The most important economic trend facing markets today is undoubtedly inflation. In the U.S and most other developed nations, prices are rising at the fastest pace in decades. Critically, this inflation is somewhat atypical. It is not driven by a considerable rise in economic demand (i.e., a booming economy) but by a decline in economic supply—namely, a significant global shortage of energy products, food items, and trained demand for blue-collar labor.
The dramatic increase in prices has led to evident demand destruction wherein people reduce consumption as more of their disposable income goes to necessary items (such as gasoline and food). This scenario has resulted in a rare simultaneous decline in the GDP while inflation continues to rise. More recently, there has been a slight but notable increase in initial jobless claims and a rapid decrease in pending home sales, indicating a high recession probability this quarter.
This precarious economic environment poses difficulty for investors. While the stock market has seen some notable losses, the overall stock market decline thus far is not as significant as that of most recessions. Considering corporate debt levels, valuations, and price acceleration are much higher than during most recessions, one could argue the stock market’s “floor” may be abnormally low. Regardless, investors would likely be wise to avoid those sectors with excess harmful exposure to inflation (such as technology) instead of those with more robust positive exposure to inflation.
One of the best pro-inflation sectors has been energy, with the popular SPDR Energy ETF (NYSEARCA:XLE) rising by over 250% since reaching 2020 lows. In February, I covered the large-cap energy ETF in “XLE: How The Russian Invasion Of Ukraine May Impact Energy Markets,” which detailed the potential outcomes of the Russian invasion oil shock on the sector. The ETF has risen an additional 30% since then, and the price of crude oil has recently reached a new cyclical high. Obviously, when prices are high, they are liable to decline dramatically. However, in my view, there is a strong argument that crude oil may soon become far more expensive, meaning oil company profits may rise much further.
Crude Oil Shortage Continues To Worsen
Total U.S. crude oil storage has declined to the lowest levels since the 2000s. Back then, the U.S. had not yet grown the shale oil patch, so domestic production (and storage capacity) was far lower. With this in mind, as well as the rapid pace of inventory declines, it would seem the shortage is nearing crisis levels if not mitigated soon. See below:
While there have been many issues regarding the production of crude oil, there have also been similar issues in oil refineries. This includes substantial labor shortages and continually low capital expenditure budgeting due to machinery supply-chain difficulties and efforts to reduce high debt levels and attract investors. Both of those issues stem from the fact that the energy industry was in a severe depression from 2014 to 2019 due to low commodity prices, and many energy companies had significant layoffs, growth in balance sheet issues, and became “toxic” to many financial institutions. Of course, the end of Russian imports and related increased demand for U.S. (and Canadian) exports have created excess strain.
The relatively complex situation in oil drillers and refiners has led to an excess strain on fuel prices. Gasoline prices have risen dramatically, but distillates (i.e., diesel) have been hit the hardest as inventories are now at extreme lows and are showing few signs of improving. See below:
The decline in distillate inventories has become significant enough that many areas of the northeast are on the verge of having no diesel fuel, which could create an additional crisis considering diesel fuel semi-trucks. While Russia, COVID, and acute labor shortages are all contributing factors, the East Coast has lost half of its refineries over the past fifteen years, so it will take some significant time before the core issue can be solved.
The oil shortage may worsen without a significant decline in demand before it improves. Despite a near-complete return in the total rig count, U.S. crude oil production levels have yet to return to pre-COVID levels. That is partly because many oil producers focused on younger wells with significantly higher per-well production during the lockdown. Since 2020, per-well production has risen dramatically and has recently declined as drillers restarted older wells with lower yields. See below:
Until recently, there has been minimal drilling of new wells (due to low CapEx budgeting and related issues) and extensive utilization in drilled-but-uncompleted “DUC” well inventories (i.e., wells that were already drilled but not in use). As that “DUC” inventory has shuttered, it will be difficult for drillers to maintain production levels.
While that explanation is a bit detailed, it can be summarized by stating that the lackluster increase in oil production since 2020 has relied on capital investments made before 2020. Since 2020, oil producers have focused on increasing output without making large investments. Problematically, since oil output levels fall rapidly as (recently completed) wells reach their first and second years of production, many oil companies may face difficulties maintaining production levels. In other words, total U.S. oil output is unlikely to rise much higher and may fall back to 2020 levels before improving. Considering U.S. oil storage levels are already critically low, a further increase in the shortage could cause oil prices to rise much higher. This explanation is detailed in “USO: Why Crude Oil May Be On The Verge Of An Even Larger Breakout,” where I surmised the potential for crude to surpass $200 by year-end.
Thinking Long-Term About XLE
For those investors looking to speculate directly on the energy shortage crisis, the crude oil ETF (USO), as well as the natural gas fund (UNG) and gasoline ETF (UGA), are superior to the energy equity ETF XLE. Generally speaking, the raw commodities have more short-term upside potential but are likely to prove far more volatile.
In the long run, high oil prices will likely finally encourage oil companies to ramp up CapEx and may also increase green energy’s payoff, ideally leading to a reversal of the supply-demand gap in fossil fuels. Thus, while oil may soon rise much higher, I doubt it will stay that high for too long. XLE may be a better “buy and hold” option for those looking to avoid trying to time that.
XLE owns the 21 largest oil companies, with Exxon (XOM) and Chevron (CVX) making up around 43% of its total assets. These companies include the entire energy sector, from production to gas stations. Generally speaking, these firms’ profits are rising across the board and are now significantly higher than they were before 2020. See below:
Exxon and Chevron make up a substantial portion of XLE and, since they operate the entire energy supply chain, have highly representative fundamentals as the fund as a whole. Both have seen their operating cash flows return toward peak the 2000s “boom” levels but are spending extremely little on CapEx – despite high margins. Again, that signifies the unlikelihood of any sustained increase in energy production as these firms have high “maintenance CapEx” (capital spending needed to keep production from falling).
XLE currently trades at a very low forward “P/E” ratio of 10.4X and a TTM price-to-cash flow of 8.8X. Its dividend yield is 2.6% today, and its expense ratio is only ten bps. If we assume large oil companies will keep profits steady or that they will rise under a more considerable increase in prices, then XLE would likely be undervalued today. Even if oil prices rise and then decline, even below today’s levels, I doubt their profits will decline much below today’s levels as they have been in a severe depression over the past decade, giving them a strong “supercycle” advantage that may last for 5-10 years.
Windfall Profit Tax Risk
To complicate matters, the U.K. has pursued a 25% “Windfall profit tax” on British oil companies (not in XLE), setting a precedent for the U.S. to follow suit. The controlling party in the U.S. is keen on enacting a measure upward of 50% on profits over $66 per barrel. Such a tax would take a considerable chunk out of these firms’ profits, large enough that I would not invest in XLE if it were enacted since its valuation would rise considerably.
From an emotional and political standpoint, this legislation makes some sense as it certainly is frustrating to many Americans to see oil company profits soar as their savings collapses. Of course, it is not technically accurate that oil companies have increased prices to “take advantage” of consumers considering oil and gas prices are set by an international futures market. Additionally, I doubt a hefty tax on profits would encourage CapEx spending, considering those are largely post-tax costs, so a windfall profit tax may actually worsen the matter.
Still, it is fair to say that energy firms’ deliberate reductions in CapEx spending are partly to blame for the energy shortage. Of course, increased regulatory burdens and the inability to find trained labor and parts (stemming from COVID lockdowns) may make it nearly impossible for many oil companies to increase production. The government, not oil companies, decided to ban Russian oil, pursue heavy rig-shuttering COVID lockdowns, and double the money supply via QE, though diverting blame can be a politically sound strategy.
The Bottom Line
In the short run, this is the most significant risk to XLE, and, in my view, it is essential to view the situation as rationally as possible. While I am otherwise bullish on XLE, I am “neutral” in the short run due to the seemingly…
Read More: XLE: Windfall Profit Tax Risk Overrides Bullish Oil Scenario (NYSEARCA:XLE)