Trends that should impact the Energy Sector in 2023

[dan_s]

Trend 1: International Natural Gas Crisis. At the risk of sounding like a broken record, Europe (and the world) is facing a multi-year energy crisis
after legacy energy (coal, oil, gas) underinvestment and continued difficulties with the energy transition. With Russia weaponizing energy and
cutting off gas flows, Europe is left to ration natural gas and source much more expensive supply, which has caused TTF and JKM (LNG benchmark)
prices to remain elevated, and likely to remain so for the foreseeable future. As natural gas is an important input to the refining process and
typically represents 25+% of a refiner’s opex, global refining margins have increased to compensate as the European refinery remains the marginal
barrel in the global refining system. As we think TTF and JKM prices are likely to remain elevated, the push-pull dynamic between cracks and
natural gas will likely continue with cracks elevated while gas-to-oil switching provides incremental demand globally.

Trend 2: S/D Still Likely to Stay Tight in 2023, Maybe Even Tighter in 2024. Even with capacity additions in the Middle East, China, and India
pushing global refining capacity back above pre-COVID levels, the S/D dynamic doesn’t significantly loosen into 2023 (and looks tighter into 2024).
1) Mismatch between regional S/D — global capacity additions (India, China, Middle East) doesn’t align to U.S. demand especially as clean tanker
rates increase and those regions of the world with capacity additions experience demand growth. 2) Capacity additions in the U.S. (mostly in the
Gulf Coast and PADD 2) in 2023 will be quickly offset by shutdowns or renewable diesel conversions occurring in 2H23 and 2024. Additionally, initial
signs points to 2023 being a heavy “catch-up” year for U.S. refiner turnarounds. Maintenance cycles will likely keep operating capacity constrained.
3) Starting February 5, 2023, the EU will ban Russian refined product imports and will need to replace ~500+MBPD of diesel imports. This will cause
diesel barrels from the US Gulf Coast and Middle East to land in Europe and likely cause diesel inventories to remain tight in the US and globally as
Russia won’t be likely to place all ~500MBPD. 4) China has quickly walked back its Zero-COVID policies and we’d expect China to return to the global
markets by 2H23 with ~1+MMBPD of incremental demand. While recession worries have been top of mind for investors, unless oil prices rally and
remain above $100+/bbl or consumer spending collapses, we don’t believe there will be a collapse of U.S. gasoline demand — and additional
demand in China is likely to offset any weakness in the U.S./West.

Trend 3: Crude Diffs. Widening crude diffs has been an under-the-radar theme for 2022, but widening Brent-WTI and Sour-Sweet Diffs have helped
refiners improve margin capture in 2022. While OPEC is likely to continue cutting sour barrels, Russian barrels are likely to land in India and China
— opening up more OPEC sour barrels to land in Europe and the US. Emergency SPR releases seem to be over (for the time being) but European
refiners preferring a lighter, sweet crude slate (due to natural gas costs) and steady WCS production forecast seems to indicate that crude diffs
will likely stay in favor of U.S. refiners, although likely down from current levels… especially as IMO 2020 continues to pressure high-sulfur fuel
oil (and with it, sour crude diffs).

Trend 4: Ramping Shareholder Returns. All the C-Corp refiners in our coverage now have some form of a shareholder return policy that is drawing
in incremental generalist interest. As of our December ‘22 estimates, we believe our refiners will return >$22bn of cash to shareholders between
dividends (~25%) and buybacks (~75%) in 2023 while maintaining balance sheets that are better than pre-COVID levels. As the original energy subsector to abandon growth for growth’s sake and driver higher returns to shareholders, refiners are continuing to show substantial capital discipline.
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MY TAKE: At some point in 2023 the Fed will stop increasing interest rates and claim (regardless of the truth) that they have tamed inflation. Less FEAR of a recession and admission that the Green New Deal isn't going to lower demand for fossil fuels this decade, should bring more generalist investors into the Energy Sector, which is still trading at historically low multiples of operating cash flow.