Coronavirus Zapped Energy Stocks

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

The Morningstar US Energy Index has lagged the broader domestic market. Energy stocks underperformed in the third quarter, as crude oil prices have been stubbornly flat and well below the midcycle level of $55/barrel for WTI crude that would incentivize the right level of development activity from swing producers like U.S. shale and OPEC. However, we believe the market is still extrapolating bottom-of-the-cycle crude prices to infinity, making energy stocks look historically cheap. Energy is still the most undervalued industry sector, trading at a discount of about 30% to our intrinsic fair value estimates.

The massive impact of COVID-19 on global demand is the primary reason that crude prices and energy stocks have not recovered along with the broader markets. We estimate a year-over-year decline in consumption of around 8 million barrels a day, easily surpassing prior downturns. To mitigate the impact of record stockpiles on crude prices, producers, including the OPEC+ group and U.S. shale firms, have made dramatic production cuts, and very little development activity is taking place. As a result, we think worldwide production will also decline by about 5.7 million barrels a day this year. This narrows what would otherwise be an unmanageable surplus, though inventories are still expected to spike well above normal levels by year-end.

And the environment for crude producers does not look much better in the fourth quarter, as the pandemic has not yet subsided enough to allow for a meaningful surge in travel that would drive up demand for gasoline and jet fuel. But we continue to expect catch-up growth in 2021 and 2022, bringing long-term demand almost back in line with pre-COVID projections. But after making major cuts this year, producers aren’t geared up to meet that demand. (In the U.S., the horizontal rig count has slumped to about 200, well below the 600 rig “Goldilocks” level needed.) Without a rebound in oil prices in 2021, producers will have no incentive to grow their production or even replace declines, resulting in a downward spiral for supply that could eventually turn the current crude glut into a shortage.