Notes from the Wall Street Gang - June 21

[dan_s]

Devin McDermott – Morgan Stanley
June 21, 2022 4:02 AM GMT

Last week's decline in Energy equities far outpaced the move in crude, bringing the sector near pre Russia/Ukraine trading levels despite oil still ~$20/bbl higher. While rising risk of a recession brings uncertainty to the near-term outlook, valuations remain compelling even at lower oil prices.

The All-America Institutional Investor Research poll is scheduled to close later this week. If deserved, we would really appreciate your vote in the Integrated Oil, Oil & Gas E&P, and Shipping categories. You can access the survey here: https://voting.institutionalinvestor.com

Energy led the market lower last week in a broad-based sell off that saw every sector finish in the red, as investors contend with rising interest rates and increasing odds of a recession. For much of the post-covid recovery, performance of the US Energy sector has largely tracked crude's move higher. This relationship broke apart last week as the move in equities outpaced the decline in WTI by >2x.

Looking historically, the performance of Energy during recessions is mixed, and hinges heavily on the magnitude of demand impacts. For now, global oil demand trends remain strong. Even with slowing global economic growth, the market should see tailwinds from still-recovering air travel, a seasonal uptick in mobility from summer driving season, and easing of China's covid lockdowns. At the same time, low product inventories, low OPEC+ spare capacity, and constrained oil & gas investment make this cycle look different than others in recent history.

What's priced in post the sell off? Based on the correlation between short-term oil prices and energy equities since the start of 2021, we estimate last week's sharp move lower was equivalent to the impact of a nearly $30/bbl decline in oil prices - far outpacing the ~$10 decline that actually occurred in front-month WTI. As a result, we estimate the sector is now pricing in an incremental $20/bbl decline in crude - a move that would put prices back around $90, in-line with levels pre the Russia/Ukraine crisis.

Looking at more fundamental valuation metrics, E&Ps and Integrateds/Majors (which combined represent 76% of S&P500 Energy) trade at ~60% and ~50% discounts to the broader market, respectively. This is wider than nearly any time in the past decade. Intrinsically, we estimate that the sector is now only pricing ~$63/bbl WTI - a steep discount to the futures curve. < I agree, as I would have to take WTI to $65 and HH gas back to $3.00 to get the Sweet 16 stock valuations back to where they are trading today.

Energy performance is mixed through historical recessions; the underlying industry fundamentals matter. An analysis of historical oil demand by MS commodity strategist Martijn Rats shows that there is not a single template for Energy performance through a recession, and the industry backdrop is key. In the recessions over 2007-09 and 2020, oil demand fell sharply, causing the supply-demand balance to weaken and Energy to underperform relative to other sub-sectors. However, in the 1990-91 and 2001 recessions, the demand impact was more modest. Over 1990-91, oil demand fell y/y for two quarters with a maximum decline of 2.7 MMbbl/d in early 1991; however, within two quarters, oil demand was growing. In the 2001 recession, oil demand stopped growing for three consecutive quarters, although it did not decline. As such, Energy performance was toward the middle of the pack among GICS sub-sectors during these periods. Looking back even further, there are historical periods (1969-70 and 1980) where tight oil market conditions underpinned Energy outperformance during recessions.

Given recent volatility, we have updated our sensitivities of key financial metrics across a range of oil prices:$100/$90 bbl WTI in 2022/23 (published case): At $100/bbl WTI in 2022 and $90/bbl WTI next year (roughly in-line with the current strip), our oil weighted E&P coverage offers a 22%/18% FCF yield in 2022/23, net debt/EBITDAX would fall to 0.5x in 2022 and decline further to 0.2x next year. EV/EBITDAX multiples would decline to 3.5x this year and 3.2x in 2023.