What Are We Going to Do About Oil and Gas?
Delwin Graham - Mar 11, 2022
Companies involved in the exploration and development of oil or gas reserves, oil and gas drilling, and refining have largely underperformed other companies trading on the Canadian stock market.
It was certainly easier to purge your portfolio of a carbon-intensive sector like energy production a few years ago. Companies involved in the exploration and development of oil or gas reserves, oil and gas drilling, and refining have largely underperformed other companies trading on the Canadian stock market. In fact, from its peak in 2014 up to the fourth quarter of 2020, the energy component of the S&P/TSX Composite Index lost more than 80 percent of its value. Up to that point, energy was the single worst performing TSX sector in five out of the previous seven calendar years. (Cf., Tim Shufelt, “Canada’s Oil Patch Revival Puts Investors in a Tough Spot”, The Globe and Mail, February 21, 2022, pg. B9)
Investors have taken this opportunity to develop renewable resources that can be used to produce energy, which include moving water, wind, biomass, solar, geothermal, and ocean energy. A concerted effort has been made by companies, countries, and institutions to reduce greenhouse gas emissions by reducing the use of non-renewable resources like coal, oil, and gas. Many of Canada’s big pension funds have made net‑zero pledges while the Caisse de depot et placement du Quebec said in September 2021 that it will sell all of its oil-and-gas holdings by the end of this year. (Cf., Shufelt, “Canada’s Oil Patch Revival …”)
The Canadian energy sector was pretty unloved. Fortunes began to change around the end of 2020. Having bottomed out with the COVID-19 pandemic, the oil patch emerged as oil prices started to rise. Big producers picked up cheap assets. For example, Canadian Natural Resources (CNQ:TSX) purchased Storm Resources for CAD$960 million in a deal that closed in late 2021, in addition to picking up Painted Pony Energy for CAD$461 million in 2020. In CNRL’s most recent quarterly results, it reported free cash-flow generation of CAD$2.2 billion – nearly five times the level from one year prior. And the company raised its dividend by 38 percent last year. (Cf., Shufelt, “Canada’s Oil Patch Revival …”)
On a sector basis, energy has gone from worst to first on the TSX, having gained 42 percent last year. So far in 2022, it has increased by an additional 27 percent. The crisis in the Ukraine has certainly been a factor.
With oil prices actually going negative in 2020, the price of West Texas Intermediate (WTI) has risen to approximately US$125.76 per barrel, as of March 08, 2022. Crude-oil prices are soaring, and the oil patch is making enormous profits. But instead of reinvesting the cash flow they produce at higher oil prices by drilling more wells, oil-and-gas companies are returning the bulk of that windfall to investors via share repurchases and dividend increases. Of course, this is good for their shareholders. First, it gives a tangible return. Second, it refrains from increasing production, which supports higher oil prices.
In regard to the price of commodities like oil and gas, it is often said that the cure for high prices is high prices: The increase in the price of a commodity will often spur increased production, which will increase supply and eventually drive down the price of that commodity. But even if Canadian and US producers accelerated their drilling programs, it would take months for that new production to come online. Both countries also lack the pipeline and export infrastructure to move additional supplies to global markets. It would seem then that oil-and-gas companies should continue to be profitable for some time.
But now, the oil market faces higher geopolitical risk with Russia’s recent moves against Ukraine. Because Russia is a major oil-and-gas producer, this could have major implications for the energy markets. For example, Germany has already halted approval of the Nord Stream 2 pipeline, which would move natural gas from Russia to Germany. If more countries take political action against Russia’s energy industry, it could put further pressure on global oil-and-gas supplies and push prices even higher. (Cf., Rekha Khandelwal and Matthew DiLallo, “Oil & Gas Stocks: Bull vs. Bear”, www.fool.com, February 27, 2022)
On the one hand, supply growth is hampered by structural and political limitations. On the other hand, the development of renewable energy sources should reduce demand for fossil fuels. But the demand for oil and gas is not going away overnight. The US Energy Information Administration (EIA) projects that even though the percentage share of oil and gas in the global energy mix is expected to fall by 2050, their absolute consumption will continue to rise. (Cf., Khandelwal and DiLallo, “Oil & Gas Stocks …”)
Whereas supply growth is limited, oil prices should continue to march forward until they meet a level of “demand destruction”. Where is that point? That is the crucial question asked by companies, countries, and institutions. We look for the oil-and-gas industry to continue to be profitable and for oil-and-gas companies to continue to return those profits to their investors, but time will tell. Please contact me at firstname.lastname@example.org or 780-408-1518 for a few ideas.