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Jason Smith, I’m managing director and a portfolio manager at Rothschild Asset Management.

Commodity prices are booming and a lot of energy stocks have followed. So what’s driven this move in oil? Well, we came into this year and oil prices were around $50 and now they’re above $80. So what you’ve seen is a few things. As we know, there’s a big push towards renewables, both in the U.S. and globally, and we’ve seen some of the large oil companies begin to allocate capital away from black oil towards renewables. While it didn’t seem like a big deal when these announcements were made, that’s because demand was depressed.

Now that oil demand is starting to recover post-Covid, when you combine that with a lack of investment, both in the near-term and longer-term, that could lead to a tighter market. We’ve also seen investors here in the U.S. really push the U.S. energy companies towards generating free cash flow and returning it to shareholders rather than throwing capital at drilling. And if companies really seem to have bought in, with most U.S. exploration and production companies instituting some level of return of capital, whether it be variable dividends, special dividends, or buybacks. We’ve seen U.S. production fall from 13 million barrels a day pre-pandemic to just over 11 million currently. And it doesn’t seem like we’re going to go back to the world of ‘drill no matter’ what any time soon.

So because the U.S. companies have shifted away from growth at any price, the onus has fallen on OPEC, plus a few other countries like Russia, to balance the market. These countries were fairly aggressive in taking barrels off the market during the downturn. Now with demand picking back up, OPEC has remained pretty measured in terms of increasing production, as they have not allowed the market to get oversupplied, which has, in turn, drawn down inventories. As of now, it does not seem like these countries are in a rush to step production back up more than they promised and they remain concerned that we might see another round of demand impact from the virus.

On top of all this, we’ve seen a few severe storms like Hurricane Aiden knock out some production in the US. And then we’ve seen a shortage of natural gas globally driven both by under-investment and some demand-pull from places like China. So, when you think about it, natural gas hasn’t competed with oil for the better part of a decade. And now, in Europe and elsewhere, oil is actually cheaper, which is creating a demand pull for things like power.

So how long can this continue? Well, when you look at supply and demand, we should start to see the market loosen in the first half 2022. Obviously, demand remains a big wild card given the ongoing recovery from Covid and this assumes OPEC continues to increase production at the rate they’ve laid out, which is about 400,000 barrels a day per month while U.S. production remains somewhat restrained.

And it’s interesting because while all the focus has been on the $30 move in spot oil prices this year, the backend of the oil curve really hasn’t moved quite as much, with prices from 2023 onward only up five to $15 a barrel year to date. But I also think that this underinvestment that we talked about earlier is going to leave the market susceptible to supply shocks in the medium and longer-term. And we should get back to a pre-Covid level of demand sometime next year, but as I mentioned, the U.S. is producing almost 2 million barrels a day less. And as demand recovers and OPEC production increases, that also means that spare capacity, which is the excess oil that is able to come to market quickly, is going to be shrinking.
Now the risk here is clearly that oil prices mean higher prices to the consumer on everything from gasoline to heating your home, to flying. So while I don’t think demand will be impacted imminently because we’re just coming out of the pandemic, there could be a negative impact in the medium-term should prices remain elevated. I think the biggest risk in the near-term is really a new Covid variant that essentially forces further lockdowns and hurts demand.

What should energy investors be looking for over the midterm? Well, I think investors have really started to get what they’re looking for from the U.S. companies. We’ve seen consolidation, we’ve seen a significant slowdown in growth and a big focus on free cash flow generation. And we’ve seen activists start to go after big companies like Exxon to try to get them to change their priorities. It generally takes time for these transitions to get rewarded by the market and we’re starting to see this happen in a sector that has underperformed in the market for the better part of the last decade.

Renewables and the focus on the shift away from oil globally clearly remains a risk for the sector, but it’s also one that I think is going to take some time to play out. So in the medium-term, it’s really about watching OPEC policy and demand trends, and then seeing if U.S. producers hold their discipline. If the latter does, I would expect to see to continue rerating of some of these names. The sector’s been the best performing sector in the market year to date so far in 2021. But a lot of that has been driven by that spot move in oil prices and and earnings momentum. Most names still trade pretty heavily discounted at historical levels. And I think, if companies stick to focusing on returning capital alongside modest growth, we could see shares continue to rerate.

So how are we currently positioned? Well, earlier this year, we went overweight energy for the first time in a while as we thought some of the stocks looked attractive and saw fundamentals improving. One name we added earlier this year was Schlumberger, which is the largest U.S. oilfield service company. So we talked earlier about OPEC being the leader in terms of bringing production back to the market, well, Schlumberger is the most internationally exposed U.S. oil service name with 80% of revenues derived outside North America. The company’s actually cut back on its North America exposure in the last few years, which tends to be a little more short-term oriented in nature, and we believe this warrants an improvement in the company’s relative valuation versus it’s peers. While valuation has improved slightly this year, shares still traded at a discount, historical levels, and we believe the company’s margins should also continue to improve from here, which could also drive the multiple higher.

Lastly, Schlumberger is looked at as a technological leader in its field. And so, while small in the scheme of business today, the company is investing in low-carbon and carbon-neutral energy technology to provide a platform for future sustainable growth, which is something we view as attractive.

Another name we’ve liked for a long time is ConocoPhillips. Conoco is the largest pure-play U.S. exploration and production company with a diverse global asset base. The company has a strong balance sheet and management team and we see it as a company with, essentially, a balance sheet of an oil major like Exxon or Chevron, with the oil price sensitivity of an exploration and production company. In 2020, Conoco purchased large Permian producer Concho. And when sector sentiment was poor, this gave Conoco the one thing it was missing in our view, a large concentrated position in the Permian Basin in the US, which is viewed as the best U.S. asset. The company then announced another nine and a half billion dollar acquisition this summer of Shell’s Permian asset, a deal we also see as accretive.

So given it’s strong balance sheet, Conoco has been a leader in terms of returning capital to shareholders, via both dividends and buybacks, alongside modest growth. And the company’s even laid out a 10-year plan at $50 oil, again, that’s 50 versus 80 today, that sees the potential for over $80 billion of free cash flow and over $75 billion of shareholder distribution. And obviously, there’s significant upside to those numbers should oil prices hold.

Renaissance U.S. Equity Value Fund
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