2018: Oil and Gas Stocks Year in Review

Oil prices went on a wild ride in 2018. After starting in the $60s, the price of crude oil would rally throughout much of the year, hitting a four-and-a-half-year high in early October, with the global benchmark, known as Brent, peaking at $86.74 a barrel. Those higher crude prices enabled oil producers to generate significantly more cash flow than expected, which benefited their shareholders while causing Wall Street to become momentarily enamored with the sector.

However, that all came crashing down during the fourth quarter as crude tumbled back toward $50 a barrel, dragging oil prices down by double digits for the year. Thus does the energy industry enter 2019 at a crossroads, with a nagging need to rein in oil production to keep prices from continuing to fall.

Any investor thinking about putting money in the oil and gas sector should understand where the sector has been to foresee where it could go in the future. Here's a look back on what caused the year's intense price volatility in the oil market, as well as how it affected the operations and profits of publicly traded oil companies in 2018.

OPEC agreed to continue providing support

No one group holds more sway over the oil market than the Organization of Petroleum Exporting Countries. The 14 nations that make up OPEC include many of the world's largest oil producers, and they coordinate their petroleum policies to nudge the oil market in their desired direction by either holding back supplies or increasing their output. This support aims to better align supply with demand, which redirects oil prices to reflect the market.

This group's actions played a starring role in 2018's oil market, though to set the stage, investors need to go back to early December 2017, when OPEC and a 10-nation coalition of non-members led by Russia agreed to stick with their plan to curtail production through 2018. That decision meant these major oil producers would hold back 1.8 million barrels per day (BPD) of supply from the oil market so that storage levels could continue draining after building up in previous years because of a gusher of new production from the U.S., which had been growing its output at breakneck speed.

That decision helped stabilize the oil market and pushed oil prices back into the $60s to begin 2018. It also reassured the market that OPEC would do whatever was necessary to stabilize prices.

U.S. oil producers boost spending, but not on more wells

With the oil market stabilizing and oil prices much higher than they were in 2017, U.S. oil producers faced a dilemma. On track to produce significantly more cash flow in 2018, they could certainly have used the money to boost capital spending by drilling more wells. However, they instead bowed to pressure from investors to begin sending them more cash.

Several oil companies had already started returning more money to their shareholders in 2017. U.S. oil giants ConocoPhillips (NYSE: COP) and Anadarko Petroleum (NYSE: APC) bought back several billion dollars of their stock that year, paid for by asset sales, and both companies continued the trend in 2018. In February, ConocoPhillips announced plans to repurchase another $2 billion in shares in 2018 after buying back $3 billion during the previous year, as well as boosting its dividend 7.5%. Meanwhile, that same month Anadarko added $500 million to its $2.5 billion share-repurchase program while boosting its dividend fivefold.

Other oil producers soon followed suit. By mid-March, exploration and production (E&P) companies in the U.S. had authorized more than $15 billion in stock buybacks. Those numbers continued to rise as the year wore on as more companies joined in, while others boosted their buyback programs thanks to higher oil prices.

Devon Energy (NYSE: DVN) initially authorized a $1 billion share-repurchase program as well as a 33% dividend increase, and then it added $3 billion to its repurchase program after selling its midstream assets a few months later. Likewise, ConocoPhillips and Anadarko boosted their buyback authorizations later in the year, each initially adding $1 billion to their programs, funded by the cash flows they were generating at higher oil prices. By year's end, Anadarko added another $1 billion to its authorization, while ConocoPhillips expects to buy back an additional $3 billion in stock during 2019.

Saber-rattling with Iran lights a fire under oil prices

One of the factors that caused oil prices to increase during the middle of 2018 was the Trump administration's promise to impose powerful new sanctions on Iran. One of the punishments would be that the nation wouldn't be able to export as much oil. However, the exact amount wasn't clear. Some Wall Street analysts thought Iran's shipments might fall by 500,000 to 1 million BPD, a manageable amount. Others, meanwhile, warned that the sanctions could remove as much as 2.5 million BPD if all countries complied, a scenario that would significantly tighten global supplies. Some market watchers suggested a return to triple-digit oil prices could be forthcoming.

The threat of sanctions led members of OPEC to begin winding down their support of the oil market, which they were doing by deciding to hold back some oil supply. In July, the group agreed to increase its output by 1 million BPD to counteract both the potential loss of Iranian supply and production issues in places such as Venezuela, Libya, and Nigeria, which were all experiencing supply problems because of economic turmoil or political unrest. Meanwhile, OPEC said it would provide further support to the oil market if needed to keep oil prices rising too high and causing damage to the global economy.

The Permian Basin pipeline problem

While the rest of the world was encountering supply issues, the top oil growth engine in America, known as the Permian Basin, started running out of gas. It wasn't that the region was running low on resources, but rather that there was a shortage of pipeline capacity.

After expanding output at breakneck speed in 2017 and 2018, producers in the Permian Basin had gotten the region's oil output up to 3.3 million BPD by the middle of 2018, which had it on pace to eclipse its 3.6 million BPD of outbound pipeline capacity in a matter of months. That put downward pressure on regional oil prices, which caused some producers to reduce their drilling activities, with ConocoPhillips, for example, moving one of its Permian rigs to the Eagle Ford Shale.

Pipeline companies, meanwhile, were building new infrastructure as fast as they could to solve this problem. Oil pipeline giant Plains All American Pipeline (NYSE: PAA) fast-tracked two of its expansion projects, incurring additional costs to do so.

The region's pipeline crunch enabled several midstream companies to lock up enough customer contracts to give new projects the green light. Meanwhile, Plains All American started moving forward with a new pipeline backed by oil giant ExxonMobil so that the industry could stay ahead of production in the future. The region's pipeline crunch also enabled others to take advantage of the situation by cashing in on their Permian infrastructure.

A crucial period for oil

Worldwide supply issues put the oil market in a state of flux. While production was under pressure, demand continued to expand, hitting a record 100 million BPD in August. That led the International Energy Agency (IEA) to note that the oil market was entering a "crucial period," as it was unclear whether the world would have enough oil to meet expanding demand, especially if the Trump administration made good on its promises to completely lock Iran out of the oil market.

However, while many oil market watchers were worrying about whether there would be enough crude to meet demand, OPEC thought the concern was on the wrong side of the equation. IEA's October oil market report noted that demand growth was starting to decelerate because of the impact higher oil prices and the trade war between the U.S. and China were having on the global economy, and it accordingly cut its forecast for both 2018 and 2019. OPEC also said its internal projections suggested that oil inventory levels could rise in 2019, given its view that supplies would outpace demand.

Merger mania hit a fever pitch

While many oil companies in the U.S used their profit windfall from 2018's higher oil prices to buy back stock, others went on a shopping spree. The first notable deal occurred in late March, when Concho Resources paid $9.5 billion to buy fellow Permian Basin driller RSP Permian. Concho saw its deal as creating a road map for consolidation.

Oil and gas producers would go on to announce a flurry of deals in 2018:

In each case, the primary aim of the acquirer -- the company that bought the smaller one -- was to accelerate its growth prospects. Concho, Diamondback, Chesapeake, and Cimarex all acquired companies that enhanced their scale in a core growth region. Denbury and Encana, on the other hand, added a new growth engine to their portfolio. Meanwhile, both Denbury and Chesapeake saw their deals accelerating their strategic plans to bolster their balance sheet, which were still in a weak state because of the market downturn that started in late 2014. Finally, all buyers believe that their combinations would reduce costs over the long term.

Midstream entities were also consolidating, primarily through parent companies' acquisition of a master limited partnership (MLP) or vice versa. Many companies have created MLPs, which are special entities that don't pay taxes at the corporate level, to take advantage of this tax benefit. However, a rule change affecting MLPs caused several companies to convert back to a corporation so that they could get around the policy shift that prevented MLPs from tacking on fees to recover income taxes along with their service rates. Meanwhile, others combined to simplify their structure and reduce costs by merging to form one stronger entity. These two factors created a domino effect in the sector as companies followed their peers in announcing these simplification transactions:

Despite all that transaction activity, several midstream companies have yet to consolidate, which suggests more deals could come in 2019.

A quick reversal in oil prices

With oil prices on the upswing for most of 2018, energy companies had the confidence to make deals. However, just as the M&A market was heating up, oil prices began to taper down after the Trump administration granted waivers to key buyers of Iranian oil, effectively watering down the sanctions' impact. Then the oil market transitioned from fretting over a potential shortfall to becoming concerned oil would begin piling up in storage again, causing a new glut -- exactly what OPEC worried might happen.

This reversal in market sentiment caused oil prices to tumble from October through November. After hitting more than a four-year high in early October, crude ended up having its worst month in two years, shedding more than 10% of its value. That sell-off continued in November, and over just 12 trading days, oil gave up 12 months' worth of gains. By the end of that month, crude oil was down another 20% -- its biggest monthly plunge in a decade -- putting it below where it started the year. That sharp drop in oil prices means oil companies will make less money, which caused oil stock prices to plunge.

The cheapest oil in the world

The plunge in oil prices made an already challenging environment in Canada even worse. The heavy oil produced out of its oil sands has traditionally sold at a discount to lighter oil produced in the U.S. and abroad, because the higher concentrations of sulfur and several metals that need to be extracted make it harder to refine. That discount, however, has widened significantly in 2018 because of Canada's pipeline constraints, as the nation has been unable to build new pipeline capacity to meet rising production as a result of intense opposition from environmentalists and other groups. Just as the country was seemingly moving forward on some key oil pipeline projects, it faced a series of setbacks, which put even more pressure on its oil prices.

At one point, Western Canadian Select (WCS), a Canadian oil benchmark price, sold at a $51.50-per-barrel discount to WTI, the U.S. oil benchmark, which itself has sold for roughly $10 a barrel below the price of Brent. That pushed the price of WCS to as low as $12 a barrel, making it the cheapest oil in the world by a wide margin.

The steep price discount weighed heavily on the profitability of Canadian oil companies. In response, large oil-sands producers such as Cenovus Energy (NYSE: CVE) began turning to rail to help get their oil out of the country to more lucrative markets. In Cenovus Energy's case, it signed three-year contracts with two of Canada's largest railways to ship as much as 100,000 BPD, agreeing to pay a mid- to high-teens price per barrel, which was a better option than selling it in the country.

The pricing problems in Western Canada got so bad that the government of Alberta, the province that produces most of the country's oil, enacted a mandated production cut of 8.7% in early December, which amounts to about 325,000 BPD. The initial reduction will start in January before dropping to 95,000 BPD by year's end, as oil storage levels in the country drain off. The move caused crude prices in the country to quickly double, though it's only a temporary solution, since Canada needs to build more export pipeline capacity to get its landlocked oil to high-demand markets.

OPEC steps in again

OPEC also joined Canada in cutting its production in December after crude prices plunged in October and November. The group and its non-member supporters pledged to reduce their output by 1.2 million BPD starting in January. That decision reversed OPEC's output increase in July in hopes of also reversing the slump in crude prices.

However, even with the cut from Canada, OPEC, and its non-member partners, the oil market appears as if it will remain oversupplied during the first half of 2019. That's because production from the U.S. is on pace to surge in the coming months after some drillers ramped up spending in the second half of 2018 in response to higher oil prices. That gusher of production could keep the pressure on oil prices in the early part of 2019, especially if demand growth slows amid a weakening economy.

If, on the other hand, demand continues expanding as expected, then the oil market should start tightening as supply begins outpacing demand by the third quarter, which could push oil prices higher. However, several things could affect that forecast. Continued production issues in places such as Venezuela, Nigeria, and Libya, as well as new problems elsewhere, could cause the market to rebalance more quickly. On the other hand, faster-than-expected production growth from the U.S. or noncompliance from OPEC members could cause supplies to come in ahead of expectations, which could widen the oversupply problem in the first half of 2019. Energy investors should be used to volatility but should brace themselves for more volatility in 2019.

What investors can learn from 2018's oil market

Two themes ran through the oil market during 2018. First, geopolitics proved to be a significant catalyst driving oil price volatility. The Trump administration's decision to impose powerful sanctions on Iran, only to water them down a few months later, created significant ripples in the oil market, causing oil prices to fluctuate wildly. That wasn't the first time geopolitical intervention affected the oil market, and it won't be the last, which is something investors need to steel themselves for in the future. The trade war with China, for example, could cause the global economy to slow down considerably, which would be likely to drive down demand for oil.

The second thread that wove its way through the oil market was that oil companies tended to react not only to oil prices but also to each other. For example, if one company made waves by announcing a big-time share-repurchase program, that seemed to lead others to do the same. Likewise, if one company made a headline-grabbing deal, it appeared to drive rivals to follow. While the first movers were proactive, those that followed were often making their moves at an ill-opportune time, as the late wave of M&A in the E&P sector came just as oil prices were starting to crash.

This review should leave investors with some clear takeaways to guide them as they invest in the oil and gas sector in 2019 and beyond. For starters, it's wise to understand what's driving the price of oil at any moment and note what could cause sentiment to change. In addition, when reviewing investment options, investors should seek out companies with a history of being a first mover, as opposed to those known to follow the herd. And finally, take all forecasts with a grain of salt, because more often than not, something that few saw coming will have a significant impact on the oil market.

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Matthew DiLallo owns shares of ConocoPhillips, Denbury Resources, Enbridge, and Enbridge Energy Partners. The Motley Fool recommends Enbridge and Spectra Energy Partners. The Motley Fool has a disclosure policy.