- Economic challenges and strong supply could depress oil and gas commodity prices.
- Despite the backdrop, there are still specific shale producers that offer investors opportunity.
- The best oil and gas companies now offer capital discipline, long-lived inventory, and a commitment to rewarding shareholders.
Stocks in the oil and gas space enjoyed a strong run during recent years as high commodity prices helped companies report historic profits. For the three-years through early March 2023, the S&P’s Oil, Gas, and Consumable Fuels Industry Index was up roughly 100%, about triple the broad S&P 500. Now, the rising tide of higher commodity prices has turned, and energy stocks are down for the year and lagging the market.
What’s next? We expect commodity prices to ebb and flow in the coming months, which means energy investors may need to be more selective. One interesting area: shale producers, where a new era of corporate discipline is creating opportunities for investors.
Oil and gas prices poised for volatility
Conflicting forces in the macro environment could lead to energy price volatility in the next six months. February’s inflation report showed the US economy continues to experience high inflation, and the Fed appears poised to raise rates further.
We expect the tighter monetary conditions will lead to a mild recession, which could undermine demand and put downward pressure on oil prices. At the same time, shale providers are poised to add supply to the market while OPEC has refused to change production plans, creating additional downward pressure on commodity prices.
On the other hand, China continues to reopen its economy after COVID lockdowns and we expect economic activity in the US to recover in the second half of 2023. Both of these trends could drive additional energy demand to offset some of the challenges. As a result, we expect oil to trade around an average price of $75-$80 per barrel in the first half of the year and average slightly higher prices — $80-$85 per barrel — in the second half of the year.
Shale producers offer potential for investors
While we are neutral to bearish on oil prices in the near term, the macro picture is just one factor to consider when looking at oil and gas stocks. The shale industry is experiencing changes in business strategy and technology that could create investment opportunities despite the challenging backdrop.
The shale oil industry is still relatively young, with the boom really starting just over a decade ago. In the first years of shale production, companies were aggressively seeking to grow output, seemingly at any cost. Today, many shale companies are adopting new capital discipline as part of a movement we call ‘Shale 3.0’. The new focus is on consistently rewarding shareholders and seeking sustainable growth through commodity cycles (rather than pro-cyclically).
This capital discipline could change the dynamics for energy investors. For one thing, many companies are offering share buybacks and dividends as they increase free cash flow. We expect payout ratios will be higher in 2023.
More broadly, in recent years, there was a perception that every time commodity prices rose enough to make shale profitable, shale companies would race to increase production — flooding the market with new supply and sending prices crashing down. This new era of shale could create more stability for the market, and a return to the pre-shale era dynamics when energy stock performance had a longer cycle.
Today’s best oil and gas stocks
We believe the best stocks in the oil and gas space have three characteristics: good capital discipline, a commitment to rewarding shareholders through dividends or stock buybacks, and good visibility into inventory without a degradation of capital efficiencies.
Our top pick in the space is Coterra (CTRA). The Houston-based shale company has a good capital efficiency number, 15+ years of inventory, and is committed to returning at least 50% of free cash flow through a quarterly return program. This quarter, the company increased its dividend and pivoted toward buybacks. They are seen as a gas play, but also have good oil inventory in the Permian basin. If gas starts recovering as we head towards 2025, they are well positioned to accelerate cash generation.
Diamondback (FANG) is another stock we like. The Permian-basin energy company is committed to returning 75% of free cash flow to investors. If the company believes its stock is undervalued, it will return cash to investors through a stock buyback; if not, it pays a special dividend. The company has 15+ years of good inventory, and they have consistently been the low-cost operator in the most productive rock in Shale.
Finally, Exxon (XOM) took a countercyclical approach in investing in recent years and is now reaping the benefits. Exxon says it expects to generate $100 billion in free cash over the next four years thanks to its investments in Guyana and the Permian basin. In some ways, it’s like the Apple of the energy sector: large, liquid, and successful. Exxon stands alone as a differentiated option among the major oil and gas companies, in our view.
The bottom line
Although some analysts have raised concerns about declining output from shale wells, we believe those concerns are driven by specific events and may be overblown. Advancements in technology can help shale producers increase efficiency. In the meantime, new capital discipline and cash returns to shareholders make shale producers interesting opportunities in the face of weakening commodity prices and weakening ‘value’ in other sectors.