- Fueling higher oil prices this year — and counter to market expectations — is a drop in oil inventories since 2015, amid rising demand
- As a result, energy stock valuations are more attractive than they were three years ago
- Energy companies have implemented capital discipline to improve cash flows
For the past three years, market observers have been concerned about accelerating oil inventories, which put downward pressure on prices. However, inventories have been drawing down rapidly, especially in the past year.
In addition, demand growth has surprised on the upside since 2015. The impact of underinvestment by energy companies for the past several years, combined with improved global economic growth, has provided a healthy supply/demand balance in the energy sector.
Current oil prices appear sustainable
My view is that oil prices above $60, or even $70, per barrel could be sustained for much longer than current expectations. I don’t believe it requires accelerated economic growth, or even maintaining the current level of growth, to keep the market relatively tight and to keep prices in the $60–$70 range.
Better capital discipline has improved energy companies fundamentally
Compared with three years ago, oil fundamentals are in a much stronger place and energy stock valuations are more attractive today, in our view. Integrated oil companies, in particular, as well as Canadian oil sands producers are leveraged to an improving macroeconomic environment, we believe. We also favor exploration and production companies with low-cost U.S. shale acreage, as we believe these stocks can outperform in a variety of scenarios for oil prices.
For many companies, free-cash flow is back to its highest levels since the start of the last upswing in 2005–2006. This is the result of solid capital discipline — lower investment levels as a percentage of operating cash flow, which I believe will continue for a much longer period than the market expects. I recall conversations with CFOs from five years ago, when energy companies were investing billions in new projects. Since then, their mindsets and corporate strategies have been re-set to a much more conservative stance. I believe this is a healthier environment that should help to prolong the duration of this upcycle.
In contrast, Venezuela shows poor capital discipline
Lack of investment has led to lower production in several countries, but Venezuela is the most extreme example. At the midpoint of 2018, Venezuelan oil production had crashed to a new 30-year low of 1.5 million barrels a day.
According to figures from OPEC and Standard & Poor’s, Venezuela lost approximately 1 million barrels per day over the past two years. The collapse is due largely to lack of investment and maintenance by Venezuela’s oil company, PDVSA.
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