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Where Oil And Gas Are Headed

Over the past three years, the S&P 500 Index has risen by 25%. During that same time span, the Energy Select Sector SPDR ETF (NYSEARCA: XLE), comprised of the largest energy companies in the S&P 500 fell by 34%.

The S&P Oil & Gas Exploration & Production SPDR ETF (NYSEARCA: XOP), more representative of the small-cap drillers, dropped by an astonishing 59%.

Simply put, the past three years have been brutal for energy investors.

The news wasn’t entirely bad though. If your only energy investments were in oil refiners, you probably did well. Valero (NYSE: VLO) was up 26%, edging out the S&P 500. Tesoro, which was renamed Andeavor (NYSE: ANDV) on August 1, doubled up the S&P 500 with a gain of 50%.

Despite the outperformance of the refiners, for the most part, the carnage has been enough to drive some investors out of the energy sector permanently. I know, because I have spoken to some of them.

But even if you have decided that the energy sector is too volatile and unpredictable for your investment dollars, you should still understand what’s going on in the sector. Crude oil is the world’s most commonly traded commodity, and a sharp rise in crude oil prices can play havoc with the entire economy — and in turn, your portfolio.

Developments in the energy sector impact how much you pay for gasoline, your home heating and electric bills, and they have a direct impact on other sectors like auto makers, airlines, trucking, and utilities.

Simply put, if you are an investor and a consumer, you have a vested interest in the energy sector. As a result, it helps to keep informed about the sector. Today I want to take a peek at what may be in store.  

The Outlook

Oil prices seem range-bound at around $50/barrel (bbl), and have been for more than a year. This is primarily due to high global crude oil inventories, and concerns that U.S. shale production growth is going to offset the production cuts organized by OPEC.

Eventually, oil will break out of this range, and early indications are that it will be to the high side. A recent Oil Market Report from the International Energy Agency (IEA) stated that global crude oil inventories are coming down and that oil demand is accelerating. The only problem is that they are falling from extremely high volumes, and it takes some time to work those off:

The IEA also projected that global demand will grow by 1.5% this year to 98 million barrels per day (BPD). It also raised the 2017 global oil demand forecast by 100,000 BPD, and said it expects similar growth next year.

Meanwhile, multiple reports indicate that U.S. shale production growth is slowing. The impressive gains seen last fall and winter by U.S. producers have slowed dramatically, and the number of rigs drilling for oil has flattened. This all points to an oil market that is balancing, and that should be bullish for oil prices.

U.S. gasoline demand continues to set records, and prices have reflected that. Despite the fact that oil prices are just about where they were a year ago, the Energy Information Administration (EIA) recently projected that retail gasoline prices will average $0.14/gallon more than a year ago. At current consumption rates, that amounts to nearly $2 billion a month flowing primarily from consumers to U.S. refiners. 

Finally, natural gas production declined in 2016 after ten straight years of gains. The decline was primarily a result of low prices brought about by strong production levels and lower demand due to mild weather. This combination caused an oversupply of natural gas, and just like with oil, natural gas inventories reached record levels and crashed the price.

Natural gas prices have bounced back this year, averaging more than $1/million British thermal units (MMBtu) higher than a year ago. In turn, this has caused production to turn higher, albeit not yet to the record levels of 2015.

Meanwhile, there are a number of demand drivers that are absorbing new gas production as fast as it can come online. Liquefied natural gas (LNG) exports have surged in the past two years, and are now moving more than 2% of U.S. supplies overseas.

Pipeline exports to Mexico have also surged, reaching more than 5% of daily U.S. natural gas production by the end of 2016. Both LNG exports and pipeline exports to Mexico are expected to continue growing.

Add in increased demand from utilities switching from coal to natural gas, and increased demand from chemical manufacturing industries and the demand side for natural gas looks like it will grow for many years. 

Interestingly, there is a disconnect between the outlook for natural gas and the fortunes of natural gas producers. EQT Corporation (NYSE: EQT), for example, is one of the largest natural gas producers in the prolific Appalachian Basin. Despite higher realized natural gas prices than they were getting a year ago, EQT’s share price has declined nearly 10% over the past year.

Such are the disconnects that create opportunities for patient investors. 

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