2019 outlook: Energy

US-based exploration and production companies turn the corner, moving beyond oil production growth to profitability.

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energy_outlook_2018_pageiconFor the past 5 years, US-based exploration and production (E&P) companies increased their production of crude oil and natural gas rapidly, with newly efficient shale drilling technologies serving as the catalyst.

The technology, known as fracturing, led to a wave of equipment purchasing, land leasing, and infrastructure development (e.g., roads, pipelines, electricity), all of which was aided by the ability of E&P companies to raise low-cost capital. While growing production, many E&Ps borrowed capital and spent money far in excess of free cash flow—the cash a company generates after investing in its business (e.g., property, plant, equipment costs)— which is typically a measure of balance sheet strength, or profitability. This lack of profitability caused some investors to remain apprehensive about owning E&Ps.

During the past year, we've seen the culmination of shale drilling technologies. The early movers into shale basins— the well-managed E&Ps with the lowest production costs—made the transition from growing production with little or no free cash flow to growing production and generating significant free cash flow. As an investor in the energy sector, this development appears to be validating the E&Ps’ business model, and that was my hope when I began favoring this investment theme several years ago. The combination of production growth and free cash flow makes these companies more valuable businesses, and helps them stand out on Wall Street among their sector peers as well as the broader market. Only a small fraction of companies in the S&P 500® index organically grow more than 10% per year and generate free cash flow.1

There are positives and negatives to these productivity improvements by US E&Ps. On the one hand, US E&Ps are more competitive globally. Shale fracturing technology has helped the US become the world’s lowest-cost producer of crude oil.2 US shale oil companies require about $50-per-barrel oil prices to justify investment, with leading companies generating returns with prices as low as $40. By contrast, every member of the Organization of Petroleum Exporting Countries (OPEC) ran a budget deficit in 2017 when oil averaged $51. The International Monetary Fund estimates that Saudi Arabia requires oil above $80 to balance its budget. In a commodity industry, companies with the lowest production costs are going to generate greater free cash flow.

The downside to improved US productivity is structurally lower oil prices, which hinders the energy sector's overall profitability and, among E&Ps, only favors the leading low-cost producers. Conversely, with oil above $70, as it was earlier in 2018, the US has demonstrated an ability to grow overall oil production rapidly. The International Energy Agency estimates that the US will grow oil supply by 2.1 million barrels per day (mbd) in 2018, which is greater than global oil demand growth estimated at 1.3 mbd. In an environment of $70-plus pricing, most US producers are able to generate free cash flow and significant volume growth simultaneously. At some point, that can become self-defeating, and recently it pushed oil prices lower. The inverse is also true. Oil prices below $40 typically lead to a reduction in US supply and a massive decline in global oil inventories.

The opportunity today appears to be in low-cost US E&P companies that are driving the global cost curve lower. Early adopters of shale technology have matured to the point where they are able to grow faster than the industry and generate free cash flow. One E&P grew oil production by 27% on a year-over-year basis and generated significant free cash flow for the quarter ending September 30, 2018. Previously, the company was growing oil production but wasn't generating any significant free cash flow. The market recently has been valuing some US-based E&P companies as if the synchronous global expansion will stall in 2019, and demand for oil will crater, with E&P stocks trading at a discount to those of large integrated oil companies (see chart above). I've been using this as an opportunity to upgrade the portfolio with higher quality E&Ps that I feel have the best prospects for generating production growth and free-cash-flow growth, and I remain optimistic that this group will outperform other areas within the sector over a longer time horizon.

Next steps to consider

Research the Fidelity® Select Energy Portfolio (FSENX).

Get more investing ideas and sector insights.

Go back to the full 2019 sector outlook.

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