Oil Supply Glut Still Saps Energy Earnings

What's down, up, down, then up again? Oil in 2016! After WTI crude bottomed out in the $20s in February, it surged past $50 in early June, pulling Energy stocks along for the ride. Then came a summer swoon, sapping enthusiasm, before an August rebound. Yet this time, some say, sentiment has turned, making Energy stocks a prime contrarian play. Hedge funds betting on another dive, high inventories and record output hog headlines, and few seem to expect significantly higher prices for a year at least. But before you start seeing dollar signs all over the oil patch, a word of caution: While expectations do seem a tad more reasonable, on balance, supply and demand drivers suggest oil probably bounces around today's low levels for the foreseeable future, keeping the squeeze on Energy earnings. Even if a new plunge isn't in the cards, we wouldn't expect lasting Energy outperformance any time soon.

From February to early June, the media played up oil's rebound and Energy's outperformance, and most extrapolated those trends forward. However, the summer slide drew more attention to the supply glut, resetting expectations somewhat-especially after OPEC output hit another record high in July at over 33 million barrels a day, about 7% more than its 2014 monthly average. An IEA report highlighting high global inventories of refined oil products like gasoline drew countless eyeballs, as did its forecast for slower demand growth. At the same time, however, the report sowed seeds of optimism for higher prices, as it projected declining global crude production later this year as firms draw down those stockpiles, chipping away at the glut and helping prices recover. For real this time.

While this hypothesis might seem plausible, hold your horses. Other, less-noticed factors should keep supply elevated for quite some time. Prices might not plummet anew, but they don't seem likely to soar either. First, oil and gas firms today are doing more with less as they adapt to a prolonged period of depressed prices. The aggressive push to trim fat includes fewer new exploration projects, job cuts and contract renegotiations with suppliers, to name a few.^[i] These efforts are paying off: Global breakeven prices for proven but untapped reserves are down $19 since 2014 to just $51, so producers can survive longer and pump more even if prices remain low-a powerful supply support not just today, but in the future.

Technological and productivity advances in the US shale industry have helped firms keep drilling and pumping. US oil rig counts just rose for the seventh consecutive week, and thanks to "multi-pad drilling," each rig can support up to a half-dozen wells. These wells in turn are ever more productive: A decade ago, a fracked well's output would drop 90% in the first four months. Now, it drops just 18%-a sign of how far extraction techniques have come. Production is nimbler, too: Short-cycle projects take months to ramp up, not years, and existing rigs can quickly activate or go dormant in response to price changes. This versatility shows up in some big oil firms' recent forays into the shale oil patch, as they attempt to harness this technology to keep output high. But, importantly, it also shows up in the "fracklog" of drilled-but-uncompleted wells, or DUCs (real acronym), the vast majority of which are profitable at $50 a barrel. Should prices rise, oil firms can start up their DUCs and flood the market with new supply.^[ii] Importantly, these aren't passing changes-they reflect a shift from an old, inflexible oil industry to a new, adaptive and competitive one. This competition is great for consumers, but slim margins likely keep Energy's performance in check.

Outside the US, the battle for market share continues. Iranian output has zoomed 25% since last year, and they're now engaged in a bidding war with Saudi Arabia for the Asian export market. Although there are whispers of a September OPEC meeting to freeze production, previous confabs at Doha and Vienna were mainly jawboning-Iran's refusal to cap production derailed these attempts. There is no compelling reason to expect a different result this time. Non-OPEC nations like Russia and Brazil keep pumping too-they need the revenue to fill state coffers, often maintaining output even on unprofitable projects in order to recoup costly upfront investments.

All this evidence strongly suggests Energy stocks aren't set for a major rebound. Sector earnings are price-sensitive, not volume-sensitive. Even if prices hover around today's levels, Energy firms probably won't see huge profits-any time margins show signs of rising, more rigs, more output and more competition should push them back down as firms respond to price signals. Against this fundamental backdrop, there are signs sentiment is still too optimistic. Master Limited Partnerships (MLPs)-investment vehicles focused on Energy transport infrastructure-are regaining popularity, as investors once again underestimate the impact of weak prices on the entire industry. Oil transport volumes and profits are tied to oil. At some point, low prices will discourage production, reducing amount of crude flowing through these pipelines. Also, Energy producers will likely pressure pipelines to charge them lower fees as contracts renew. As for those claiming bearish Energy hedge fund bets are too pessimistic and urging contrarians to buy, this misinterprets how markets work. Even if the hedgie consensus is wrong and oil doesn't plunge, that doesn't mean it soars. While markets frequently defy the herd, they don't necessarily do the opposite. Stable-ish prices would also defy expectations. Lastly, output records and inventory spikes are backward-looking-as they fade from the headlines, supply-boosting fundamentals like productivity improvements and healthy competition should remain.

Even if production does tick down a bit, as the IEA foresees, oil and gas firms have the financial and technical wherewithal-plus the incentives-to respond to potential price increases and keep output robust. Energy earnings plunged (down another -82.1% y/y in Q2) as oil and gas firms adjusted to sub-$50 prices. Earnings may stabilize, but that is a function of the year-over-year benchmarks becoming more favorable, not massively improving profitability. We'd suggest retaining some Energy exposure for diversification purposes-large, integrated firms that can weather low prices make the most sense, in our view-but there isn't sufficient reason yet to base big portfolio moves on the hope of a turnaround.