The global coronavirus pandemic has upended economies and industries in massive ways. One sector that has been whipsawed by the illness is energy, which was out of favor and now has come back sharply. Investors should take the positives of today with a massive grain of salt, though. Here's why energy stocks look set to continue posting strong results, and why that could set up the industry's next downturn.
The green flag
When the pandemic first hit in 2020, one of the key responses was for economies around the world to effectively shut down. Non-essential businesses were closed, people were asked to socially distance, and employees who could work from home did so. That resulted in a decline in demand for oil and natural gas. Investors reacted to that by selling shares of energy sector names, including even financially strong giants like ExxonMobil (XOM 1.15%) and Chevron (CVX 1.54%).
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Energy companies, meanwhile, reacted by pulling back on their spending. That's pretty normal during an oil downturn. However, this tendency generally sets up the next upturn. Exxon, for example, slashed its capital investment budget from $31.1 billion in 2019 to $21.4 billion in 2020. Chevron took its capital spending budget from $21 billion in 2019 to $13.5 billion in 2020.
Essentially, oil drillers pulled in their horns to save money and help to balance supply with demand. But those one-year drops were related specifically to the pandemic. There are longer-term trends at play here as well, though. Industrywide capital spending peaked in 2014 at around $780 billion and fell to just $310 billion in 2021.} That said, when the global economy began to reopen, energy demand picked up and supply wasn't sufficient to meet the renewed demand. As a commodity, this imbalance led oil prices to rise and, as you would expect, energy company results rebounded strongly. To put a number on that, Exxon went from a $0.33-per-share loss in 2020 to a profit of $5.38 in 2021. Chevron's rebound was even more impressive, going from a $2.96-per-share loss in 2020 to a profit of $8.14 per share in 2021. Again, these are short-term changes related to an extreme event, but they highlight the tension between supply and demand that can cause drastic industry shifts.
The green light here is that these good results are likely to continue, because demand for oil still appears to be outstripping supply. Geopolitical tensions are one reason for this, but a still-important piece is related to the spending plans of oil and gas drillers. Capital investment to boost production has inched higher, but the industry is showing a material amount of spending restraint.
The red flag
The energy industry is not a simple market, and there are a lot of moving parts today. For example, the push toward clean energy is likely to mean lower demand over the long term. And geopolitical tensions are a wild card that is hard to predict. However, high energy prices in this industry have historically had a very predictable impact on capital investment.
Just like it is predictable that low prices will lead drillers to pull back on spending, high prices generally lead drillers to spend more on drilling. We are already seeing that start to take shape. For example, Exxon entered 2022 with capital investment plans of between $21 billion and $24 billion after spending just $16.6 billion in 2021. Overall, the industry is still moving very slowly when it comes to increasing capital spending. While this could be a new paradigm, over 100 years of history suggests that this restraint won't hold forever. And when investment levels pick up more materially, the industry will be setting itself up for the next downturn.
Investors should keep a close eye on spending across the industry and know that the historically cyclical energy sector is likely to go through the same boom and bust pattern that it always has. Cycles like this can last several years, but the current good news will eventually lead to bad news as the industry's capital spending (and thus production) pendulum eventually shifts back in the opposite direction.
History rhymes
Nobody knows what the future holds, and this time could, in fact, be different for the energy sector. But when you hear "this time is different" on Wall Street it is usually time to get worried. The energy sector is benefiting from high energy prices right now for a number of complex reasons. But high energy prices have historically led to increased production and an eventual industry downturn as supply comes to exceed demand. Enjoy the high energy prices today, but don't forget the lessons of history for this highly cyclical sector.
