Energy Stocks Are Running on Empty

After rebounding to $61.43 per barrel on June 10, West Texas Intermediate (WTI) crude oil resumed its slide, hitting a six-year low, $41.81, on August 17. Energy firms are bleeding cash left and right. Their earnings and revenues are down big, and a few weaker players are beginning to sell assets or enter bankruptcy. All year long we've warned you it is too early to bottom fish in Energy, despite plentiful assertions otherwise. Now, with Energy stocks down double digits year-to-date amid flattish broad US markets, some again suggest it's time to hunt for cheap value in Energy. But fundamentals suggest bottom fishing still isn't wise.

Energy bulls primarily argue low prices will cause firms to slash production. Before long, they posit, growing demand will burn off the excess supply, reversing the current glut, and causing prices to rise. This, they claim, is not discounted into plunging Energy stock prices. Oil bulls cite the fact active US oil rigs have more than halved since oil's price slide, falling from 1,573 in August 2014 to 672 now. It's a matter of time, they claim, while watching rig counts and weekly output estimates religiously.

However, despite declining rig count, US oil production hasn't dropped. US oil output rose from 8.6 million barrels per day (mb/d) in August 2014 to 9.5 mb/d in May 2015, the latest available data point. Production peaked at 9.7 mb/d in March. It is only down a measly 1.9% since.

Exhibit 1 US Oil Rig Count and Oil Production 2013 - 2015

Source: Baker Hughes, as of 8/17/2015, US oil rig count, 8/2013 - 8/2015, US Energy Information Administration, as of 8/17/2015, US oil production, 8/2013 - 5/2015.

It turns out energy firms idled the least efficient rigs-doing more with less and keeping output high. Though cratering prices rendered oil production much less profitable, firms still have an incentive to generate revenue and recoup exploration and drilling costs. Many smaller, pure-play shale drillers loaded up on debt to expand production when prices were high. These firms can't afford to cut production and idly wait for higher oil prices.

Moreover, improvements in drilling technologies have allowed some producers to slash costs dramatically over the last year, many to below current oil prices. In McKenzie County, North Dakota, a core area of the huge Bakken field, the median breakeven price is currently just over $29 per barrel, half the overall Bakken breakevens some estimated last fall. Moreover, as oil has fallen the last four weeks, oil rig counts have actually increased. There is little sign US shale firms are materially slashing production.

Plus, additional supply is waiting in the wings. As prices slid, shale producers left many wells uncompleted, to avoid churning out more oil while prices are low. At the first sign of rebounding oil prices, producers can quickly turn on the spigots, flooding the market with new supply, putting downward pressure on prices. According to Rystad Energy, an independent oil and gas consulting and data firm, at the beginning of June the so-called "fracklog" stood at 3,850 wells. Some estimate this adds up to about 500,000 bpd of output, an effective shadow supply on top of global supply that already exceeds demand by almost three million bpd.

Outside the US, production also remains high and rising. According to the International Energy Agency, North Sea oil production is set to grow by 65,000 b/d this year. While not a huge increase, it would be the second straight year of growth-the first such stretch in 15 years-in a region many believed in terminal decline. Part of this is because North Sea platforms are experiencing fewer shutdowns this year. But also, oil prices hovered above $100 per barrel for much of this expansion. A year ago this week WTI and the global benchmark, Brent, were roughly $97 and $102, respectively. Until last October, oil prices motivated firms to "drill, baby, drill." Firms acted on those signals and invested to boost output, which takes time to pay off, even if the payoff is roughly 60% smaller. New tax breaks earlier this year gave UK producers another small incentive to pump.

Production is also growing in the Middle East, a region dominated by national oil firms. Total OPEC production was 31.5 mb/d in July, the highest since 2012, as cartel members (particularly Saudi Arabia) fought for market share amid plunging prices. Iraqi production hit a record high last month. Iranian production will get a boost should the US and other countries lift sanctions as part of the recent nuclear deal. Troubled countries reliant on national oil firms for revenue like Iraq, Iran, Libya and more largely can't slash output.

So supply will likely remain bloated for the foreseeable future. What about demand? Some suggest cheap energy prices will boost consumption, supporting higher prices. While consumers do respond to incentives, this force is likely incremental in the foreseeable future. Demand growth, while positive, isn't likely to keep pace with all that rising output. Balancing the market will take sharply rising demand, falling production or a combination of the two. According to the International Energy Agency, global oil demand will likely grow by 1.6 mb/d this year and another 1.4 mb/d in 2016. Even if this proves accurate, demand won't catch supply for over a year, presuming supply remains constant-unlikely given global oil market dynamics.

The question for Energy stocks is whether sentiment has caught up with dreary fundamentals. Some claim after a brutal commodities slump over the past year investors have capitulated, believing resource prices will be "lower for longer," hence low prices are baked into Energy stocks. But market bottoms tend to occur not just when sentiment is poor, but when it is worse than fundamentals-not the case today, as illustrated by widespread calls for falling production to drive a quick rebound. A sustained Energy recovery likely won't happen until the remaining bulls throw in the towel, giving up on the idea the sector represents value after a big decline.

This isn't to say you should own no Energy stocks. It is a big sector globally, and eliminating it increases risk. But we'd limit exposure to large, integrated oil and gas producers. They have diverse revenue streams that benefit from low oil prices (refining and chemicals for example), partially offsetting exploration and production units. These firms should also have the wherewithal to snap up assets from struggling small producers-in other words, let them do the bottom-fishing for you.