Bad news is good news for (some) oil stocks right now

OPEC has agreed to extend production cuts, which energy investors hope will help correct the painfully imbalanced global supply and demand equation. This pushed oil prices higher from their recent lows and energy stocks rose again. But there is something else going on in the industry that investors need to consider that could limit the growth of energy companies large and small. Here’s what you should watch and how you should think about it.

Forget short-term ups and downs

Oil and natural gas are commodities subject to dramatic and frequent price movements. All it takes is a bit of news and prices can skyrocket or crash, often taking the stock price of energy industry giants like ExxonMobil (NYSE:XOM) and Chevron (NYSE: CVX) higher or lower. Stocks of smaller players like Chesapeake Energy (OTC: CHKA.Q) and Matador Energy (NYSE: MTDR) are usually even more impacted.

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There’s a disconnect here that’s important to recognize, though. Oil majors like Chevron frequently explain to investors that they don’t pay much attention to short-term energy price movements, preferring to focus on the long-term supply and demand equation in the energy sector. That’s not to say short-term price changes don’t have an impact – current low oil prices have led Chevron to scale back capital spending plans as it attempts to balance cash outflows. with cash inflows. , Chevron still sees a bright long-term future for oil, as does Exxon. So while these companies pull back, they keep their eyes on the long term and keep spending.

Smaller players are also pulling back, but the impact on their businesses may be more dramatic, especially when it comes to onshore drilling in the United States. This is because unconventional wells tend to produce a lot of oil initially, but the flow slows down quickly enough to become a trickle. In order to maintain production growth, unconventional drillers must continue to drill. Exxon and Chevron have diversified businesses, mixing short-cycle assets (like unconventional U.S. wells) and longer-cycle assets (like offshore wells), as well as significant downstream businesses that add even more variety to the cash flow.

Simply put, the biggest players can not only afford to spend more even during tough times, but they also have business profiles that allow for greater flexibility. But it evokes the bad news that is emerging in the energy market, despite the rise in oil prices.

Historically low

This bear cycle in the oil sector has been particularly brutal due to a combination of factors, including the long-term increase in US onshore production, an untimely price war between OPEC and its Russian partner, and the decline in demand related to the global crisis. efforts to slow the spread of COVID-19. Things got so bad that oil prices briefly dipped below zero, which in theory means oil drillers were paying customers to take oil away from them. And there is still a huge glut of stored oil that needs to be cleared before a sustained price increase can really take hold.

XOM Chart

XOM data by YCharts

This is where the “bad news is good news” factor comes in. Generally speaking, reduced capital spending means slower production growth for oil companies. For an American driller on land, this can quickly lead to production declines. So it’s terrible for US land drillers that the number of rigs operating in the US today is near historic lows. This is no small problem – the current number of active rigs is now around 80% below the peak levels seen in 2012.

Drillers are backing up very hard, and that will have significant implications for their individual businesses. But with low cash flow due to low oil prices, there really wasn’t much choice. Indeed, some companies in the US onshore space are already bankrupt, and others are likely to follow.

However, from a global perspective, rapid growth in US production was one of the factors that led to excess oil supply in the first place. Thus, a significant decline in onshore drilling will actually help accelerate the process of rebalancing supply and demand. Add to that the OPEC production cuts and the outlook is starting to improve on the supply side. On the demand side, there is still plenty of excess oil stored to operate – but with economies around the world starting to reopen, oil needs are returning to more normal levels. So a sharp drop in drilling is bad news on the one hand, but on the other it is exactly what the oil market needs.

turn things around

When watching energy sector news, be sure to think about the long-term supply/demand equation like the energy giants do. This is what counts, and what will really determine what is good news and what is bad news. In this regard, a drop in drilling in the United States, a key source of excess supply in the global market, is very good news, even if it means that there will probably be an upheaval in the sector. In fact, a few more bankruptcies could also be an advantage if they promote more rational long-term drilling plans. On the downside, what you’ll want to watch out for is a major rise in energy prices leading to a major spike in US drilling, as this could kick-start a whole new bear cycle. Overall, as an investor today, you should probably focus your attention on companies that have proven they can weather volatile times like this, like the integrated giants.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.

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Felix J. Dixon