XLE: Crude Oil Goes Boom! Protect Yourself, Buy Energy

Introduction

On April 20, I wrote an article titled XLE: Be Protected The Next Oil Bull Market Will Be Wild. In that article, I made the case to buy energy stocks to be protected from what could become a raging bull market in energy commodities.

Here’s a part of my takeaway:

Investing in the energy sector has become more challenging due to recent structural changes, which I view as a long-term positive for the industry. There is a high probability that oil prices may surge into the triple-digit territory once demand hits its bottom, thanks to the OPEC cuts and their expectations of stronger-than-anticipated long-term demand.

[…] Therefore, I strongly recommend holding energy stocks for both their potential capital gains and dividends, and I believe that having some exposure to the energy sector is critical in the current energy and inflation environment, which was not necessary before the pandemic.

Since then, the Energy ETF (NYSEARCA:XLE) has rallied roughly 11%, beating the S&P 500 by 300 basis points.

Now, it’s time for an update. Not only have I written countless articles on various energy stocks, updating my bull case, but we’ve also seen a confirmation of my thesis.

After breaking out in July, crude oil futures are back at $90. That’s despite poor consumer confidence and a general downtrend in economic growth.

In this article, I’ll discuss the drivers of this bull case and explain why I continue to believe that owning energy stocks is so important.

So, let’s get to it!

Supply – The Driver Of Higher Prices

Like every other commodity, oil is all about supply and demand.

The supply picture is what worries me (meaning, it could cause high inflation for many years to come) because major basins in the U.S. are running out of steam.

After the Great Financial Crisis, U.S. shale production was the reason why global oil prices were subdued most of the time (especially after 2014). In 2007, the U.S. produced roughly 500 thousand barrels of oil per day using unconventional measures (horizontal drilling). Now, that number is 8 million barrels per day higher!

This annoyed OPEC a lot. It even annoyed U.S. producers, as they were producing so much that every decline in demand caused oil prices to crash.

So many smaller players went bust in the past few years.

Now, things are changing. U.S. shale is running out of stream. We’re not seeing peak oil but a significant decline in supply growth. Producers are seeing rapidly declining Tier 1 drilling reserves. They focus on free cash flow generation instead of production growth and reward investors through dividends and buybacks.

They have learned their lesson – especially in an environment where new climate movements want to put big oil out of business.

As the chart above shows, shale production is barely higher than it was prior to the pandemic. The only basin with growth left is the Permian (the big one).

Even that basin is expected to reach peak production in 4Q24.

OPEC Is Back

With the U.S. losing pricing power, OPEC is witnessing a chance to become more powerful.

One of the reasons why oil is back at $90 is aggressive output cuts from OPEC (mainly Saudi Arabia). Saudi Arabia wants to protect $80 Brent at all costs. It also seems to be willing to defend $90 Brent, given that they announced an extension of the cuts.

Global oil markets face a deficit of 1.2 million barrels a day during the second half of 2023 following last week’s announcements by the OPEC+ leaders that they’ll extend cutbacks to the end of the year, the agency said. It’s smaller than projected last month, as a result of historical changes to demand estimates, but still poses risks for consumers. – Bloomberg

Because of the supply squeeze, we’re dealing with an increasing supply shortfall, pushing up prices.

We can assume that OPEC is likely playing a political game here. While I’m obviously not a political insider who knows what, for example, the Saudis are up to, I can imagine what they are doing here.

Looking at the chart below, we see that crude oil storage levels in the U.S. are way below anything we’ve seen over the past five years (and before that).

Including the strategic reserves, reserves are more than 200 million barrels below their longer-term average. Also, we’re going into a major election year. I doubt Biden – or any Democrat – wants to buy back oil in this environment.

Having said that, demand developments are also favorable.

No, Demand Isn’t Peaking

As reported by Bloomberg on September 14, forecasts from leading energy analysts suggest that global crude oil consumption is on an unstoppable ascent.

The International Energy Agency (“IEA”) projects a record-breaking 102.2…