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Portfolio Update

One Upgrade, One Downgrade

By Elliott H. Gue, on Nov. 10, 2017

With the Brent and West Texas Intermediate (WTI) future curves in backwardation, global oil inventories have started to come down, tightening the market and sparking a welcome rally in the price of this commodities.

Previous recoveries in crude-oil prices ultimately proved fleeting because near-term futures never traded a premium to contracts further out on the curve, a condition that incentivizes market participants to draw-down inventories.

Add in the ever-present potential for disruptions to Nigerian and Libyan hydrocarbon production, as well as the recent shake-up in Saudi Arabia, and the risk-reward balance still skews to the upside for oil prices.

Whereas WTI prices have increased 37 percent from their intraday low in June to this week’s intraday high, SPDR Oil & Gas Exploration & Production (NYSE: XOP) made a new 52-week low in August and has gained less than 20 percent over the intervening months. Put another way, WTI recently broke to a new 52-week high, while the upstream-focused exchange-traded fund is down more than 18 percent from the high set in December 2016.

This divergence reflects several factors.

For one, many investors doubted the sustainability of WTI’s initial rally off its June lows—a reasonable response when you consider the fleeting nature of past recoveries. Oil and gas producers’ revenue and earnings also benefit more from prolonged periods of higher oil prices than they do from a short-lived price spike.

The market’s growing disillusionment with many US exploration and production companies’ inability to generate cash flow also contributed to this underperformance. Throughout the shale boom and the 2016 boom-let, many operators demonstrated poor capital discipline and had no qualms about tapping the debt and equity markets to fund drilling activity and production growth.

Of course, for many years, Wall Street rewarded operators for this behavior; names with the strongest production growth often outperformed. This culture of growth at any cost underpinned concerns that higher oil prices would prompt US exploration and production companies to drill aggressively, driving output growth but no free cash flow or profit.

But the emphasis has shifted in recent quarters. This environment favors companies that can generate meaningful production growth and free cash flow when oil prices range between $50 and $60 per barrel. Names that issue debt and equity to support growing capital expenditures will struggle. Further evidence of this paradigm shift, coupled with resilient oil prices, should set the stage for energy stocks to play catch-up.

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