HH The Oil Patch Is Where It’s At In 2018

The last two and one half years has been good for most investors with the S&P 500 returning roughly 29% over that time frame.

However, returns in the energy sector over that same time frame were just short of abysmal. This poor performance of the energy sector is tied directly to the price of crude oil which peaked in June of 2014 but dropped significantly through the remainder of 2014 and early 2015.

Using the Vanguard Energy ETF (VDE) as a proxy for the energy sector, the return over the last two and one half years was roughly -31%. However, in 2018 and into 2019, I’m expecting to see a significant turnaround in both oil prices and share prices of those companies that explore for, drill for, produce, and transport crude oil.

I believe that in 2018 and likely into 2019 we will see strong earnings growth and share price appreciation in the energy sector.In this article, I will lay out the basis and rationale for earnings growth and share price appreciation and offer some ideas for capitalizing on crude price increases.

Economic Growth

While there are a number of drivers that can move the price of crude oil, the most important and reliable is economic growth.As the global economy grows, consumption of transportation fuel increases and more petroleum products are produced and consumed. This is particularly true for the non-OECD countries.

In the more developed countries (OECD countries), the correlation is weaker due to increased efficiencies in the transportation sector. While electric vehicle (EV) usage has increased over the last decade, EVs only provide for a small fraction of total personal transportation miles traveled and widespread EV adoption is still decades away. There won’t be any material reduction on transportation fuel consumption in the next several years.

Both Goldman Sachs and Barclays are projecting global GDP growth at 4% for 2018, a pace not seen since 2011. While Morgan Stanley is a bit more conservative with their projection at 3.8%, they are still predicting a very healthy rate of GDP growth globally. This expected robust GDP growth will translate into higher consumption of petroleum and petroleum products.

Source: EIA

The chart above is included to show the correlation between petroleum consumption and economic growth, but is not indicative of current non-OECD economic growth estimates. With global economic growth expected to outperform in 2018, petroleum consumption is expected to increase.

OPEC

Starting in November 2014, OPEC initially attempted to strangle US shale and other higher cost crude producers through allowing the surplus of crude production to suppress crude prices. Several OPEC countries including Saudi Arabia increased crude production at this time to further suppress prices in their attempt to shake out the financially weak producers. The effort was only partially successful in that a few very week shale oil producers were pushed into bankruptcy and some longer term deep water drilling projects were shelved or cancelled.

But, after two years of crude prices between roughly $30 – $50, the prime US shale acreage was still producing with some companies having increased production during those two years. In November 2016, OPEC changed course and set production quotas for its members that effectively cut production by 1.3 Mbpd to a total of 32.5Mbpd.