2020 has brutalized the oil industry. Investors have lost billions as the sector continues to struggle with a double-digit decline in demand and global production that threatens to pour more crude on an oversupplied market. As a result, the Energy Select Sector SPDR ETF (NYSEMKT:XLE), which tracks the energy stocks in the S&P 500, is still down almost 50% from pre-pandemic highs.
Other sectors have driven the market back to all-time highs. The Technology Select Sector SPDR ETF (NYSEMKT:XLK) has been the best performer by far; the sector is still up 27% so far this year, and up an incredible 65% since late March. What should investors do? Is it time to pivot some of those profits out of tech stocks and take a hard look at the oil patch?
Before taking a dime and putting it at risk in the oil patch, there's a lot more to understand about the implications of a protracted downturn in oil demand, and how it could weigh on oil stocks for some time to come.
A summary of the 2020 oil crash
The 2020 oil story begins -- and will end -- with the coronavirus pandemic. In early February, the International Energy Agency warned that oil demand was going to fall in the first quarter due to the impact of the novel coronavirus. In its February oil markets report, the IEA said China was shutting down its economy to control the spread of the virus that causes COVID-19. Even at that point, energy experts saw some of the implications; the impact on China alone would result in the first quarterly decline in global oil demand in more than a decade.
Oil prices would fall more than 10% in February as concerns about the coronavirus grew, but by the end of the month, the global Brent crude benchmark was still above $50 per barrel. Enter Russia and Saudi Arabia. An epic crude oil standoff ensued that kicked off a global crash in crude prices, which still weighs down the entire sector. Before the calendar turned to March, there was still hope that global heavyweights would reach a deal to curb oil output and stabilize the market. Long story short, OPEC, led by Saudi Arabia, proposed a deal that called for Russia to cut 1 million barrels per day from their combined production.
Russia balked. In response, Saudi Arabia walked away from the table and went to war with Russia and essentially every other oil producer on earth. The petrostate, which controls the largest -- and some of the cheapest -- oil reserves on earth, announced it would ramp up oil production sharply above prior levels and would increase its oil exports by an incredible 43% in mid-March.
While the world's oil giants battled for market share, driving oil prices down more than half, the coronavirus was spreading around the world. By April, global oil demand had fallen 30% -- about triple Saudi Arabia's entire 2019 oil output -- and the global oil industry was in free fall.
Demand quickly rebounded from the bottom but is still far from recovering, while prices remain depressed. According to the U.S. Energy Information Administration, global production averaged 91.5 million barrels per day in August; that's about 9.7 million barrels per day below 2019 levels. For context, that's the equivalent of removing all of Saudi Arabia's 2019 oil production from global demand.
Is it time to buy oil stocks? Some signs point to maybe
The oil industry has been brutalized by the coronavirus crash, but there are some indicators that it's getting better. Demand and prices did stabilize and improve over the summer, spending months at prices that are above breakeven levels for many producers.
Occidental Petroleum (NYSE:OXY) is a good example. The oil producer, saddled with almost $40 billion in debt following the ill-advised acquisition of Anadarko Petroleum last year, said it would pay Berkshire Hathaway a cash dividend on its preferred shares this quarter. That's definitely a move in the right direction after Oxy was forced to pay Berkshire with common stock in the second quarter due to the oil price crash that had it (and essentially every other oil producer) bleeding cash. For Oxy, oil prices near or above $40 make funding its operations and starting to address its debt feasible.
More recently, a merger between Devon Energy (NYSE:DVN) and WPX Energy (NYSE:WPX) gave investors hope that the U.S. oil patch could start to consolidate itself out of the downturn with more deals structured to reduce costs and drive better returns for investors. The two companies say they will implement a dividend strategy starting at Devon's current $0.11 per share quarterly payout, which will use up about 10% of operating cash, and pay a variable distribution based on market conditions and cash flows. The goal is to pay as much as 50% of excess free cash flows, but only so long as the company has at least a certain minimum amount of cash on the books.
This is a stark difference from the sort of M&A activity oil companies have taken in the past. The Oxy/Anadarko deal in particular is one of the most egregious, with the company paying $57 billion, mostly in debt, to buy Anadarko. The deal was widely panned as being wildly expensive. Oxy has been nearly crippled with the resulting debt, and serious questions linger about its ability to survive the downturn.
Yet just as quickly as the path forward looked better, the gorillas stepped back into the room.
Here's the biggest risk to oil stocks
With global demand still well below prior levels, global giants are fighting for every barrel of market share. Early in September, Saudi Arabia slashed crude prices to two of the biggest global markets. Prices to Asia were lowered following a decline in crude orders by Chinese refiners, which bought record amounts of crude in the second quarter at discounted prices. Those orders slowed over the summer, but Saudi Arabia is soaking up as much market share in this high-growth region as it can.
The move to cut prices to U.S. refiners is a shift in strategy for the country. It sent some of the lowest levels of crude in the past decade to the U.S. in the second quarter, but has pivoted back to the second-largest oil market on earth, putting shale producers on notice that it's here to compete and will win on price. Crude prices have fallen about 10% since the beginning of the month, and the key U.S. benchmark, West Texas Intermediate, is back below $40 per barrel at this writing.
Russia, the U.S., and Saudi Arabia are the three largest oil-producing countries on earth. All have seen their oil output fall sharply this year:
The difference is that in the U.S., mineral rights on private land are owned by private citizens, while Russia's and Saudi Arabia's oil are government-controlled. Their vast reserves are also generally much cheaper to produce than the shale resources U.S. producers are developing.
Between a lower cash production cost and the fact that oil revenues drive a massive portion of those countries' economies, the ongoing downturn in demand will continue to weigh on prices as these global heavyweights fight for every oil dollar they can earn. Considering how much of their financial reserves many U.S. oil producers have already burned through this year, the margin of safety is thinner, and a price war isn't a war U.S. oil producers are built to win.
Do petrostates smell blood in the water?
Over the past five years, U.S. oil producers have cranked up the output to record levels, making the U.S. the world's largest producer of crude oil. At the same period, it has largely fallen on the OPEC+ group led by Saudi Arabia and Russia to moderate global production and thus stabilize prices:
OPEC+ has played a major role in stabilizing the oil market while U.S. shale producers have steadily taken more market share over the past five years. I expect that, so long as global oil demand remains depressed below 2019 levels, Saudi Arabia, Russia, and their cohorts in OPEC+ will only act as a stabilizing force to a limited extent. There's simply too much at stake for these oil states, and their pricing power is their best weapon against U.S. shale producers.
As much as oil markets have stabilized, many U.S. oil companies have a much smaller margin of safety today than they did six months ago, and a further, prolonged deterioration in oil prices could prove fatal. The shale industry may not be facing an existential crisis, but plenty of individual companies are. Even the ones that can outlast a protracted price war will suffer. It's too hard to tell what will happen next to make the space worth risking capital in right now. Simply put, outlasting a downturn is a far cry from being a successful investment.
Put it all together, and with few exceptions, investors would do well to continue avoiding the majority of stocks in the oil industry for the foreseeable future.