What the commodity boom could mean for investors

The surge in commodity prices could offer an opportunity for energy investors in the medium term, says a New York-based portfolio manager, even as renewables and a shift away from oil remain longer-term risks for the sector.

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“Commodity prices are booming and a lot of energy stocks have followed,” said Jason Smith, managing director and portfolio manager at Rothschild Asset Management.

Smith said large oil companies in the U.S. and elsewhere started allocating capital away from oil and toward renewables when demand weakened early in the pandemic. In April 2020, a barrel of West Texas Intermediate (WIT) cost as little as US$17.

“While it didn’t seem like a big deal when these announcements were made, that’s because demand was depressed,” he said.

Now that demand is starting to recover, the lack of investment is leading to a tighter market. A barrel of WTI has been trading above US$80 for most of the past month.

Oil production has fallen in the U.S from 13 million barrels per day pre-pandemic to more than 11 million now, Smith said, and it “doesn’t seem like we’re going to go back to the world of ‘drill no matter what’ anytime soon.”

“We’ve also seen investors really push the U.S. energy companies towards generating free cash flow and returning it to shareholders rather than throwing capital at drilling,” he added.

Slower U.S. production has left the Organization of the Petroleum Exporting Countries (OPEC) plus Russia to balance the market. However, with demand increasing, OPEC has remained measured in terms of increasing production, Smith said, 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,” Smith said.

Last week, OPEC ignored pressure from U.S. President Joe Biden to pump more oil and decided to maintain its cautious monthly increases. A recent report from Moody’s Investors Service said crude oil prices have surged by about 20% since August, while natural gas prices are up 50% in the U.S. and have doubled in Europe and Asia.

However, Moody’s expects energy prices will start to ease in 2022 “because some factors contributing to the current market dislocations are transient and will be resolved soon.”

“When you look at supply and demand, we should start to see the market loosen in the first half of 2022,” Smith said.

“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 $5 to $15 a barrel year to date,” he said.

Smith warns that under-investment will leave the market susceptible to supply shocks in the medium and longer term, with potential for higher consumer prices on everything from heating their homes to flying.

However, he said the biggest near-term risk is a new Covid variant that forces more lockdowns and hurts demand.

So what does this mean for energy investors? 

Energy has been the best performing sector this year, Smith said, “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. If companies stick to focusing on returning capital alongside modest growth, we could see shares continue to re-rate.”

Smith said his team went overweight on energy for the first time in a while earlier this year based on improving fundamentals and attractive prices.

Investors have started to get what they’re looking for from U.S. energy companies, he said: “We’ve seen consolidation, we’ve seen a significant slowdown in growth and a big focus on free cash-flow generation.”

The rise of renewables and the shift away from oil remains a risk that will take time to play out, he said, but 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 they do, investors should be rewarded. Two names that Smith favours in particular are Texas-based Schlumberger Limited, which is the largest U.S. oilfield services company, and ConocoPhillips, the largest pure-play U.S. exploration and production company, also based in Texas.

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