Energy stocks aren’t getting much help from oil prices this year, but they could get a boost from an unusual place—deflation.
Oil prices have been stuck between roughly $68 and $75 a barrel since the start of May, and not even Saudi Arabia’s surprise announcement following the OPEC+ meeting on June 4 was able to change that. The Saudis said that they would cut crude oil production by 1 million barrels a day in July, on top of the already agreed-upon cuts made by OPEC+ members, which have been extended through 2024. WTI crude, the U.S. benchmark, gained 1.1% this week through Thursday, to a mere $72.53.
There’s only so much Saudi Arabia can do on its own to prop up the price, however. That’s especially true when China’s postpandemic economic reopening is sputtering and Russia needs to sell oil at any price to fund its war effort, explains Edward Yardeni, president of Yardeni Research. A stable oil price might be the best outcome that Saudi Arabia can hope for. “[They] may be slowing the descent of oil prices,” Yardeni writes.
Flat oil prices may still be enough to deliver plenty of earnings for producers, even if there’s no repeat of oil’s 2022 gains. Last year’s boom was accompanied by ballooning production costs, thanks to rising prices for labor, drilling equipment, diesel and other fuels, and the chemicals and raw materials used for extracting and processing oil and gas. When commodity prices are soaring, producers are happy to pay up rather than risk missing out on the bonanza. When there isn’t that rising tide to lift all producers, there’s more scrutiny of companies’ costs.
And oil stocks have received plenty of scrutiny this year. Not only is energy the worst-performing sector in the
S&P 500,
down 8.5% this year, it’s also one of the cheapest. The
Energy Select Sector SPDR
exchange-traded fund (ticker: XLE) fetches just 10.4 times expected earnings over the coming year, versus 18.6 times for the overall index.
There’s some good news for U.S. producers: Their production costs are likely to reverse somewhat in the coming year as the craze continues to subside, inflation abates, and new development remains limited. Prices for the tubes and pipes used in oil production and transport are already down over 20% over the past year. Costs of various oil-field services—which reset periodically when contracts are renewed—have been trending lower. Fracking machinery and sand prices are holding in there for now, but appear set to fall as availability improves.
Citigroup analyst Scott Gruber expects overall costs to drop by around 10% for U.S. shale drillers in 2024. How it impacts individual companies will depend on when their contracts roll over. Gruber points to
Devon Energy
(DVN) and
Marathon Oil
(MRO) as among the biggest potential beneficiaries, with the majority of their generally shorter-term drilling contracts rolling over in the second half of the year.
That won’t prevent revenue from declining—oil prices are down 40% from their peak last summer, after all. But it can help profit margins. The analyst consensus calls for an 18% drop in Devon’s sales in 2023 and another 9% decline in 2024, but Wall Street sees its earnings before interest, taxes, depreciation, and amortization, or Ebitda, margin rising to 59% in 2024 from 51% this year. That could help deliver 5% Ebitda growth next year despite the revenue decline, per analysts’ forecasts.
Not all producers will get as large a boost, including
Diamondback Energy
(FANG) and
EOG Resources
(EOG), argues Gruber. “FANG has excelled during the inflationary period which, along with a few longer-term [electric fracking] contracts…likely equates with relatively less deflation benefit,” he writes.
The benefit to oil and gas producers’ profit margins won’t reverse the overarching force of the declining value of the commodity that they sell. But it’s an underappreciated strength of Wall Street’s most unloved sector this year.
Write to Nicholas Jasinski at [email protected]
Read the full article here
