser may violate the new Marketing Rule under the Investment Advisers Act.  If you choose to utilize or cite material we recommend the citation, be presented in context, with similar footnotes in the material and appropriate sourcing to Aptus and/or any other author or source references. This is notwithstanding any considerations or customizations with regards to your operations, based on your own compliance process, and compliance review with the marketing rule effective November 4, 2022.

Advisory services offered are through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-ACA-2304-5.

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Source: Strategas, 11/29/22

For a commodity-driven sector, the dispersion since July 1 has been significant, to say the least. 

Source: Bloomberg, LP, 11/29/22; XLE – Energy Select Sector SPDR ETF, CL1 – generic front month crude oil contract
(note: difference in price and total return represents roll yield from the downward-sloping crude oil futures curve)

We believe there are multiple forces at work driving this short-term phenomenon. First, energy equities are … equities. True, their input is a commodity, but their earnings are valued by the equity market. After years of equity multiple compression (driven in part of ESG concerns, governmental policy, and poor corporate management), energy equities have finally gained some traction as an investable sector. This has led to a long-awaited (though still relatively anemic) uptick in valuation.

Looking at Bloomberg consensus numbers, XOM went from 4.8x EV/EBITDA on 6/30 to 5.3x as of 11/29. PXD expanded from 4.4x to 5.3x over the same period. One could argue that valuation had simply gotten too cheap, in conjunction with broader market flows out of underperforming sectors like tech needing to find a home elsewhere. 

Secondly, since COVID, energy equities have lost some correlation to oil. 

Source: Strategas, 11/22/22

We would attribute this in part to the way management teams are using the cash flow they are generating. During the last period of sustained, elevated oil prices (2010-2014), companies were rewarded by increasing production, which required them to not only reinvest all cash flows, but to borrow more from ready-to-lend debt markets to do so. This ultimately led to poor returns, overburdened balance sheets and disappointed investors who essentially fled the sector. This time, domestic producers are substantially taking a more shareholder-friendly cash flow return approach, foregoing big production increases to reduce debt, pay dividends and buyback stock.

Finally, while the front month crude oil price (the one you see flashing on TV) has been plummeting, longer-dated contracts have stayed remarkably resilient. In other words, the crude futures curve has flattened out quite a bit. This is a near-term bearish signal, but when pricing a company’s future of cash flows over multiple years, investors are more concerned about the average price than the spot price. 

Notice in the following graph, the current curve (orange) 1-24 month spread is <$8/barrel, while that spread on July 1 (green) was >$29/barrel! Concerns over global economic growth and COVID lockdowns in China have dented current demand, but a myriad of factors including tight global inventories, OPEC+ price support and a US government potentially switching from draining the Strategic Petroleum Reserve to refilling it, have proven to be a longer-term floor for crude. 

Source: Bloomberg, LP 11/30/22

Regardless of the reason, the move in energy equities relative to oil begs the question, “Are energy equities now overpriced?” While they aren’t as attractive as they were 6 months ago (or especially 12 months ago), we believe they are still enticing for the long-term investor. 

Looking at XOM again as an example of valuation, at 5.3x EV/EBITDA, it is nowhere close to its five-year average of 7.1x (same for PXD – 5.3x vs 6.6x). Moreover, while the sector has gained some traction this year in the eyes of certain investors who had put it in the penalty box, it can hardly be described as over-owned. Excluding the drop since the COVID downturn, at 5.2%, energy carries the lowest weight in the S&P 500 looking back 25 years (and compares to a historical average of 11% going back to the 1970’s). For further context, at 6.4%, AAPL has more influence on the index than the entire energy sector!

Source: Strategas, 11.30.22

Of course, energy equities can’t stay disconnected from oil forever. Were the price of oil to find footing from its notable price slide, a return to positive correlation could also prove a tailwind for energy equities. Near-term demand concerns will undoubtedly fill the headlines, but we believe the longer-term, more structural forces of global undersupply and lack of adequate investment will provide support for oil prices for some time to come. 

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

The content and/or when a page is marked “Advisor Use Only” or “For Institutional Use”, the content is only intended for financial advisors, consultants, or existing and prospective institutional investors of Aptus. These materials have not been written or approved for a retail audience or use in mind and should not be distributed to retail investors.  Any distribution to retail investors by a registered investment adviser may violate the new Marketing Rule under the Investment Advisers Act.  If you choose to utilize or cite material we recommend the citation, be presented in context, with similar footnotes in the material and appropriate sourcing to Aptus and/or any other author or source references. This is notwithstanding any considerations or customizations with regards to your operations, based on your own compliance process, and compliance review with the marketing rule effective November 4, 2022.

Advisory services offered are through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2211-23.

The post The Divergence in Energy Stocks vs. Crude appeared first on Aptus Capital Advisors.

What Goes Into the Retail Price of Gasoline/Diesel?

Let’s start by looking at the components of gasoline/diesel pricing. It is not entirely uncommon for folks to refer to oil/gasoline interchangeably. But as this graphic shows, there are more forces at work than just the price of oil.

Data as of April 30, 2022

Perhaps the most important (and most complicated) component of that breakout is refining. As a brief primer, refineries break crude oil down into its various components, which are then selectively reconfigured into new products. Refineries have three basic steps, 1) separation – piping crude oil into a hot furnaces where resulting liquids/vapors separate into petroleum components called fractions, 2) conversion – additional processing of heavier fractions into lighter, more valuable molecules, typically though a process known as cracking, and 3) treatment – required blending in order to obtain the proper octane level, vapor pressure rating and other special considerations¹. The result is a number of various products for end-market uses, the majority being gasoline and distillates.

Data as of March 31, 2022

Refining and Product Inventories – The Supply Side

Now that we are all refining experts (minus the PhD in chemistry), it becomes clear that this process is vital in getting product (gasoline/diesel) to retail (gas stations everywhere). With product demand rebounding from the COVID lull (more on that later), the global refining system has to be ready to meet that demand. The problem is capacity is currently constrained. Raymond James estimates that three million barrels per day (MMbls/d) of global refining capacity is shut-in today compared to 2019². Furthermore, the IEA (International Energy Agency) estimates that refinery processing rates this year will be down about 1.3 MMBls/d below 2019³. Why the discrepancy in those two numbers? The answer is that refineries are running at near peak utilization, this according to the EIA:

¹ US Energy Information Administration https://www.eia.gov/energyexplained/oil-and-petroleum-products/refining-crude-oil.php

² May 27, 2022, Industry Comment

³ May 30, 2022, BloombergNEF

“Total refining capacity has decreased since 2020 because of several refinery closures and conversions. Gross inputs into refineries are only slightly above the five-year average even though refinery utilization is at the top of the five-year range, which indicates that refineries may be running closer to maximum capacity utilization than gross inputs alone would indicate. The faster increase in gasoline demand compared with production has led to inventory draws, and U.S. gasoline inventories are currently 8% below the five-year (2017–21) average for this time of year⁴.” The picture in distillate markets is even more extreme.

⁴ May 23, 2022, EIA Gasoline and Diesel Fuel Update

Data as of May 30, 2022

Data as of May 31, 2022

Furthermore, the same thing is happening internationally across all major product lines.

Data as of May 29, 2022

Speaking May 10th at a conference in Abu Dhabi, Saudi Energy Minister Prince Abdulaziz bin Salman said, “I am a dinosaur, but I have never seen these things,” referring to the surge in refined products prices. “The world needs to wake up to an existing reality. The world is running out of energy capacity at all levels.”

Refining and Product Inventories – The Demand Side

Here is where the real tug-of-war lies. We have seen that supply is constrained, with refineries running near peak capacity and product inventories well below average. The makings of this shortfall came out of the 2020 COVID lockdowns, where expectations did not foresee the vaccine-induced reopening effect of 2021. Demand came roaring back, leaving the aforementioned supply issues fully exposed. Now gasoline demand, while still firmly above 2020 levels, is back in question, as fears of an inflation-fueled slowdown riddle global economies.

Data as of May 27, 2022

The supply side is proving to be the bigger issue, as even muted demand is gobbling up what product is available. The result has been soaring refiner margins, known as crack spreads.

Data as of May 30, 2022

Conclusion

Soaring prices at the pump show little signs of abating any time soon. Not only are crude oil prices high (even in the face of indefinite Chinese COVID lockdowns), but the global refining system is running near full capacity in an attempt to compensate for lingering inventory shortages. The result is tightness in inputs and outputs that could only be partially solved in the near-term by material demand destruction. Longer-term, change in investor sentiment and public policy will likely be required to necessitate a sustained investment cycle leading to secured and predictable supply.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.

Advisory services are offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2205-25.

The post Oil Market Update – Products Edition appeared first on Aptus Capital Advisors.

Russian/Ukrainian Conflict

 It is difficult to understate the importance of Russian oil, not only to western Europe, but to the world. According to the February 2022 OPEC Monthly Oil Market Report, Russia is the second largest global producer of oil at 9.95 million  barrels per day (MBls/d), behind the US at 11.75 Mbls/d with Saudi Arabia a near tie at 9.87 Mbls/d (Nov. 2021 production numbers). To further put this in context, Russia’s share represents right at 10% of global supply. However, unlike the US, which consumes far more oil that it produces, Russia is a large net exporter, meaning that the majority of that nearly ten million barrels of oil each day is being consumed by other parts of the world. The primary beneficiary is Europe, although some of that oil makes it over to the US as well (7% of total November 2021 crude imports to be exact, per the US Energy Information Administration). 

Source: Strategas Securities, LLC, as of 02.28.2022

Disruption of these flows would wreak havoc on global supply, which is why foreign countries who have sanctioned everything from Russian banks to private citizens’ assets abroad have fallen short of denying Russia a market for their most valuable natural resource. Amos Hochstein, the State Department’s senior energy security adviser, said in an interview last Friday that, “sanctions will not target the oil flows as we go forward,” simply because this would be deemed more of a punishment for US and European consumers than it would Russia. Hochstein elaborated, “If we target the oil and gas sector for Putin, and in this case the Russian energy establishment, then prices would spike. Perhaps he would sell only half of his product, but for double the price. That means he would not suffer the consequences while the United States and our allies would suffer the consequences.” 

Given Russia’s place in the global energy scene, it isn’t at all surprising that oil markets would wake up at the sight of heightened geopolitical tensions. Indeed, allowing some sort of premium to account for the thought that the commodity could be used as a weapon in this war makes rational sense. However, while this will certainly drive near-term movements in oil, we don’t believe this is the primary reason to be bullish over the long-term.

Global Supply/Demand Fundamentals

Coming in to 2022, the three major energy forecasting agencies (US Energy Information Agency – EIA, International Energy Agency – IEA, Organization of the Petroleum Exporting Countries – OPEC) all expected that 2022 would be the year when increasing oil supply would outstrip demand and inventories would reverse their decline, leading to more normalized prices. At the end of third quarter 2021, this is where they all stood:

Source: Bloomberg, as of 02.28.2022

Since that time, the outlook has tightened considerably. The IEA has increased its 2022 demand forecast by 900,000 bls/d, citing a milder-then-expected negative impact from the Omicron variant and a weather-driven switch to oil from gas for residential heating and industrial needs. Moreover, while OPEC+ has continued its pledge of adding 400,000 bls/d per month through September 2022 (the gradual rolling-off of COVID-era cuts), they have repeatedly fallen short of that mark due to several member nation’s inability to ramp production from existing capacity. Regarding that point, the IEA noted that unless OPEC+ member nations with spare capacity (namely Saudi, Iraq and UAE) make up for the production deficits of the broader group (namely Angola and Nigeria), the total amount of oil lost in 2022 could approach one billion barrels! The COVID pandemic not only drove oil prices lower than we’ve seen in years, it disincentivized investment in new production, which has now become apparent even in those countries that were believed to have ample ready inventory.

Source: Raymond James, as of 02.28.2022

All of this wouldn’t be overly concerning in a normal environment, but global inventories are currently lower than normal. Even if markets return to a surplus in 2022 (which is looking less certain than it did a few months ago), the added supply will only serve to put a small dent in depleted inventory levels. This is being seen globally, as well as here at home:

Source: Raymond James, as of 02.28.2022

Source: US Energy Information Agency, as of 02.28.2022

Speaking of here at home, how are US producers responding to the jump in commodity prices? As the largest producer of oil and liquids (includes condensate, natural gas liquids) in the world, certainly the US has the ability to influence global supply. The answer is two-fold: yes, activity has increased, leading to greater production domestically; but no, companies are not responding with the frantic growth-at-all-costs proposal of past cycles. This point was driven home in an interview post 4Q’21 earnings announcement with Scott Sheffield, CEO of Pioneer Natural Resources – one of the largest independent E&P companies in the country and largest acreage owner in the prolific Midland Basin. When asked about increasing output in response to elevated oil prices, he responded, “Whether it’s $150 oil, $200 oil, or $100 oil, we’re not going to change our growth plans.” This is coming from a guy who expects oil prices to climb higher, as demonstrated by the fact that Pioneer bought out their entire 2022 oil hedge book in 4Q’21 in order to have unfettered upside exposure to the commodity going forward.  

To be fair, not everyone is following suit. Financial discipline has been witnessed primarily at the public company level, where shareholders are demanding the return of capital over reckless growth (still marred by the capital destruction days of the 2010’s). But after years of industry consolidation, private companies only represent ~30% of US oil production, down from over 60% several years ago¹. That means that lower reinvestment rates, even if just at the public level, should keep spiraling production increases in check.

Source: Strategas Securities, LLC, as of 02.28.2022

This has resulted in free cash flow generation not seen from the energy sector since 2008. Not only are oil prices high, but companies have become much more efficient operators than they were ten or even five years ago. With that said, this level of underinvestment can’t continue. The primary means by which domestic producers have been able to maintain this level of hydrocarbon output while keeping expenditures in check is that they’ve been drawing on an inventory of discounted flows known as the DUC (drilled-uncompleted) well count. This represents those wells that have been drilled to total depth but not yet fracked and put on production. At any given time, there must be some level of DUC inventory due to the fact that operators often complete several wells in a row to utilize frac fleet efficiency. And during times of lower oil prices (like much of 2015 – 2020), operators are incentivized to drill wells (to utilize long-term drill rig contracts) but hold-off completion until prices improve. Right now, we’re seeing the opposite – DUC’s are being drawn down at a record rate in order to increase production without spending as much money. 

Source: Raymond James, LLC, as of 02.28.2022

This means the rig count has to go up. It bottomed in July 2020 at 276/1,030 (North America / World) and has since climbed to 886/1,632. This seems like a huge jump but put in the context of the all-time high in 2011 of 2,740/3,722, it pales in comparison. Given the vast increases in drilling efficiency and speed, there is no reason to expect absolute numbers will approach 2011 levels. But it is reasonable to think rig counts must rise to offset natural production declines, stem the drop in DUC count and satisfy global demand.

Conclusion 

In terms of energy markets, the conflict between Russia and Ukraine is currently getting all the attention. But as we’ve discussed, there are fundamental issues at work which give us cause to be an oil bull long past the (hopefully soon) conclusion of this war. As COVID reaches the endemic phase, oil demand has come roaring back and is forecasted to surpass its 2019 highs this year². At the same time, we think the chronic underinvestment in oil supply both domestically and internationally has created a situation where demand can’t easily be met in the near-term, at least not in a meaningful way as to build the inventory depletion of the last year. As a result, we remain bullish on oil price and the companies that produce it. We have been overweight energy in our Compounders stock sleeve since the beginning of September 2021 and we seek to maintain that position. 

While a global peace would certainly take the hostility premium out of oil, we expect that these longer-term factors should keep the floor above $80/bbl, perhaps for the next year or two to come. Domestic operators have become extremely efficient at producing oil, generating free cash flow at levels below $50/bbl. It is hard to imagine a perpetual environment where that type of economic rent is allowed to exist, and prices should eventually settle around the $65/bbl mark. Until then (and even after), domestic E&P companies generate tremendous free cash flow and have developed shareholder-friendly return policies, making them some of the highest-yielding companies in the index. Moreover, we have gotten more bullish on oil field services, as a dwindling DUC well inventory and the need for more production will drive a higher rig count and related services, even as operators pledge fiscal discipline. 

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2202-35.

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If you’ve filled up your car lately, you likely noticed a higher price at the pump. Gasoline prices, as everyone knows, are directly correlated with crude oil prices, and we’ve come a long way since the depths of the COVID crisis.

Source: Bloomberg, LP, as of 11.04.2021

You’re seeing that right…if you recall, oil briefly went to -$37.63/bbl (barrel) in April of last year, driven by a confluence of various factors (COVID-stifled demand, a brief Russia/Saudi price war, and most notably, a contract expiration at a time when physical storage was almost impossible to come by). The International Energy Agency (IEA) estimated that global oil demand fell from a high of 100.5 MMBls/d (million barrels per day) near the end of 2019, to just 83.0 MMbls/d in the summer of 2020. That type of move begs for a supply reaction, and it got one:

• OPEC+ (those “+” countries include Azerbaijan, Bahrain, Brunei, Kazakhstan, Malaysia, Mexico, Oman, Russia, Sudan, and South Sudan, though you almost only hear of Russia because they produce nearly double the amount of the other nine combined) cut 9.7 MMbls/d in May 2020. They have since began bringing some of that production back online, currently adding 400,000 bls/d per month until they reach full capacity, which is expected in September 2022.
• The largest oil producer in the world going into COVID, the United States, saw its output decrease from 13.0 MMbls/d at year-end 2019 to 11.0 MMbls/d just a year later. In similar fashion, the North American rig count, which stood at 1,350 at year-end 2018, fell to a low of 276 in July of 2020.

Even with such a response, crude inventories piled up. Just here in the US, total crude inventories peaked at 539.2 MMbls in July 2020 – compare that to 429.9 MMbls at year-end 2019.

Source: EIA (US Energy Information Administration), as of 11.08.2021

At the time, the narrative of “peak oil demand” was getting a lot of traction. Would the world ever return to where it was prior to the pandemic? Fast forward to today, and we’re already nearing where we left off in 2019. In fact, the average forecast for 2022 from OPEC, IEA and EIA sees demand at 100.4 MMBls/d. Perhaps not without its hiccups, but the confidence brought on by the COVID vaccine announcement in November 2020 ushered in a global reopening that has seen GDP surpass its prior highs and pulled oil demand along with it.

That is a look back, let’s consider where we’re going from here. As I mentioned to start this piece, gas prices are high (the national average just hit $3.48/gal, highest since Sept. 2014)! So has the return in demand been fully priced in? Perhaps it has overshot?

Many analysts believe that while the current market is still undersupplied (by somewhere in the area of 1-2 MMBls/d), that will alleviate itself as OPEC brings back spare capacity through its reverse taper and reinvestment elsewhere brings new product into the market. Indeed, the same three agencies which forecast a return to 2019 demand levels in 2022 see the market as being oversupplied for the year.

Source: Bloomberg, as of 11.08.2021

And we all know that the entrepreneurial spirit of the US oil patch can’t contain itself, right (drill baby drill!)? Well, that may not be the case this time. In fact, publicly traded domestic operators have gotten the not so subtle hint over the last few years that investors want returns, not more oil. As such, we’re seeing a phenomenon in US E&P (exploration & production) – spending only what it necessary to hold production flat, while using abundant excess cash to pay dividends, buy back stock and pay down debt.

Source: EIA (US Energy Information Administration), as of 06.01.2021

Domestic producers aren’t the only ones underinvesting in future production. Take OPEC+ for example: though they are on a current path of increasing production at a rate of 400,000 bls/d per month, some countries (namely Nigeria and Angola), haven’t even been able to meet their quotas due to fiscal neglect of their assets.

September 2021 production output vs quota by OPEC+ member country

This lack of investment comes at a time when investment in fossil fuels is becoming increasing unpopular to begin with. This week, leaders of the United Nations are meeting in Glasgow for the COP26 summit, a pow wow on how to “accelerate action towards the goals of the Paris Agreement and the UN Framework Convention on Climate Change (source: ukcop26.org).” And it’s not just coming from policy makers…Larry Fink, CEO of the world’s largest investment manager by AUM, BlackRock, has made climate change one of his marque issues in capital allocation going forward (https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter). In other words, even if operators wanted to produce more, there is a lot in the way of structural disincentives to do so.

We’re keeping an eye on all of this. But as it relates to investments, two things are certain:

• Domestic operators have become extremely efficient at producing oil, generating free cash flow at levels below $55/bbl. With oil priced near $80/bbl as of the time of this writing, it is hard to imagine a long-term environment where that type of economic rent is allowed to exist. Oil prices can do any number of things in the short term, but we would expect for them to come down over time. This sentiment is confirmed in the futures curve, which currently forecasts oil to settle in around $60/bbl four years out.

Source: Bloomberg, LP, as of 11.08.2021

• A regime shift in the way people look at climate change and ESG will put a structural ceiling on the valuation multiples offered to those working in “old world” energy. Even with that being the case, most all high quality, well capitalized, domestic E&P companies are trading below 5x EV/NTM EBITDA. Even a climate activist has to agree – that’s cheap!

Source: Strategas, data as of 2Q’21 end

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