1 green flag and 1 red flag for rallying oil stocks

The global coronavirus pandemic has disrupted economies and industries in massive ways. One sector that has fallen victim to the disease is the energy sector, which was out of favor and has now come back strong. Investors should take today’s positives with a huge grain of salt, however. Here’s why energy stocks look poised to continue posting strong results and why that could trigger the next industry downturn.

The green flag

When the pandemic first hit in 2020, one of the main responses was to effectively shut down economies around the world. Non-essential businesses have been closed, people have been asked to socially distance and employees who could work from home have done so. This has led to a drop in demand for oil and natural gas. Investors reacted to this by selling shares of names in the energy sector, including even financially strong giants like ExxonMobil (XOM -2.24%) and Chevron (CLC -3.16%).

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Energy companies, meanwhile, responded by cutting spending. This is quite normal during an oil drop. However, this trend usually prepares the next rally. Exxon, for example, cut its capital expenditure budget from $31.1 billion in 2019 to $21.4 billion in 2020. Chevron increased its capital expenditure budget from $21 billion in 2019 to $13.5 billion in 2020.

Essentially, oil drillers pulled their horns to save money and help balance supply and demand. But those year-long declines were specifically related to the pandemic. However, longer-term trends are also at play here. Industry-wide capital spending peaked in 2014 at around $780 billion and fell to just $310 billion in 2021.} That said, when the global economy began to reopen, demand power resumed and supply was not sufficient to meet renewed demand. As a commodity, this imbalance drove oil prices higher and, as expected, earnings from energy companies rebounded strongly. To quantify this, Exxon went from a loss of $0.33 per share in 2020 to a profit of $5.38 in 2021. Chevron’s rebound was even more impressive, from a loss of 2.96 $ per share in 2020 to earnings of $8.14. per share in 2021. Again, these are short-term changes related to an extreme event, but they highlight the tension between supply and demand that can cause drastic changes in the industry.

The green light here is that these good results should continue, as the demand for oil still seems to exceed the supply. Geopolitical tensions are one reason, but an ever-important element has to do with the spending plans of oil and gas drillers. Capital investment to boost production has increased slightly, but the industry is showing significant spending restraint.

The red flag

The energy industry is not a simple market, and there are a lot of moving parts today. For example, the push towards clean energy will likely result in lower demand in the long run. And geopolitical tensions are a difficult wildcard to predict. However, high energy prices in this industry have always had a very predictable impact on capital investment.

Just as low prices are predictable to cause drillers to cut spending, high prices generally cause drillers to spend more on drilling. We can already see it starting to take shape. For example, Exxon entered 2022 with capital investment plans of between $21 billion and $24 billion after spending only $16.6 billion in 2021. Overall, the industry is still progressing very slowly in regarding the increase in capital expenditure. While this may be a new paradigm, over 100 years of history suggest this restraint won’t last forever. And when investment levels increase more significantly, the industry will prepare for the next downturn.

Investors should keep a close eye on spending across the sector and be aware that the historically cyclical energy sector is likely to experience the same boom and bust pattern it has always experienced. Cycles like this can last for several years, but the current good news will eventually lead to bad news, as the pendulum for industry capital expenditure (and therefore output) will eventually swing back in the opposite direction.

The story rhymes

No one knows what the future holds, and this time could, in fact, be different for the energy sector. But when you hear “this time it’s different” on Wall Street, it’s usually time to worry. The energy sector is currently benefiting from high energy prices for a number of complex reasons. But high energy prices have always led to an increase in production and an eventual slowdown in the industry, as supply exceeds demand. Take advantage of high energy prices today, but don’t forget the lessons of history for this highly cyclical sector.

Steve R. Hansen