The shale revolution of the 2010s catapulted the United States to the top of the global energy food chain. Yet the view from the top has been awfully lonely for investors.
Although America is now the world’s largest producer of both crude oil and natural gas, energy stocks have been losers. Big ones.
The S&P 500’s energy sector has generated a total return, including dividends, of just 6% in 2019. It’s easily the weakest sector in the stock market.
That trend is hardly new. This year will be the eighth year in the last nine that energy stocks underperformed the broader market, according to Raymond James.
For the decade, the energy sector is up a paltry 34%, according to Refinitiv. That’s by far the worst total return of any of the S&P 500’s 11 sectors. The next closest sector, materials, has climbed five times as much. And tech stocks, the darlings of the bull market, have soared are up nearly 400%.
“That’s pretty bleak,” said Pavel Molchanov, an energy analyst at Raymond James.
The next closest sector, materials, has climbed five times as much. And tech stocks, the darlings of the bull market, have soared nearly 400%.
The chronic poor performance of energy stocks has been driven in large part by low oil and natural gas prices. The shale revolution may have unlocked vast amounts of new supply, but now the world is drowning in it.
“Shale oil companies were a victim of their own success,” said Bob McNally, president of consulting firm Rapidan Energy Group. “They produced so much oil that they stepped on themselves.”
Oil and gas companies spent wildly to make the United States the world’s leading producer. They borrowed so heavily that they have little cash left over to share with shareholders in the form of dividends and buybacks. And some companies stressed their balance sheets so badly that they went bankrupt during the 2014-2016 oil crash.
“Being a big producer and having a profitable energy sector are two very different things,” said McNally, a former energy adviser to President George W. Bush.
Are oil companies the new vice stocks?
There’s another force likely at play here: climate change. Increased awareness of the climate crisis, the rise of socially-conscious investing and concerns about peak oil demand have all limited the appetite for oil and gas stocks. Put simply, fossil fuel companies are in the penalty box. And that’s depressing valuations.
“You’re seeing investors exit the space,” said Ben Cook, portfolio manager at BP Capital Fund Advisors.
A wave of major pension funds, endowment funds and other intuitions have divested from fossil fuels. Even the $1 trillion sovereign wealth fund of Norway, a nation whose wealth was largely built on oil, is gradually phasing out its investments in exploration and production companies.
“The energy names are almost viewed as a class of vice stocks like alcohol and tobacco,” said Cook. “That perception has created a negative pall over the whole sector. I don’t know how you overcome that.”
‘Drowning’ in excess supply
It’s impossible to say how the next decade will play out for the energy sector. But low prices, weak balance sheets and climate change probably hold the answer.
Natural gas prices remain depressed, in large part because of excess supply. The oil boom in the Permian Basin of West Texas has only deepened that glut because natural gas is a byproduct of the oil being pumped.
“We’re sort of drowning in gas. It’s hard to manage,” said Rapidan’s McNally.
Oil prices have been subdued since late 2014 when Saudi Arabia-led OPEC flooded the market with supply. Crude eventually crashed to just $26 a barrel.
OPEC, along with allies like Russia, have since reversed course by restraining production in an effort to mop up excess supply. Those efforts have successfully put a floor beneath crude but failed to sustainably lift prices above $70 a barrel. It’s a far cry from the 2008 peak north of $140 a barrel.
McNally warned that the supply glut will likely stretch into 2020, keeping a lid on prices and energy stocks.
“There is simply too much new supply next year. We don’t see an end to it,” he said.
The good news for the energy industry is that oil companies seem to be heeding Wall Street’s pleas for better capital discipline. Companies are no longer plowing every penny of their cash flow back into drilling. They are promising to keep some of it to pay down debt and return to shareholders.
“That’s a new phenomenon. Many investors are skeptical it will last but our view is that it will,” said Molchanov of Raymond James.
Climate crisis isn’t going away
But it’s hard to see how the pressure from climate change will improve for the energy sector.
Capital could become even scarcer. Goldman Sach (GS)s this week became the first large US bank to rule out loans for new oil projects in the Arctic.
The climate crisis may pose new obstacles for oil and gas companies, including crackdowns from governments. Some 2020 Democratic presidential candidates have called for banning fracking altogether.
In the 2010s, excess supply was the defining challenge for the energy industry. In the coming years, it could be climate change.