A look at the Energy Sector
It has been a turbulent few years for the energy sector and more specifically, oil & gas, with US crude trading with a negative price tag during the throes of the COVID-19 pandemic and trading north of $120 US/bbl (West Texas Intermediate or WTI) during the energy sector euphoria of 20221. The energy sector has also become somewhat quite polarizing in recent years given the gradual transition away from traditional fossil fuels and what this means for traditional oil and gas.
Recently we saw oil dip down to the low $70s/bbl on the back of the OPEC+ (Organization of the Petroleum Exporting Countries) news that they were not going to indefinitely extend their production cuts, and we have since seen a bounce back off that level – with WTI currently hovering right around $81/bbl.
As of market close on June 21, 2024, on a year-to-date (YTD) and 1 year basis, the energy sectors both North and South of the border have fared well; with the US energy sector up 6.2% and 13.3% respectively, and the Canadian energy sector up 8.8% and 18.7% respectively.
The Canadian energy sector is the second-largest sector in the TSX after financials. Currently, the energy sector accounts for close to 20% of the S&P/TSX 60 Index by market capitalization, it is a huge part of the Canadian economy.
Where do we go from here?
There are reasons to be bullish on the energy sector. It is fairly unlikely that we see that $100+/bbl level again in the near term, but given the US is currently in the later cycle of the business cycle where energy has historically performed well, a $90/bbl level is a realistic outcome. 2022 and 2023 can be viewed as being mid-cycle, meaning that this was the period where the central bank was raising rates, the economy acclimates to the higher rates and higher energy prices, and the sector and commodities tend to perform well during the late business cycle phase.
Demand vs. Supply
Travel is a key driver of demand, and we are entering the season where air and ground travel picks up. There was some weakness in demand during the winter months when warmer weather created a decrease in the demand for oil, but even given the weaker start, we’re tracking around 1.3 million barrels of oil demand growth per day which is above trend.
We’re starting to see CapEx that is being driven by the transition to green energy and to some extent, defense spending, and you’re seeing it across commodities broadly. This CapEx cycle is stimulative for metals, yes, but it is also great for energy demand. While some investors are concerned about long-term demand given the transition to sustainable energy, oil has continued to surprise to the upside.
On the supply side, the spare capacity of oil production is isolated to a few countries; namely Saudi Arabia and the UAE. The surprises in US production that occurred last year have not been repeated this year, and if we look at the non-OPEC+ production increases from Guyana and Brazil, this is just from CapEx spend that goes back several years (about a decade) and there has been no new pipelines or new investment since. Looking out to the next few years, many argue that the oil supply continues to tighten.
Experts continue to tout that US natural gas prices are headed much higher in the years to come. An arbitrage becomes efficient where the export of natural gas from the United States allows the American and European natural gas prices to balance each other out. It is important to keep in mind that China, India, and Indonesia continue to increase their coal production which is the equivalent of over 7 million barrels per day. This is part of the reason why in 2023 gas prices went negative in Europe and we saw gas prices in the US dip as well.
Other considerations
The Canadian energy sector is impacted by many other variables as well. Inflation is an important factor, as inflation rises, that should also help the energy sector which we have seen recently. Conflicts around the world are another potential tailwind, with impacts to supply and demand. Legislation and political agendas are another important influencer as we say with the recent U.S. Inflation Reduction Act which was a catalyst for renewable energy projects.
There is a lot to think about in the Energy sector – namely in oil and gas – but the overall near-term story of supply vs. demand remains supportive as we continue throughout the summer months and geo-political events continue around the world. This, coupled with the supply-side announcements from OPEC+ which indicate the cartel’s production cuts of ~3.6 million bpd until the end of 2025 and ~2.2 million bpd until the end of September 2024, should provide an additional driver for the sector.
Ways an investor can gain exposure to the energy sector in Canada and the US:
First, BMO’s Equal Weight Oil & Gas ETF (Ticker: ZEO)2 is an ETF that is designed for investors who are looking for growth solutions in their portfolio. This solution has an equal-weight exposure to Canadian oil & gas stocks, allowing for lessened security-specific risk.
For those looking for additional cash-flow from their energy exposure another solution is BMO’s Covered Call Energy ETF (Ticker: ZWEN)3 has been designed to provide exposure to a portfolio of energy, and energy related companies while earning call option premiums and generating additional cash flow. The call options are written out of the money and selected based on analyzing the option’s implied volatility.
1 https://oilprice.com/oil-price-charts/
2 ZEO Annualized distribution Yield of 3.98% as of June 30, 2024. Annualized Performance NAV of 1Y -24.67%, 2Y -13.07%, 3Y -23.26%, 5Y – 16.20, 10Y – 0.60% and Since Inception 1.69%.
3 ZWEN Annualized distribution Yield of 8.88% as of June 30, 2024. Annualized Performance NAV of 1Y -21.33% and Since Inception 8.46%.
Annualized distribution yield definition: This yield is calculated by taking the most recent regular distribution, or expected distribution, (excluding additional year end distributions) annualized for frequency, divided by current NAV. The yield calculation does not include reinvested distributions.
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