Cyclical upswing in Oil and Oil-Service?
Oil-related stocks have been one of the few areas of strength in the current bear market. Will it continue?
With the summer holidays behind us, early autumn is the time for a number of large conferences, often orchestrated by brokerage houses, banks or industry organizations. One of the most famous in Norway was held in Oslo last week, and I had the pleasure of attending. The conference has historically been dominated by companies linked to the exploration, extraction, transport and processing of oil and gas, as well as the service industries surrounding these. In recent years, there has also been an increasing number of companies focusing on renewable energy, and in particular offshore wind power. Many of those who build, own, and operate such installations are also traditional oil/gas companies, and the service industry is largely the same.
Norwegian media covered the conference thoroughly, and there have been many reports. Sharply worded statements from profiled investors tend to get the most attention, but the general impression was undoubtedly this: The conference was jam-packed, to the extent that the doors had to be closed on some company presentations when there wasn't even standing room left in the halls. The mood was characterized by optimism both among investors and companies. There were probably also some enthusiastic share purchases both throughout the day and evening as the wine arrived in the glasses. Many of the presenting companies saw their stock prices set new weekly or monthly highs on Wednesday and Thursday, then fall to new weekly lows on Friday when the mood in the market soured.
For the fund I manage, energy is the sector we have the second most focus on after tech. We then include the entire energy sector in a broader sense than oil, which can be described in more detail in a later post. While tech currently has headwinds from almost every direction, energy has undoubtedly had more tailwinds. Can one make any qualified guesses as to how the development in the oil sector will be going forward?
Well, as usual, it's a complicated picture and nobody knows the future. However, let me throw out some puzzle pieces of comments and considerations as I see it right now.
- The mood among both investors and companies seems to be good. Optimistic investors buy stocks, and optimistic companies make investments. This supports further upswing.
- The technical trend in the price charts of most oil and gas producers such as Equinor, AkerBP, Shell, Exxon and Chevron is up. However, the well-known energy sector ETF XLE in the US reached its preliminary annual peak on June 8, then fell 27% in one month, and has since climbed up to Friday to close 15% below the annual peak. The sector fund is still currently trading above its 50, 100 and 200 day moving averages, and these are stacked on top of each other. Technically speaking, the uptrend is therefore still intact, but it is not very strong.
- The oil companies' earnings are directly dependent on the oil price, and their willingness to make future investments is largely influenced by their view of the long-term development in this commodity. The oil price does not show the same degree of technical strength as the oil companies. In the short picture, oil is now trading below both the 200, 100 and 50 day moving averages. That is not very strong. In a longer-term chart (below) we see that the price is now below the 1-year average, but at 90 USD/barrel it is still 10 USD above the 2-year average, and close to 20 USD above the 10-year average. Again, OK but not particularly strong.
Oil price (Brent) with monthly candlesticks over the last 20 years. Grey line is 12 months moving average, blue line 24 months and brown line 120 month. In other words: 1, 2 and 10 year moving average. Source: Infront.
- The long-term oil price chart shows the previous time when the price was between 100 and 120 USD. This period led to heavy overinvestment, and a subsequent downturn and capacity overhang. The oil companies remember this. They also remember very well that it is not more than 2 years since the price was down to touch USD 20 (and US oil for a brief moment had a negative value).
- The oil companies' investments are a dominant part of the oil service companies' income. Autumn is traditionally budgeting time for the oil companies, and a dip in the oil price down towards the 10-year average now is unlikely to increase investment appetite. Analyzes presented at the conference also showed that investments are increasing somewhat compared to 2020 and 2021 but are still at low levels. It also emerged that it is smaller and independent oil companies that increase investments first. The big ones (so-called Oil Majors) are still holding out. This is not unusual at the start of an upswing cycle, but also makes one question the strength, speed, and timing of such an upswing.
- I would like to mention, however, that around the conference I heard anecdotal stories which suggested that some of the larger oil companies had a touch of desperation when they saw the upcoming tightening of access to resources in the supply chain. Until we see this reflected in concretely increased investments, however, it is difficult to attach any particular weight to this. But these are good stories, and we have seen this before. it is what creates cycles.
- The uncertainty surrounding the upcoming level of investment is somewhat reflected in the charters of the oil service companies. The oil services sector ETF OIH in the USA has a weaker technical picture than the above-mentioned XLE containing the oil companies. OIH hit its preliminary year high on June 7 and then fell a near-vertical 36% in 26 days. The ETF is dominated by the big service companies such as Schlumberger and Halliburton. Several smaller service and rig companies saw their share prices halve in one month. This is not strong technical behavior and indicates a lurking nervousness among investors. At the time of writing, OIH is trading below its 200-day moving average, while this as well as the 50- and 100-day are close together and moving sideways. I would characterize the current trend as unclear.
- Fundamentally speaking, the service sector is very cyclical. Many of the segments are highly capital intensive in that the companies must own or have access to rigs, ships, and other heavy equipment. This costs a lot to build and maintain. If there is excess capacity, the temptation to rent out equipment (such as rigs) at low rates just to cover interest and maintenance will be high. The alternative is often bankruptcy. Only when rates have been at a high level for a long time will it seem profitable to build new capacity. When many do this, capacity can again be seen to exceed demand, and lay the foundations for a new downturn. My impression from the conference is that we are a long way from seeing a new wave of construction yet. There is still an offer overhang from the previous cycle peak. The companies have also been restructured to varying degrees. Some have been through this (for example in a chapter 11 bankruptcy), while others still have a balance sheet characterized by too much debt. In terms of capacity and rates, we seem to be facing a period of clearly increasing profitability for many of the companies in the sector, but the balance sheets and ownership situations in some of the companies make the picture complicated for an equity investor. There should ideally be some capital left when the debt is paid.
- Capital-intensive industry is by nature interest rate sensitive, and interest rates are on their way up at full speed. The US 5-year Treasury yield is now higher than 10 years ago. On top of this, investors must add a risk premium, and this credit premium has also risen. Higher interest rates favor investments with near-term income, and we see this through little willingness among the larger companies to make exploration and production investments with cash flows far into the future. This inhibits increased production and capacity expansion, and thus supports a longer period of higher oil prices. At the same time, high interest rates rarely lead to cheers from companies that have to refinance their debt, and there are many of them in this sector.
As usual, it is difficult to draw any clear conclusions in the stock market. As a technician, I think the slightly weak oil price gives cause for caution, and so does the startlingly high speed with which many share prices fell during the summer's correction. On the other hand, there are clear signs of increasing tightness and profitability in some segments, and the arguments for a longer recovery cycle in these seem good. I think it might be wise to draw up a list of stocks that you want to own for a longer swing up and use a weak market and any dip in the price of oil this autumn to enter these at presumably good levels. Otherwise, the fluctuations will, as always, create short-term opportunities that can provide good trades along the way.
Disclaimer: After many years in the brokerage industry, in 2021 I published "Paleo Trading: How to trade like a Hunter-Gatherer” and launched a hedge fund that trades according to the principles described in the book. Vontobel asked if I would write posts for their blog, similar to what traders and managers do in other countries. It is emphasized that nothing written on this blog is to be regarded as personal advice or a concrete call to take positions. Everyone must be responsible for their own decisions and familiarize themselves with the products they use.
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