Oil production could slow considerably in 2020 as the U.S. shale industry begins to exercise more capital discipline. Will this change be enough to make the energy sector appealing again? Energy Research Analyst Noah Barrett and Associate Analyst Brian Dang weigh in.

Key Takeaways

• Despite a recent string of geopolitical crises, the world’s oil supply has trended higher and prices have dropped due to the prodigious growth of the U.S. shale industry.
• But the world’s oversupply of oil could finally be persuading energy companies to tap the brakes as more firms focus on sustainable growth.
• As such, we believe investors should be wary of companies with increased capital spend and overpriced, dilutive merger and acquisition activity funded by debt. In our view, over-levered, over-spending, high-growth companies will likely struggle in 2020.

A drone strike on Saudi Arabian oil facilities. The assassination of Iranian general Qasem Soleimani. An attempted coup in Venezuela (not to mention the country’s ongoing economic decline). A decade ago, any one of these events would be enough to cause oil prices to spike above $100 per barrel. But even with each of these significant geopolitical crises occurring over the past 12 months, Brent oil, the benchmark for global crude, is down more than 10% for the period, to little more than $50 per barrel.¹

How to explain it? Put simply: U.S. shale. In 2020, U.S. crude production is expected to average approximately 12.8 million barrels per day (bpd), more than double the amount a decade ago thanks to the growth of the U.S. shale industry. As a result, despite a string of geopolitical disturbances – not to mention continued production cuts by the Organization of the Petroleum Exporting Countries (OPEC) – the world’s oil supply has trended higher.

Energy stocks, in turn, are suffering. In 2019, a benchmark of U.S. oil and gas exploration and production (E&P) companies fell by more than 9%.² In contrast, the S&P 500® Index returned nearly 30%³. The new year is proving to be no better: Brent prices have slid more than 20% since peaking in early January on worries that the Wuhan coronavirus will crimp demand in China, the world’s second-largest consumer of crude⁴.

2020: A Turning Point?

Energy’s problem was born out of years of $100-plus oil prices, which made it all too easy for firms to practice destructive capital behavior. But reality is coming home to roost. Crude prices are likely to be range-bound in the near term. Technological and operational efficiencies are poised to reach a plateau. To thrive in today’s oil environment, companies must focus on sustainable growth and returning profits to shareholders, not drilling wells at any cost.

To that end, we believe 2020 could be a turning point. Already, we’re seeing evidence of more prudent behavior. Rig count numbers are declining, capital expenditures are slowing and inventory levels are down. In December, OPEC and non-OPEC members, such as Russia, agreed to extend and deepen production cuts from 1.2 million bpd to 1.7 million bpd through March. Increasingly, the industry is tapping the brakes, and, as such, we think the world’s oversupply could flip to an undersupply scenario by the second half of 2020.

Oversupply Potentially Flipping to Undersupply

[caption id=”attachment_272135″ align=”alignnone” width=”899″] Source: International Energy Agency (IEA), Organization of the Petroleum Exporting Countries (OPEC), Energy Information Administration (EIA), Janus Henderson Energy Team. Data as of 1/30/20.[/caption]

 

Our outlook assumes that the coronavirus’s impact on global oil demand remains largely a first quarter phenomenon. Should the virus’s negative impact on oil consumption persist much longer than currently projected, we could see pressure on crude supply/demand fundamentals through 2020.

Regardless, we believe energy firms will have to prove to investors that they can be good stewards of capital. The sector’s continued underperformance relative to the broad market – as well as crude prices – is evidence of this deep-rooted skepticism. Offering investors a sub-par dividend with little ability to grow is not good enough. Rather, we believe a combination of earnings growth, dividends and buybacks above the market average will be necessary to win over investors.

Energy Stocks Underperform

[caption id=”attachment_272146″ align=”alignnone” width=”946″] Source: Bloomberg and Janus Henderson Investors, as of 2/10/20. Data indexed to 100 on 1/1/15. WTI = West Texas Intermediate, a benchmark of U.S. crude prices.[/caption]

 

Finding Opportunities in the Energy Sector

In our view, the companies best positioned to achieve these goals will be those that maintain steady but disciplined rates of growth while also demonstrating the ability to generate free cash flow throughout the business cycle and stay focused on returning cash to shareholders through dividends, buybacks or debt reduction. Already, we are seeing some of these qualities in E&P companies as well as midstream operators.

Clean balance sheets are also key. While leverage has been declining for the space in general, there is still much work to be done. We believe investors should be wary of companies with increased capital spend and overpriced, dilutive merger and acquisition activity funded by debt. In our view, over-levered, over-spending, high-growth companies could struggle in 2020.

Abandon Your Doubts,

Not Your Goals

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¹U.S. Energy Information Administration, as of 2/6/20.

²Morningstar. Data based on returns for the SPDR S&P Oil & Gas Exploration & Production ETF, which tracks an equal-weighted index of companies in the U.S. oil & gas exploration & production space.

³Bloomberg, as of December 31, 2019.

⁴U.S. Energy Information Administration, as of February 10, 2020.