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Energy stocks have been struggling the past two months, reflecting, in part, a steady weakening of oil prices. When oil prices fall, that generally indicates that supply is outweighing demand. But the factors that are driving oversupply may not be sustainable, which means prices could soon return to the previous higher levels. 

During the recent oil slump, West Texas Intermediate (WTI), a leading oil price benchmark, slid by about 40%, from about $76 per barrel on October 3 to a low of just under $46 per barrel in December. Stocks in the energy sector have followed suit, with the S&P 500 Energy sector posting double-digit losses over that time frame.

Actual and Neutral Fenderal Funds Rate

These dramatic declines broadly reflect a number of recent changes in supply and demand trends. For example, in early November, the Trump administration issued waivers that eased sanctions against Iranian oil sales, which had the effect of enhancing global supply. 

But the bigger story around supply stems from the U.S., where domestic producers have boosted production significantly in recent years. A decade of investments and increased oilfield activity has resulted in higher oil and gas output. The U.S. is likely to become a net oil and petroleum products exporter by 2020 – a remarkable change after decades of dependence on foreign oil. In fact, the U.S. has recently regained the lead as the world’s leading oil producer at about 11.6 million barrels per day.

This expansion of supply comes at a time when the global economy appears to be slowing. Although we believe demand for oil will continue to increase in 2019, it could be at a slower pace than 2018. The combination of rising supply and average demand growth explains a lot regarding the current downward pressure on prices.

But one thing we’ve noticed about energy prices is that they can move dramatically, and quickly, in response to even modest changes in supply and demand trends because supply and demand are tightly balanced. Forecast changes of just 200,000 to 300,000 barrels-per-day on a 100 million barrel-per-day base can move markets. Moves are often compounded by investment flows – from speculators – that can play into the movement of day-to-day prices. In recent weeks, oil speculators have been shorting energy (essentially betting that oil prices will decline) in response to supply and demand news, which puts further downward pressure on the price.

Broader Realities May Push Prices Higher

Short-term supply and demand movements typically have a direct impact on energy prices. But we think it’s valuable to look beyond the day-to-day fluctuations and evaluate the bigger picture. What we see are a number of factors that may drive energy prices higher over the longer term.

One of the biggest signals that the current price downturn is likely to be temporary is that current oil inventories have dwindled to a relatively low level. By definition, inventories rise when there is oversupply. Ordinarily, prices come down because there is a backlog of unsold oil that needs to be worked through. That’s not the case today. In fact, inventories are currently below normal – as they have been throughout most of 2018, as the following chart illustrates:

What’s more, the capacity to produce more oil is tightly restrained. For example, production in Saudi Arabia has recently reached an all-time high of just over 11 million barrels per day, which is about 1.4 million barrels per day below the country’s claimed capacity of 12.5 million barrels. This 1.4-million-barrel difference represents the vast majority of the world’s spare capacity. In an environment where excess capacity is so limited, there is little room for production or geopolitical hiccups. 

It’s also true that the energy-producing countries have moved quickly to address the current supply-demand imbalance. At the recent December OPEC meeting, the OPEC nations, along with Russia, agreed to restrict production in order to bring supply and demand more into balance.  Canada, separately, is cutting output by over 300,000 barrels per day.

Of course, it’s possible that these countries won’t stick to their pledged targets, as has sometimes been the case in the past. But the evidence suggests they may not have much choice. Many energy-producing companies and nations simply cannot achieve a viable return on invested capital at the current depressed price levels.  Saudi Arabia communicated its 2019 government expenditure plans in mid-December and oil prices in the mid $80s are needed to balance the budget.

One other crucial factor that will affect oil supplies in the future is the fact that oil is a depleting resource. There are very few untapped oil sources at this time, and those that are known would require higher oil prices in order to be economical. Existing oil fields – even recently developed ones – produce less oil, less efficiently each year. These realities suggest that, over the long-term, the WTI price is more likely to move toward $70 or $80 per barrel to incentivize investment rather than it is to stay at around $50 or below.

While a return to higher prices may be unwelcome news to U.S. consumers, rising prices may be considered a positive for the overall economy. This is a change versus historical perceptions since the U.S. has evolved from being dependent on oil imports to becoming a net exporter of oil and petroleum products. The positive impact includes hundreds of thousands of U.S. workers employed in the sector, a tax and royalty income stream to state and federal coffers, and the potential for favorable changes in the geopolitical landscape.

The Advantage of Fundamentals

It’s our view that chasing the latest trends or trying to anticipate short-term price movements only increases the risks and undermines the opportunity to benefit from the investment potential of the sector.

Instead, we take what we learn about everyday market dynamics and use that to evaluate energy companies in context. We want to identify the best firms within each industry segment – with the best financial fundamentals, the best management, and the best products or technologies. Our goal is to invest in these best-in-class firms across a diversified array of industries because we believe that superior companies typically are best able to position themselves for success, regardless of current market dynamics. We believe that strong fundamentals are the most reliable indicator of sustained long-term earnings and growth potential.

All information and representations herein are as of 12/20/2018, unless otherwise noted.

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management associates. Actual investment decisions made by Thrivent Asset Management will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product.  Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

Past performance is not necessarily indicative of future results.