Energy investors faced headwinds in 2019, with energy debt and equity continuing to underperform the broader markets amid trade tensions, weak demand trends, and other challenges. Yet we see bright spots emerging in the energy markets as we enter the new year – and continued volatility and price dispersion are likely to create opportunities for active investors.
In this Q&A, portfolio managers John Devir and Greg Sharenow discuss their outlook on energy markets for 2020 and what investors should be watching, including geopolitical developments and the growing focus on environmental, social, and governance (ESG) factors in commodity and energy investing.
Q: What drove the challenges to energy markets in 2019, and how do you see 2020 unfolding?
A: As the U.S. equity bull market celebrated its 10th anniversary in 2019, energy equities continued to be left largely in the cold. We believe a confluence of factors led to the significant underperformance of energy in 2019: U.S.–China trade tensions, weaker-than-expected global demand for oil, and low natural gas prices, along with rising ESG and political concerns, all contributed. Additionally, despite higher oil prices, defaults in the sector were about three times what we saw in 2018.
While investor sentiment remains at all-time lows, we see green shoots emerging in 2020. Recession risks have decreased, as reflected in steepening of the U.S. yield curve, while global purchasing managers’ indices (PMIs) appear to be stabilizing, and OPEC policy remains supportive of global oil prices. More importantly – and for the first time in over 10 years – U.S. exploration and production (E&P) companies appear to be abandoning their original strategy of growing production at all costs in favor of a focus on living within their means, improving operating efficiency, and generating free cash flow. Against the backdrop of very negative investor sentiment, we favor U.S. midstream companies and select E&Ps and integrated majors (referring to the largest public companies with operations spanning the value chain, from exploration to marketing and retail) with strong balance sheets and which, in our view, are capable of generating positive free cash flow in a lower-for-longer commodity price environment. However, there is still no shortage of underperformers in energy, so we expect volatile equity and credit prices with meaningful dispersion among the various subsectors.
Q: What segment of the energy value chain is best positioned for outperformance?
A: While the U.S. oil and gas rig count was down 25% in 2019 versus 2018 according to Baker Hughes, we expect the production of oil, gas, and natural gas liquids (NGLs) to grow in 2020, albeit at a slowing pace. We believe midstream energy companies in North America stand to benefit the most in an environment of stable commodity prices and growing production. Additionally, in light of the slowing in U.S. shale growth, an increased focus on ESG, and rising political risk, the free-cash-flow generation potential of conventional international operators and U.S. majors may look attractive given their scale, geographic diversity, and strong balance sheets.
Finally, we believe many stressed E&P operators may have little choice but to sell mature and cash-flow-positive assets at heavily discounted valuations amid a weak M&A (mergers and acquisitions) market, a wall of upcoming E&P debt maturities, and unfriendly capital markets. Given PIMCO’s depth and breadth of resources in energy, our time-tested investment process, and long-standing relationships with company management teams, we believe we are well positioned to navigate the potential volatility and to identify the most attractive public and private investment opportunities.
Q: What is your outlook for the oil and natural gas markets this year?
A: In contrast to oil and gas equities, oil prices were quite resilient during 2019, with December Brent crude oil averaging 12% higher year-over-year. OPEC supply cuts, both voluntary and involuntary, continued to support the oil market and were sufficient to offset tepid global demand and surging U.S. supply. As we look at 2020, OPEC+ (which includes the OPEC member nations plus key non-OPEC nations, including Russia) continues to chart a supportive course, and oil demand is expected to rebound. However, the most important development is likely the rationing of capital to U.S. E&P companies, which is finally bringing discipline to what we view as the most price-depressing force in the oil market. While we still expect production to grow at current prices, this shift in capital allocation is, at the very least, likely to offer some floor to oil prices, and may provide a meaningful tailwind.
The outlook for the global natural gas market is best described as poor. Oversupply – driven by surging output in the U.S. and growing liquefied natural gas (LNG) supplies globally – has exceeded demand growth. This overhang will likely continue to weigh on prices for the near future. However, as in the oil markets, we believe U.S. producers will likely reduce gas-directed capital expenditures even further amid low prices. Moreover, we think the downside to U.S. natural gas prices specifically is likely limited, even without cold weather, given improving demand due to rising U.S. LNG exports, shifting net exports (less from Canada, more to Mexico), and rising demand in power markets due to coal displacement.
Q: Macro and geopolitical factors have played an outsized role in energy markets. What should investors be watching in 2020?
A: There is no shortage of macro, geopolitical, and political considerations on the horizon. On the macro front, a rebound in global manufacturing and trade would be a welcome sign after trade tensions contributed to slowing economic activity and weaker oil demand. However, most forecasts already embed an acceleration after the China–U.S. “Phase 1” trade deal is finalized.
We also see a number of geopolitical hot spots. First and foremost, given recent events, are the escalating tensions between the U.S. and Iran. While there have been periodic bouts of optimism that the U.S. and Iran could reach some sort of détente, we view the chances as slim given that neither side is likely to concede to the demands of the other. As such, we expect pressure on Iranian exports to persist, providing support to oil prices. In addition, under U.S. economic sanctions, Iran has arguably demonstrated its efficacy in disrupting oil exports from the region, a potential upside risk to prices. Meanwhile, political developments in Iraq over the past few months, with growing dissatisfaction with the country’s leadership as well as external influences, have raised concerns about the sustainability of energy supplies. And uncertainty in North Africa – specifically in Algeria and Libya, two key oil producers – is more of a concern than it has been in years, with the latter effectively embroiled in a civil war between two competing governments. Any loss of output resulting from rising instability would require other OPEC producers to rapidly reverse output cuts, which tempers the upside, but would at the very least provide more runway for rising U.S. supplies.
Lastly, the political cycle in the U.S. is about to heat up with the upcoming 2020 presidential election, and issues related to energy and the environment are likely to be front and center. While rhetoric on these topics may exceed practicable policy decisions and legal authority, any movement to curtail U.S. production growth could be supportive of oil and natural gas prices and would create a material dispersion between winners and losers in the corporate space among those who benefit and those who don’t.
Q: What are the implications of climate change and increasing opposition to hydrocarbon development for energy investors?
A: Environment, social, and governance (ESG) factors have long played an important role in commodity markets, particularly when it comes to creating policies to reduce hydrocarbon consumption. Policies targeting emissions reductions and fuel efficiency standards have significantly altered supply, demand, and pricing in the commodity markets, creating both risks and opportunities for active investors. And while ESG-related factors and the commodity markets have long been intertwined, growing investor awareness has put ESG concerns at the center of many capital allocation discussions.
Questions about the future of hydrocarbon demand stemming from environmental concerns – along with the realization that many oil and gas producers have not been good stewards of capital or sufficiently reoriented their business models to a low-carbon economy – have driven both public and private capital away from the energy sector. However, one unexpected effect of the growing focus on ESG could be underinvestment in non-renewable energy sources, most notably petroleum, that may be critical to maintaining future global economic activity until the global economy can transition to a more sustainable low-carbon-intensity economy.
Remember, the oil and gas business is highly capital-intensive, requiring substantial investments just to keep output flat, much less to meet the growth in demand expected over the next 10 years. (Even if the global economy does make notable progress in the next decade toward transitioning to less carbon-intensive energy sources, demand for oil and gas in many regions, including faster-growing emerging markets, will still likely rise over that timeframe.)
In 2020 and beyond, the expected decline in investment should be supportive of oil prices overall and give rise to potentially attractive private investment opportunities as companies are compelled to shed assets to repair their balance sheets. In addition, as the political season heats up, the prospects of more severe regulatory limitations on oil and gas investments cannot be ruled out and would be a bullish development for commodity prices. As stewards of investment capital, we must focus on monitoring and forecasting market trends and on thoroughly evaluating energy sectors and investments from the bottom up – even ESG-related factors when building commodity-based portfolios. These factors are increasingly impacting commodity market dynamics and should be carefully evaluated by active management.
For more PIMCO views on inflation-related investments, visit our inflation page.