The Dividend Cafe - Energy, Oil, and 2023

Episode Date: February 17, 2023

Today's Link - https://bahnsen.co/3IxtjXf Since the new calendar year began just about six weeks ago oil prices are basically flat, having started right around $80/barrel and still sitting now right around the same level.  The energy sector indices are all up on the year, somewhere around +1%, so nowhere near the level, the market is up year-to-date, but up nicely nonetheless.  It's not been a rally mode, but it's not been a sell-off, either. Yet there is a lot going on under the surface.  One can be forgiven for being suspicious of the idea that both the commodity side and public equity side can stay flattish and benignly boring for long. My goal in this week's Dividend Cafe is to update our macro perspective on the energy sector and offer some correct practical suggestions around investing in it.  It's a little economic, a little political, a little global, and a lot of fun.  But you knew that already ...  So let's jump into the Dividend Cafe! Links mentioned in this episode: TheDCToday.com DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to the Dividend Cafe. I am excited for a Friday discussion on energy. And we have covered a number of topics this year that I think are prominent economic considerations in the current state of markets. We've looked at the recession scenarios. We've obviously talked about the inflation-deflation debate. There's plenty of Fed and interest rate stuff out there. And then last week was a broader discussion of where dividend growth investing fits into the kind of current paradigm, as well as the ongoing paradigm that we expect and believe in macroeconomically.

And yet, in the weeds of this, in the both short-term and longer-term scenarios, we have an ongoing interest in the subject of energy. First of all, we care about the concept of U.S. energy independence. has profound impacts to other aspects of the market, both in the sense that higher energy costs represent a higher input to much of the entire economy, both for producers and consumers. We recognize that lower energy costs could be reflective of weakening demand conditions. There are, of course, supply issues with energy that may be relevant to geopolitics. So energy touches a lot of things and a lot of things touch energy. And then from an investor

standpoint, we care because of our own exposures that we both have and want to have that are both real and that are theoretical or hypothetical for the future. So when we talk about the current state of energy, let me give you a little context. Everyone, I believe, is aware that it was the highest performing sector in the market last year. And by highest performing, I mean everything else was down and energy was up and it was up a ton, about maybe seven years worth of returns in one year. Then in 2021, energy was the highest performing sector. But that was in a year where almost everything else was up, too, but energy was just up more. So we're a whopping six weeks into 2023.

And I'm not sounding any alarm bells on what's happening in the energy sector. Oil prices are about flat on the year. They've hovered a little bit above and a little bit below the flat line ever since the year started. And the energy sector, from an equity standpoint, is basically up about 1% on the year. And so it's up nicely in a six-week period, but there's other things up more as we've had a kind of risk-on environment. So it's been pretty benign, and yet I'm bringing up the subject to talk about where we're going from here because I think you have some people that could be considered really wildly bullish on the energy sector and others that would be quite bearish. And we have

a view that I want to unpack more intelligently. So first and foremost, let me just kind of explain something about oil prices last year. I think most of you know that the Biden administration announced in March of last year that they were going to release 180 million barrels from the Strategic Petroleum Reserve, and this was being done as a protective measure because of the impact on oil markets from Russia's invasion of Ukraine. And you can reasonably argue that by the end of the year it served its purpose if the purpose was political but it also served its purpose if it was to hold prices either lower or at least in check and oil prices very likely would have been a lot higher had they not done that? Now, initially, there was a good 90 days, 75 days of a million barrels of oil per day being released from the SPR. And oil prices re-hit their high in July of what they

had seen back in March, about $120 a barrel. So I think that it was a bit nuanced at first. But the five points that I kind of make about strategic petroleum reserve is that it did bring oil prices down last year. It was probably politically beneficial. OPEC's production in the second half of the year helped contain oil prices, too. Now, they did not cut, excuse me, they did not increase production near the level the Biden administration wanted them to. But from where their cuts had been previously, they picked up and that was impactful to global supply. Number four, let's not forget that China was essentially locked down all of last year.

And so there was substantial impact to global demand that was also holding prices in check. And then number five, that like all government interventions, there's a diminishing return over time. So the impact of this release of supply from Strategic Petroleum Reserve did what it did in 22, but just from a diminishing return, the law of marginal utility cannot have the same catalytic effect going forward. And in fact, they're actually looking now to start the replenishment of the reserves,

not to continue releasing from them. Now, there is a sense in which any form of price controls, and in this case I'm referring to two things, the sort of implicit attempt at controlling price through manipulating supply by releasing from emergency reserves. So it's a kind of less direct but nevertheless obviously intended price control mechanism. And also just the literal price controls in terms of the caps with Russia. There's a couple of interventions that I think we historically understand work until they don't. If you're talking about holding prices in check, price controls, by definition, control price for a time. And then even the price control itself at some point, the distortion unwinds the very benefit you're trying to get because you create a shortage. And therefore, with the diminished production as a result of the price control,

especially if you're controlling the price at something less than market clearing level, then you disincentivize production, you end up with a shortage, which you're not talking about just freezing prices, but you actually end up reversing. The analogy I use is a teeter-totter. It doesn't stay there in the middle. You're either pushing something higher or the other side, and that's really the way price controls work. They force prices down for a bit, but then, of course, at a normalization, you have diminished capacity, diminished inventories, and you see prices go much higher.

and you see prices go much higher. Even more than that, though, the strategic petroleum reserves themselves not only losing their impact of putting downward pressure on prices and that diminishing return you get, and then the fact that perhaps it is being used to incentivize further underproduction, which at some point the chickens come home to roost. But you also have to replenish. And so markets are well aware. The administration's already had to cancel some of their planned purchases.

But there's a chart I want to put up right now showing you the stock of crude oil in the strategic petroleum reserve. And when you look at that diminishment of our access to emergency reserves back down to basically 40-year-ago levels, the markets are well aware that that has to be replenished and the administration is very confident they can replenish it without an issue. But I don't know and I don't know anyone else who knows how they can do so. There's also another fact that as you see that chart and how many reserves have been depleted, they have enough cash on hand in the fund to buy back 84 million barrels of oil. But that's 140 million less than it was when they began these purchases. And so there is a significant challenge that I think will create some form of upward pressure on prices going forward. Admittedly, though,

the timing being quite uncertain there. Anecdotally, I want to mention that the U.S. dollar has historically been inverted with oil prices. And there's a pretty logical reason. Oil on the global market is denominated as it transacts in dollars. So therefore, a stronger dollar is generally going to mean a weaker oil price and a weaker dollar is a stronger oil price. That's tautologically true, all other things being equal. And generally, all other things are not totally equal, but they're kind of close. And so that inverse relationship holds. But it hasn't held at all for a while.

And the simple reason is that all other things are not equal at all. There's a variety of issues around the Chinese yuan, issues happening with the U.S. dollar in a Fed tightening period, a substantial Fed tightening period like we've obviously had over the last nine months. So between other currency complexities, stuff in the economic cycle, that correlation is not there. Do I believe that in theory we'll see a point in time at which a weaker dollar could be pushing oil prices higher? I do, but I would not place our worldview on where oil prices go on where we see the dollar going right now just simply because of the various non-correlative circumstances that exist between the dollar and oil. But it's at least on the table that some reversion of the mean in that relationship were to come back. Now, what else is worthy of our discussion when we think about oil prices right now? I want to talk about something that is an old principle. It's a new principle. It's an unchanging principle. It's all of the above.

It's geopolitics. And there's an asymmetrical reality when you think about oil prices with geopolitics. Now, it doesn't have to be. It'd be pretty symmetrical if you said world peace is breaking out everywhere. China and the U.S. are hugging it out. Russia is not getting favors from China. All of those things could symmetrically produce downside forces on oil. And yet, because the geopolitics are probably not looking at circumstances like that, but more either bad things happening or just sort of status quo, not an actual threat of world

peace breaking out. Therefore, it becomes very asymmetrical for the very reason that the geopolitics is mostly asymmetrical. We have some bizarre things happening in the relationship between China and Russia. We see China getting cozier with Saudi Arabia. We see Russia getting much cozier with Iran. You have Iran talking about its ability to go online now with nuclear weapon production. And you have Israel saying they're not going to let it happen. And I'm tempted to do so. I may do a special podcast unpacking a deeper level of some of these foreign policy considerations. But for our purposes today, the very simple point I want to make is that none of them represent an obvious downward pressure oil prices. And all of them represent a potential and asymmetrical upward pressure on prices. Again, it could very well hang in there because everything just sort of behaves. But most of these things that are a little bit, when you look at China's sort of tacit approval of Russia and where a number of these different

dynamics with Iran, Russia, China, I think Saudi Arabia fits in there as well. I don't think people have to be very imaginative to see those things putting upward pressure on oil prices. That risk of geopolitics taking oil from 80 to 110 seems much higher likelihood, even if it doesn't happen, then some circumstance in geopolitics bringing oil to 50. Now, let's take the geopolitics out and look at other things that could push the supply and demand of oil. coming to the rescue to produce more and then therefore create a better price dynamic where there's still profitability for the U.S. oil industry between 50 and let's say 60, $65. And yet it's not coming from a total collapse of demand. And yet it gets, you know, the lower

input price is beneficial to both producers and consumers than, let's say, 80 or 90 or 100 or what have you. The only thing I would say is that there is a significant political reason that's not very likely to happen. There's a significant cultural reason that that's not likely to happen. And even if I wanted to take the so-called ESG anti-fossil forces out, if I wanted to take the president administration's hostility and even threats saying we won't need fossil in 10 years and that kind of stuff out, what you do have is still an oil industry that has learned, I believe, from lessons of the past where they were over levered to a global cyclicality that was not sustainable. And that lack of capital discipline bit them and bit them hard. I don't think these things are mutually exclusive from

some of those political and cultural forces we're talking about. You not only want to behave as a good steward of financial resources when you learn from the lessons of more recent history, but also you hear the threats that in 10 years, 20 years, there are political and cultural forces calling for your extinction and that has to be priced into some of your decision-making and consideration. So I don't see the U.S. oil industry all of a sudden abandoning its newfound fondness for capital discipline. And I don't see production getting up to the levels that would bring supply and demand in line just here from the U.S. would bring supply and demand in line just here from the U.S. The other side, and this is probably the most popular bearish view as to how oil prices could drop quite a bit and hurt the upstream energy

sector significantly, is a full-blown recession. And not just a recession, but a rather severe one. And the thing I would say about that is that I've already said it over and over. I would say about that is that I've already said it over and over. Nobody knows that a recession is coming. Certainly a recession of a severity would erode demand. That would impair volumes. It would impair margins around the oil prices. And yet the supply curve, if it were moving left, it wouldn't matter much if the demand curve was moving down. But without people knowing that that will happen, and that having to happen potentially up against these geopolitical uncertainties I've talked about, and then finally the ultimate hedge to the demand erosion thesis, it ends.

Even if there is a recession, it ends. And on the other side of it, there's a normalization. And that's not necessarily something I'd bet against or around in terms of that timing. And so you have a number of reasons to not allow that to drive a decision, if anything, to maybe maintain some sort of agnostic humility in how you're viewing the sector based on the potential ramifications of a recession. Now, I'm putting another chart up on the screen now that I think is quite useful on this discussion about demand side, because I think two can play at this game. Is there the potential of a big diminishment of demand if we were to have a recession? Of course. But I would just simply point out that as you see on your screen of this chart, demand, the daily consumption globally of oil has not even come close to coming back to trendline levels,

that we are significantly below trendline levels out of the COVID moment. We recovered a lot, but there is still a big gap. So sure, let's think about demand erosion. Let's think about recession. Let's think about what demand destruction does to oil. But let's also think about the possibility of pent up demand, of catch up demand, of demand surge, because that isn't necessarily something I'd bet on either, but it's not off the table, just as the inverse is not. So let's go back to just this discussion of the industry itself, a couple of data points I want to share. And I'll have us, let's put up the chart of the week now that I think is pertinent to this portion of our discussion. You see the rig count, it's called the Baker Hughes rig count of the normal rigs that are online and that are responsible for extracting oil right now.

And I just want you to note, there were 244 rigs in operation in our country at the COVID low, August of 2020. And we're up to 759 now. So we've gotten quite a bit more online. And yet you can see from the chart that there were almost 2,000 in the insanity of 2015. And there was still about 1,100 online when oil prices were about $55 to $60 a year or so before COVID. a year or so before COVID. So there is a kind of sweet spot here in the middle where we're well off of the ridiculously low levels when the world was shut down, but we're nowhere near back to where we were in 2018, let alone 2015. I think that speaks to energy executive rehabilitation and discipline and doesn't speak to us getting back in over our skis. So allow me to conclude with four takeaways that summarize our view on the energy sector right now. I'll anecdotally just share that I suspect China is going to add 1 million barrels per day to global demand. It could be a little less than that. And I think that's about

half of the total increase. I think you're going to see somewhere between 1.8 and 2 million barrels per day more in terms of daily need. And these numbers come straight from the International Energy Agency, the IEA themselves. So that number could be up or down a little bit, but that is in the calculus. And then I'd point out that Russia is saying they're going to cut production by 500,000 barrels per day. They haven't coordinated that number with the cartel, the OPEC+. China and India are both buying Russian oil at cheaper prices, but then turning around and selling it into world markets.

Russia has certainly, it would be of no surprise to any of us if Russia were to use oil, if they were to weaponize the oil price in terms of their efforts in the marketplace and as part of their strategy in this Ukraine effort and something against NATO, something against Europe, something against the West. And so those things linger. something against the West. And so those things linger. How do I want to interpret all of the things we've talked about today with the supply side, with where we think the U.S. energy production industry stands, where these geopolitical realities are? What are our takeaways? Number one, rebalance your upstream exposure. If you were overweight the last two years, as we were, and as we recently have in that rebalancing, just to reset weightings to the right target level, de-risking some of those exposures from the great moves higher of both 2021 and 2022.

So again, there's a risk mitigation that we're recommending as energy bulls, just to de-risk on the upstream side, your producers, explorers, drillers, etc. Number two, maintain upstream exposure, recognizing that there is A, an offensive upside potential based on variety of supply demand, profit making, traditional possibilities, but B, a defensive hedge potential based on the potential of geopolitical disruptions and even economic challenges. If you were to see higher energy prices have a kind of negative effect through input prices and a negative effect on the consumer that you hedge against some of that economic damage that could be done by being exposed to the higher energy prices themselves. So you have both an offensive and defensive benefit to maintaining upstream energy exposure. Number three, view energy as less correlated

to the broad S&P for a variety of reasons. And then recognize that that low correlation from energy to S&P could end up being a good thing or it could be a bad thing. It was obviously a great thing last year when the S&P did terrible and energy did very well. But in theory, that low correlation could mean energy has a muted

year and the S&P moves much higher. I don't expect that, but I'm just saying, view it as non-correlated. Don't view it as a direct hedge on the S&P. Don't view it as, or excuse me, a hedge or a levered play. It's none of the above. And then number four, maintain midstream exposure. Be overweight in midstream, the pipelines, the storage, the transportation side of both oil and gas. Where a rising dividend stream, focus on volumes, greater volumes of oil and gas going through the pipelines impacts your revenue model. You have less leverage to the underlying commodity prices, yet you're still in an adjacent strategy to oil and gas, to upstream production. But you maintain a very attractive risk reward tradeoff. Some bad things can happen to midstream.

Some good things can happen to upstream that midstream doesn't participate in fully. This isn't a secret sauce per se. It's just a way to be adjacent, have an overweight, and yet a very different risk-reward characteristic. So yes, midstream once again. different risk-reward characteristic. So yes, midstream once again. That's the extent of what I wanted to say about the energy sector. I hope those four takeaways are practical, actionable, and understandable. But the broader thesis here continues to focus on supply-demand fundamentals, where most things like this should be, with a real, I think, cognizant reality of the

geopolitical implications and why we just refuse to say it's a foregone conclusion we're going back to $40 oil. The geopolitics suggest against it, the supply suggests against it, the behavior of these companies, by the way, the behavior of OPEC+, which I didn't dwell on much today, all speak to the unlikelihood of that bottom falling out. The one component that could see the bottom fall out on oil prices is just a severe global recession. But for reasons I've pointed out, I either see that as unlikely or as uninvestable when one thinks about the energy sector for the other reasons we've discussed. Thanks for listening to the Dividend Cafe. Thanks for watching the video.

I hope the charts are helpful. And I look forward to coming back to you next week with another Dividend Cafe. We will not have a DC Today for you on Monday based on the President's Day holiday. The market's been closed. Stock market, bond market, banks all closed. But reach out with questions and please do your part to subscribe, share this video and all those fun things. Thanks for listening to, watching and reading Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, Thank you. or for statements or errors contained in or omissions from the obtained data and information referenced herein.

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