Milan Cacic
November 25, 2022
Money Financial literacy Economy Commentary News Weekly update Weekly commentaryIF YOU THINK ENERGY IS EXPENSIVE NOW, WAIT UNTIL NEXT YEAR!
It has been a dismal year for every sector of the S&P 500 except for energy. The chart below gives you a visual of just how lopsided returns have been this year.
We have had a few clients ask us if we are still bullish on energy after it's significant out performance this year. The quick answer is yes. Below are some of the reasons we think energy prices will stay at current levels or go higher.
- Most energy companies started the year from a very low level that was triggered by the pandemic. Remember that time when oil contracts traded in the negatives?
- It appears that Europe may make it through the winter as current Natural Gas storage levels are at 90% (which is still not enough on its own to get through a normal winter). However, with voluntary and mandatory measures to reduce consumption they may squeeze by. If they don’t run out the Natural Gas this winter, the storage will be empty by spring, and they will have to go through the same refilling cycle again next year.
- It also should be noted that 40% of this year’s Natural Gas storage in Europe came from Russia. If Europe is to fill their storage again next year, they may have to look elsewhere for that 40%, which might be difficult to find.
- There has been a significant lack of investment in fossil fuel energy projects over the past 5 years. It is likely that this underinvestment will continue as very few companies are willing to spend money on projects that have a 10-20 year breakeven when the world is trying to phase out fossil fuels in the next 8 years.
- In August, China imported 2 million barrels per day fewer than expected. At some point, China will break free from the COVID lockdowns and consumption will normalize. It is probably a good thing for the world that China is in lockdown otherwise who knows high oil might be.
- The draining of the United States strategic reserves will come to an end this month. They have drained more than 200,000,000 barrels in the last 7 months, equivalent to 1,000,000 barrels per day of production. By law, these barrels have to be replaced which will not only make the supply of oil worse but the mandatory buy backs will increase demand.
The markets over time will fix these energy imbalances. As more wind, solar, nuclear and liquified natural gas facilities get built these energy shortages will be balanced. However, it takes time to build these projects and it is unlikely that the shortage will be fixed within the next two years. In the meantime, large energy companies with strong balance sheets are trading at an average of 4x cash flow while mid-cap and small-cap companies are trading at an average of 2x cash flow. It is hard to ignore these numbers. Hopefully management uses their free cash flow to buy back shares or pay out shareholders. We should find out soon as most oil and gas companies are expected to be debt-free by first quarter 2023 if they choose to use their cash flow to pay down debt.
I have also included a piece from our CIBC Economics Team entitled “ Delayed gratification”.
As always if you have any questions please feel free to give us a call.
Have a great weekend.
Milan