Rising oil demand, limited spare global supply and Russian supply risk, coupled with ongoing capital discipline and the positive free cash flow of US companies support a Most Preferred view of the US energy sector. (ddp)

Assuming on 30 December the S&P energy index is close to current levels, 2022 will be the second year in a row of significant outperformance of the US energy sector—in 2021 the S&P energy index was up 55% on a total return basis. The logical question is: can the S&P energy index “three-peat” the annual outperformance in 2023? The UBS Chief Investment Office (CIO) believes the answer is yes—a case that was made in the UBS annual CIO Year Ahead report.

Even more than 2021, the year of 2022 highlighted our view that energy reliability and security, energy affordability and energy decarbonization are equally important ingredients of global energy supply. Limited spare capacity, recovering and growing global demand pushed oil prices around and propelled the valuations of energy companies which were increasing dividends and buying back stock. As Chinese oil demand recovers in 2023 and risks to Russian oil supply increase, CIO expects higher oil prices in 2023. This should support another year of relative outperformance of US energy equities.

According to the International Energy Agency (IEA) in mid-December, oil consumption data recently has surprised to the upside. In addition, the IEA continues to believe globally we are not investing enough in renewables, and we are not investing enough in traditional energy resources (oil and gas). Recognizing that 80% of global energy demand is satisfied with fossil fuels, we need investment in both fossil fuels and lower carbon alternatives. When combined with our expectation for global oil and gas demand growth through 2035, we believe long-term supply and demand trends support our Most Preferred view of the US energy sector.

With a free cash flow yield of over 10% and a cash flow multiple of about 5 times, we see the sector as both attractively valued and well positioned for relative outperformance in 2023, particularly if consensus earnings and cash flow estimates are revised higher. We believe the capital discipline at US energy companies and investor expectations for rising crude oil prices in 2023 have driven the S&P energy index's relative outperformance of crude oil prices recently. Though that same outperformance leaves energy equities vulnerable to additional declines in crude oil prices, we maintain our bullish view for crude oil through year-end and into 2023. CIO has a USD 110 per barrel (/bbl) target for Brent crude in March 2023 -- that converts to USD 107/bbl for West Texas Intermediate (WTI) crude.

Oil demand concerns will eventually wane, but with limited spare capacity of crude oil globally, a renewed focus on energy security and affordability, and an increasing understanding of the reality that fossil fuels provide 80% of global energy and will have to be a large part of the intermediate term transition, supply should be the key driver of oil prices in the intermediate term. This is particularly true given the global emphasis on energy reliability and energy affordability.

Issues we are thinking about for 2023

Capital discipline

Despite inflationary pressures in 2022 that pushed smaller companies to raise capital spending to reflect the impact of inflation on production growth, most large companies maintained production plans, capital spending plans and shareholder focused returns. Though oil prices have declined since mid-June, returns remain elevated and companies remain focused. Dividends and share repurchases continue to increase. With another year of capital discipline and our expectation for rising oil and natural gas prices, we see the energy sector well positioned to grow earnings and cash flow year over year.

2023 inflation and capital spending

In early 2023, US energy companies will disclose their guidance for capital spending for the year ahead. We expect capital spending will have to rise another 20% or so to support low single-digit production growth, given existing inflationary trends for labor, materials and associated oil field services. As discussed above, we expect energy companies to maintain a focus on capital discipline in 2023, but inflation trends will be important. If inflation trends accelerate, this could portend some upside risk to capital budgets in mid-2023.

Inventory depth

As the US energy industry continues to grow slowly with a focus on capital discipline, we have been thinking more about inventory depth and industry reserves. It appears increasingly clear that some of the best acreage in the best plays in the US have been drilled and are producing. Though some additional Tier 1 acreage remains in company inventories (particularly in the Permian), we expect we will spend more time talking to management teams about future growth and reserves in 2023.

Mergers & acquisitions

Assuming capital discipline remains in 2023 and companies focus on controlling inflation and growing reserves, this could set a multi-year stage for additional consolidation in the industry through M&A. The energy industry is no stranger to M&A and several companies on our Most Preferred list used M&A over the last several years to strategically expand. We expect this trend will continue over time.

Energy policy

Though tight supply and demand trends across energy are likely to keep prices elevated, we believe it is important to keep in mind that the energy transition will be complex and time-consuming. We do not expect material energy legislation in the US in 2023, but we would applaud increasing efforts from the executive branch to advance energy policy for both fossil fuels and lower carbon technologies in the US. The Inflation Reduction Act of 2022 was a good start, but the US really needs a durable plan to ensure reliable, affordable and lower carbon energy over the next 20 years and beyond. The absence of energy policy will only lead towards more energy price volatility during the time-consuming transition.

Main contributor: James Dobson

This content is a product of the Chief Investment Office (CIO).