Rising oil and natural gas prices are driving a rally in U.S. energy stocks, signaling the beginning of a new phase in the ongoing story of America’s energy dominance as companies look to tap debt markets to expand operations.
While the latest uptick in prices won’t completely make up for the slow recovery rate this year, the outlook for the U.S. oil and gas sector in the coming year is very bright indeed. Oil prices are now at their highest levels in the past two and a half years, with U.S. benchmark crude West Texas Intermediate (WTI) recently breaching the milestone $60-a-barrel mark for the first time since June 2015.
A polar vortex, meanwhile, has heated up the natural gas market with trading above $2.90 per million Btu – up more than 15% since before Christmas – amid forecasts for a colder-than-normal winter across the country.
U.S. energy stocks are following suit. The S&P Energy ETF (XLE)is up 7% this month, and technical indicators suggest it’s ready to go higher. The fundamentals say so, as well.
OPEC and non-OPEC producers, led by Russia, have agreed to extend price-supportive oil production cuts through the end of 2018, an arrangement that effectively subsidizes U.S. oil producers. Pipeline outages in Libya, the North Sea and elsewhere, as well as mounting tensions in the Middle East, have also helped bolster prices in past week.
Recent trading activity in WTI and European benchmark Brent crude shows investors are increasingly seeing oil prices as a one-directional bet and are putting their money on prices continuing to climb.
Forward price curves for both WTI and Brent are in a state of “backwardation,” which demands higher prices for prompt deliveries compared to future supply, pointing to increased tightness in the oil markets.
A tighter market means higher oil prices, but how high will prices go? We could easily see WTI prices reach – and remain – in the mid- to high-$60s based on growing global demand and continued uncertainty. That’s more than adequate to drive another round of investment by shale producers. As recent pipeline outages have shown, supply disruptions and geopolitical fears could tack on further premiums. Saudi Arabia also remains highly motivated to enforce OPEC’s recently renewed production restrictions in the run-up to the planned public offering of its state-owned Saudi Aramco in the second half of 2018.
All of this is good news for American producers, who are well positioned to seize on this moment. As prices have moved higher, domestic producers have increased their hedging, essentially locking in prices for their future production and guaranteeing robust cash flows. Expect producers to continue to increase hedging for both oil and gas during price upswings in 2018.
The more cash flow the sector generates, the more it will spend on drilling. A drilling boom bodes well for the services sector, the contractor firms that help producers drill and complete wells. The oil services sector was battered particularly hard during the oil price downturn and badly needs a lift.
Shares of most oil services companies remain stuck in full downturn mode and therefore provide the biggest upside to investors. Higher commodity prices will increase access to capital markets across the board for the U.S. energy sector, allowing companies to expand their drilling programs, restructure debt and bolster their balance sheets.
Forecasts for a 20% increase in U.S. exploration and production spending in 2018 are likely low since most producers set their capital budgets when the price of oil was still below $60 a barrel.
The U.S. oil and gas sector is also reaping the benefits of an industry-friendly Trump administration. The new tax reform lawsigned by President Trump this month slashed the corporate tax rate from 35% to 21% while maintaining every tax deduction valued by the oil sector, including the option to expense Intangible Drilling Costs and same-year expensing for capital investments, something particularly important for smaller independents and drilling companies. Industry confidence in Washington has surged since President Trump took office last January, based on his agenda of regulatory reform following eight years of what many saw as overreach and a tendency to favor the environmental lobby by the previous administration.
Big things were expected from the U.S. oil industry in 2018 even before the recent uptick in prices. Now, the sky appears to be the limit. The latest projections by the U.S. Energy Information Administration (EIA) show domestic oil production rising to a record 10 million barrels a day in 2018 – an increase of 800,000 barrels a day from 2017 – on back of a resurgent shale sector.
The EIA forecast is based on a forecasted average WTI price of $53 a barrel – a price point that looks extremely conservative now. Some see the potential for U.S. producers to shoot themselves in the foot by drilling so hard and producing so much that global markets once again become oversupplied, holding prices in check. But while there’s sure to be plenty of drama between U.S. producers and OPEC, even Saudi Arabia – which risks losing market share with every uptick in U.S. production – believes there will be room for America’s 10 million barrels a day of output without crashing the market.
As the U.S. energy sector prepares to toast the entrance of 2018, an inflection point for investing has been reached with all signs pointing to a strong rally in the new year and plenty of good cheer.