Anatomy of an energy market meltdown

The recent performance of companies in the oil and natural gas exploration and production sector has been extremely disappointing.

At the end of July, the SPDR S&P Oil and Gas Production ETF (XOP) finished at $38.35, down 18% for the month.

That also represents a more than 50% drop from its 52 week high set in August 2014.

 

Energy-bust

 

Furious Decline

To put the fall in perspective, the XOP’s $37.44 close on July 27th was its lowest since 2009, the same year that the stock market bottomed out in the aftermath of the financial crisis.

The decline in XOP has been led by the furious decline in crude oil prices.  

During the past 12 months, the prompt month WTI crude oil futures contract has gone from $98.29 per barrel in August 2014 to $47.12 per barrel at the end of July.

 

False Rebound

Crude prices dropped precipitously during the fall of 2014, and the selling only accelerated after OPEC announced no planned production cuts around Thanksgiving 2014.  

Prices bottomed out at $43.46/barrel in March, rebounded to around $60, and remained at that level through June.  Prices collapsed in July, however, falling over 20 percent.

 

Gas Bust

Natural gas prices also have fallen sharply over the past year, although in recent months they have somewhat stabilized.  

The prompt month Henry Hub natural gas futures contract was as high as $4.489/MMbtu as recently as November, before declining to as low as $2.49/MMbtu at the end of April.  

At the end of July, the futures price stood at $2.716/MMbtu, a 9 percent gain from the April bottom.

 

Iran Returns

The fundamentals driving the price of crude down have been well documented.  

OPEC continues to show no sign of slowing down production, in spite of weak prices.  

Where OPEC once actively defended the price of oil by curtailing production to stabilize prices, OPEC now hopes that lower prices will force US based shale producers to shut down production.  

Iran, an OPEC member, has actually recently announced its intentions to possibly double its crude production to take advantage of the removal of economic sanctions in exchange to submitting to restrictions on its nuclear program.

 

China Slowdown

In addition, concerns about an economic slowdown in China have been pressuring crude prices.  

The Caixin’s Purchasing Managers’ Index, a key measure of the health of the Chinese manufacturing sector, has dropped into negative territory.  

Chinese GDP growth for the 2nd quarter of 2015 was 7 percent.  

While the accuracy Chinese GDP has been questioned by outsiders, on a relative basis this represented the lowest growth level since the global financial crisis.

 

Outlook

Looking forward, I have several thoughts regarding the sector. First, the technological advances that made the shale revolution possible are going to continue to lower production costs.  

Horizontal drilling is an amazing engineering feat that has helped drive down the cost of energy, and the industry will continue to leverage new technology to maximize production and lower costs.  

Even an extended, sustained period of lower prices will not jeopardize the long term viability of the E&P sector.  

 

Attractive Valuations

Secondly, even assuming oil and natural gas prices stay where they are, I think the sector is relatively undervalued right now.  

In my opinion, the downside risk has become relatively mitigated, and I think the initiation of Gulf Coast LNG exports in the near future will inject some bullish sentiment into the natural gas market.

 

Photo credit: Jim Sage Via Flickr Creative Commons

 
The investments discussed are held in client accounts as of August 12, 2015. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.