Our Favorite Long-Term Themes: Oil Dependency

How Bearish is too Bearish?

Year-to-date, energy (XLE) is the worst-performing sector in the S&P 500. Energy was the second-best performing sector in the first quarter and was up as much as 17% at the beginning of April, and has been on a steady decline lower, now up just shy of 3% through mid-September. Crude prices have followed and are negative on the year and down 10% in the last three months.

On September 10, Brent crude futures hit their lowest level since December 2021, just shy of $70/barrel. OPEC (Organization of the Petroleum Exporting Countries) updated its 2024 and 2025 oil demand projections and lowered its expectations to 2.03 million barrels per day (bpd) from the previous estimate of 2.11 million bpd. Its 2025 forecast was also lowered to 1.74 million bpd from 1.78 million bpd.

Declining demand in China has been one of the main drivers of lower energy prices. China consumes around 50% of the world’s refined products and 15% of the world’s crude oil. Oil product demand in China is expected to decline -1.1% annually until 2025, due to a continued drag coming out of COVID-19, slowing economic growth, and greater electric vehicle adoption.^[1] Over the past decade, the annual increase in Chinese oil demand has accounted for more than 60% of the total average global increase, so negative economic data and slowing growth out of China have weighed heavily on the commodity’s outlook.^[2] Oil demand in the region shrank 0.5% y/y in the first half of 2024, and it is unlikely that the country will hit its 5% GDP growth goal this year.

China’s CPI rose just 0.3% y/y in August – the slowest speed since March 2021, suggesting a slowdown in consumer spending and reduced business activity. We think China is well-attentive to its economy, and believe its government is just a few bad data points away from a program to stimulate the Chinese economy, which would ultimately benefit crude and commodity demand.

Chart 1 & 2: Over the Past Decade, China Led the Globe in Oil Demand, which is Now Slowing^[3]

U.S. Production is the Highest in the World, at Record-Highs

Relative to China, the U.S. economy remains well-balanced and will likely see 2-2.5% GDP growth this year. The U.S. recently hit record levels in oil production at 13.4 million bpd and averaged 12.9 million bpd in 2023 and 13.3 million bpd in December 2023, both previous record-highs.^[4] The U.S. is exiting peak driving season and entering pre-heating season. September is historically the worst month of the year for crude future prices given this slowdown in demand as we await colder weather.

The U.S. economy seems to also be at a major turning point. The Fed just lowered its policy rate for the first time since 2020, and easier financial conditions should support cyclical sectors of the economy. Central banks around the world are also following suit, with some even ahead of the Fed in lowering interest rates. Lower interest rates should be supportive of an already well-functioning, growing economy. The U.S. is on the cusp of beating inflation, with a healthy consumer, growing corporate profits, and a balanced labor market. Also, the U.S. dollar is the weakest it has been since January 2024, which should help crude prices.

Chart 3: U.S. Oil Production Hit a Record-High in 2023^[5]

What Helps Improve Global Oil Demand Going Forward?

High levels of supply, low levels of demand, China’s weakness, and a murky global economic growth outlook has crude price at the lowest level in nearly three years. Sentiment across investors is also extremely low – oil net managed money positioning is at an all-time low since Goldman Sachs began tracking in 2011.^[6]

But oil demand is likely to remain elevated, and even accelerate, in the years to come. Goldman Sachs projects that peak oil demand is over a decade away due to rising global incomes and slower adoption of electric vehicles. An outsized need for petrochemicals and refined products like jet fuel could more than offset the slowing demand for gasoline, in the case that electric vehicles are adopted at a faster rate than expected. RystadEnergy shares a similar view, and projects growing demand for oil in transportation and industrial services will outpace low-carbon alternatives in the medium-term.^[7]

Exxon Mobile (XOM) sees no slowdown in oil and natural gas use. By 2050, they project that oil and natural gas will still make up over 50% of the world’s energy mix, and state if every new car sold across the world in 2035 was electric, oil demand by 2050 would still be 85 million bpd – equivalent to levels seen in 2010.^[8] The company sees a plateau in oil demand beyond 2030, but demand will remain above 100 million bpd through 2050. Industrial demand is likely to grow by 30% in the next ~26 years, with commercial transportation growing 10%. Light-duty vehicles are expected to see an oil demand decline of -25% by 2050.

Chart 4: Peak Oil Demand is Still 10 Years Away^[9]

And not to mention artificial intelligence (AI), which will provide a number of efficiencies to the energy market. New technological developments have been shown to save humans operating drilling rigs 5,000 commands and increase the speed of drilling by at least 30%, with cost savings in the range of 25-50%.^[10] The president of SLB’s well construction unit has stated that he believes 15% of all wells will be autonomously controlled by AI in the next three to five years. AI is likely to improve workflows and cut costs through all stages of oil exploration and production, which have yet to be fully tapped into.

How We Are Exposed to This Theme

The energy sector is currently greatly out of favor, as seen by record-low positioning and fears of a global slowdown. We see immense value in many energy names and believe there will likely be a turnaround with the Fed embarking on a new easing cycle. The U.S. Energy Information Administration (EIA) sees oil prices returning to $80/barrel later this month through withdrawals from global oil inventories, led by OPEC. They expect Brent crude prices to average $82/barrel in 4Q24 and $84/barrel in 2025, around 15% higher than current prices.

We added to our energy exposure through XOM. XOM maintains a diversified revenue mix across upstream, downstream, and chemicals. The company is guiding for a +10% organic compounded annual growth rate (CAGR) through 2027 assuming Brent crude prices of $60/barrel. XOM’s recent acquisition of Pioneer Natural Resources doubled the company’s oil production to 4.3 million bpd with many synergies likely to be found. XOM’s near-term catalyst is its annual corporate plan update on December 11, 2024, which will likely bring many new developments. Longer-term, XOM’s Product Solutions business is projected to contribute $4.7 billion to its earnings by 2027. The company is expected to buy back $20 billion in stock next year, and trades at a ~13x forward P/E ratio.

SLB (SLB) is a second name we prefer in the energy sector. SLB is the number one oil field services company, trading at historically cheap valuation levels. It has a strong international business growing high single digits and has increased technology adoption which has aided margin expansion in its digital and integration division, with margins up 435 basis points to 31% last quarter. SLB has $7 billion worth of buybacks and dividends in the next two years with an analyst day scheduled later this year to showcase key growth drivers across the business.

Diamondback Energy (FANG) is one of the best operators in the Permian basin with very low leverage. Efficiency is the name of the game for FANG – in the last quarter, the company dropped its rig count by 15%, had a higher per-crew completion rate, and drilled wells 10% faster than compared to January. FANG raised its production guidance and saw its free cash flow rise by over 50% y/y. Along with the broader sector, FANG is down -12% in the third quarter.

Other names we are exposed to include Chevron (CVX), BP (BP), and Shell (SHEL). These companies are some of the largest integrated oil companies in the world with diversified asset bases. They maintain strong balance sheets, growing dividends, and are not exposed to an individual industry – they are active in all parts of the oil exploration and production supply chain.

This sector is greatly out of favor, and we believe it could see a turnaround. China is nearing the tipping point of stimulating its economy, thus benefitting oil prices and demand. Supply is likely to slow down in the coming months and demand growth across industries should be plentiful in the years to come. Companies in the sector have been beaten down by growth fears and lower crude prices which has provided us the opportunity to buy quality companies on sale.

^[1] Source: Reuters. As of September 10, 2024.
^[2] Source: IEA. AS of September 12, 2024.
^[3] Source: IEA. As of September 12, 2024.
^[4] Source: IEA. As of March 11, 2024.
^[5] Source: IEA. As of March 11, 2024.
^[6] Source: Goldman Sachs. As of September 15, 2024.
^[7] Source: Rystadenergy. As of May 15, 2024.
^[8] Source: Exxon Mobile. As of August 2024.
^[9] Source: Goldman Sachs. As of June 17, 2024.
^[10] Source: Bloomberg. As of March 14, 2024.