2018 outlook: energy

US-based exploration and production companies remain the sector’s sweet spot.

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energy_outlook_2018_pageiconWith many energy companies around the world facing profitability challenges due to crude oil prices hovering in a $45-$55 range for much of 2017, I continue to maintain conviction in certain higher-quality, US-based exploration and production companies (E&Ps). These companies have adjusted their cost structures to reflect the lower commodity price environment and now have the ability to self-fund material production growth. Importantly, this ability of the US to increase volumes puts the profitability of many international energy producers at risk. Looking out into 2018, I continue to believe those E&Ps that have embraced new, disruptive technology offer a compelling combination of risk and earnings growth potential.

Two deflationary forces within the energy sector have driven down commodity prices, but may benefit US-based E&P companies. First, the ease with which US energy companies have been able to raise capital has led to increased oil production capacity within the industry and lower oil prices around the world. Second, improved well productivity via new shale-fracturing technology has allowed US E&Ps to increase production growth and achieve profits even as crude oil prices have declined well below their most recent cyclical peaks. US shale production represents only 5% of the world’s supply of crude oil, but that rate of production, if altered, can influence the price of crude oil given the tight balance of global supply and demand.

Several US E&P companies have demonstrated the ability to grow oil production at half the commodity price of just a few years ago. Companies operating in the Permian (Texas) basin, for example, have the ability to boost production at 20% per year for the foreseeable future, based on our estimates. Many of these companies continue to benefit from strategic land ownership near fertile basins, improving well efficiency and productivity, and by maintaining little or no debt. These are real competitive advantages in an environment of lower commodity prices.

Conversely, the growth of US shale oil production and the decline in global crude oil prices during the past few years has put considerable pressure on the profitability of some companies, particularly foreign E&P producers that drill offshore. Many foreign E&P companies cannot produce oil profitably when it is priced near $40 a barrel or less. The Organization for Oil Exporting Countries (OPEC), a group of foreign countries that collaborate to manage their collective exportation of crude oil, has seen annual net export revenues fall from a peak of $1.18 billion in 2012 to $433 million in 2016. Looking into 2018, I do believe there are some factors that could provide support for oil prices to remain at the upper end of its recent range or even move higher, but I am not optimistic that crude oil prices will recover to historical peak levels.

In addition, the market has been valuing some US-based E&P companies as if commodity prices will remain low in perpetuity, and also as if they will not achieve production growth going forward (see chart above). I see that as an opportunity. Overall, given these industry dynamics, I have been allocating capital to the US E&P stocks with better cost positions, production growth, and return prospects than their foreign peers. This strategy wasn't rewarded during the first three quarters of 2017, as E&P stocks underperformed the broader energy sector. Importantly, this underperformance was due to multiple compression rather than sub-par cash-flow growth. I remain optimistic that this group will outperform other areas within the sector over a longer time horizon.

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John Dowd is a portfolio manager for Fidelity Investments. Mr. Dowd currently manages energy sector portfolios and subportfolios. He joined Fidelity in 2005 as an equity research analyst.
Fidelity Thought Leadership Vice President Kevin Lavelle provided editorial direction.
Views expressed are as of Dec. 1, 2017, based on the information available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
References to specific investment themes are for illustrative purposes only and should not be construed as recommendations or investment advice. Investment decisions should be based on an individual's own goals, time horizon, and tolerance for risk.
This piece may contain assumptions that are "forward-looking statements," which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.
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Because of its narrow focus, sector investing tends to be more volatile than investments that diversify across many sectors and companies. Sector investing is also subject to the additional risks associated with its particular industry.
The energy industries can be significantly affected by fluctuations in energy prices and supply and demand of energy fuels, energy conservation, the success of exploration projects, and taxes and government regulations.
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