Traders are watching oil vs. oil stocks and thinking something has to give. One side is wrong. There is a huge divergence that has developed between energy stocks and crude oil. Crude oil is 40% below its peak in March of this year, yet energy stocks are far and away the best performing sector in the S & P this year, up 62% and only 4% off the highs it hit a few weeks ago. Why the huge disparity? Energy bulls insist supplies will remain tight and oil prices will likely be higher in 2023. “Our belief is the market will recognize we have an oil supply problem and they will buy service [stocks]…the next phase is the market realization is that we are short oil and we need oil, and to us that is an oil service trade,” Paul Sankey of Sankey Research said on our air November 18th. “There is clearly an oil scarcity thesis that has emerged among investors, who are piling into the sector, despite clear indications of relative over supply and lower oil prices ahead,” John Kilduff from Again Capital told me. David Meats, who covers energy stocks at Morningstar, agreed: “The logic is investors think oil markets will remain tight indefinitely,” he told me. Still, there is considerable debate about oil prices in 2023. On the demand side, many believe the global economy will contract in 2023. On the supply side, not everyone agrees there is a scarcity problem. “Imagine the price setup if the several problem producing countries were somehow rehabilitated: Russia, Iran, Venezuela, Libya, and Nigeria,” Kilduff told me. “More supply is in the process of coming online from Brazil and Guyana, and you saw that the Biden administration is allowing Chevron back in to Venezuela.” Finally, when all else fails, there is the hope among bulls that OPEC will ride to the rescue. “I think that the equities are looking, perhaps hoping, that OPEC+ will continue with its proactive stance of cutting production when necessary, in order to support higher oil prices,” oil analyst Andy Lipow told me. So who’s winning? For the moment, it looks like the bulls are winning: Energy stock prices remain elevated, suggesting investors are optimistic about 2023. “The P/Es of most of the oil companies remain attractive, on a valuation basis, especially if you believe demand will ramp up and take oil prices with it next year,” Kilduff told me. One additional wildcard: China. Whether China reopens or remains subject to variable lockdowns could have a big effect on oil prices. Variable dividends Lower oil prices are not just a threat to profits: many oil companies have instituted variable dividends, where the variable portion of the payouts are dependent on cash flow. Companies with a variable dividend include Pioneer (PXD), ConocoPhillips (COP), Devon Energy (DVN), Diamondback Energy (FANG), and Coterra Energy (CTRA). These companies, for the most part, are in a sub-set of the Energy space: exploration & production. This makes sense, since these companies are the ones most exposed to oil prices. Diamondback Energy, for example, has a yearly base dividend of $3 per share, but has announced additional “variable” dividends each quarter this year: Diamondback Energy (variable dividend announcement) November 8: $1.51 August 3: $2.30 May 3: $2.35 Variable dividends have an obvious advantage for companies: They can easily reduce the variable portion of the dividend should cash flows change. Investors have little room to complain if that happens, because that portion of the dividend is “variable.” This takes a lot of pressure off of companies. Other big players in the energy space, like Exxon Mobil and Chevron, pay relatively high fixed dividends. They are under constant pressure to maintain those relatively high dividends whether cash flows are strong or not. Companies with variable dividends have more flexibility. The downside: No one is sure what the total payout (the fixed dividend plus the “variable” dividend) will be from quarter to quarter. “They [variable dividends] are very much at risk at $75 [for oil] and the decline in oil prices drops right to a companies bottom line profitability (all other things being equal). Clearly the 1Q 2023 variable dividend would be at risk,” Lipow told me.
