Is Energy Due for a Rebound?

The energy sector was 2019’s worst performer and it’s only gotten worse in 2020.  In this Q&A, David Byrns discusses the industry’s recent challenges and outlook for the rest of the year and beyond.

How could crude oil prices become negative?

In April, prices for futures contracts of West Texas Intermediate (WTI) crude oil nosedived into negative territory for the first time as storage tanks worldwide neared their physical limits. When WTI futures contracts expire, contract holders are expected to take delivery of the oil. And taking delivery requires storage. But with supply continuing to significantly outstrip demand due to COVID-19 mitigation measures, storage tanks are nearing capacity. So, as WTI futures contracts approached expiration, holders traded furiously to unload them to avoid taking delivery of the oil. These trades pushed prices into negative territory. Notably, negative crude prices could occur again as monthly futures contracts near expiration, and storage availability remains tight.

How will the crude oil oversupply situation affect the energy sector?

Due to the depressed pricing environment, we expect to see quite a few bankruptcies in the energy sector. Companies with high levels of debt, little cash on hand and exposure to U.S. shale are the most vulnerable. For example, Whiting Petroleum, a Denver-based oil producer, filed for bankruptcy as crude prices cratered. Until this situation stabilizes, it could be survival of the fittest with fewer and larger companies remaining after a shakeout and consolidation. Companies are drastically cutting operating and capital expenditures to survive.

In the meantime, oil production needs to shrink significantly to help balance the market and work down the current glut of inventory. Energy companies in the U.S. are doing that by pulling drilling operations and shutting down wells. The U.S. became the largest crude oil producer in 2018 largely due to a shale oil boom in places like the Permian region of Texas and New Mexico and Bakken oil region of North Dakota. Having a large oil production base contributes to U.S. energy security and can provide a level of stability to global crude oil prices.

What will it take to stabilize the energy sector?

We’re swimming in crude with no place to store it. Two things must occur to balance supply and demand. First, as lockdowns ease, we need economies to resume activities to help restore demand.  Second, major oil-producing nations must continue to cut production to help reduce excess supply and draw down inventories. We’re starting to see this happen voluntarily through agreements among OPEC+ countries and involuntarily by producers shutting down their wells. The agreement between Saudi Arabia and Russia to decrease supply was an important step. The absolute level of production cuts among OPEC+ participants is still short of balancing the market, but we’re encouraged that their agreement puts a ceiling on supply through April 2022. If the agreement holds, we believe crude oil supply and demand could normalize in 2020 with inventories potentially getting back to more typical levels in 2021.

How have low oil prices affected value investors?  

Energy and financials sector stocks represent large weights in value indices. Lower energy prices have pressured both sectors, contributing to value’s continued underperformance compared to growth. Banks were already suffering from weak net interest margins due to low interest rates, and now the low price of oil threatens the credit quality of their loan portfolios. They will need to work through energy industry bankruptcies and the broader economic downturn before their returns can improve. In the energy sector, investors will be watching for positive impacts from supply cuts and resumption of demand. Given the lack of downside protection in these stocks, we’d rather invest a little late than early and would like to see continued decreases in supply and stabilization of the COVID-19 pandemic.

References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.

The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

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