Will energy stocks rise from the ashes?

Preston Caldwell: Energy stocks have been decimated in the first quarter. The Morningstar US Energy Index fell 49%, exceeding the 19% decline in the overall market. Energy stocks have fallen in tandem with oil prices, which have fallen 60% since the beginning of this year.

The primary driver of this oil price crash has been reduced demand related to the COVID-19 outbreak. Also, there's the prospect of increased supply due to the failure of OPEC Plus to reach a new production cut agreement. In the near term, investors have every reason to be worried.

We project 2020 oil demand will fall 2.8 million barrels per day, the largest single-year drop in nearly 40 years. Because oil producers cannot adjust overnight, global oil markets are likely to be oversupplied on the order of 3.3 million barrels per day in 2020, which dwarfs the excess seen in prior 2014 to 2016 downturn.

However, we believe that long-run oil demand will be relatively unscathed by COVID-19 following a near-complete economic recovery, and we maintain our midcycle price estimate of $55 per barrel WTI.

Even after factoring in lower revenue in 2020 and 2021 due to depressed prices, we see vast opportunities in energy, and it remains the most undervalued sector, trading at a 49% discount to our average value.

However, we would caution investors to watch for bankruptcy risk in some names given the severe hit to cash flows over the next few years. We see $55 per barrel as the marginal cost for oil that will balance global oil supply and demand in the long run.

We expect this marginal barrel to come from U.S. shale. And the shale business model does not work in the current environment of low prices. Without a rebound in oil prices, producers have no incentive to grow their production or even replace declines from existing wells. This would eventually result in a downward spiral for supply that would turn the current glut into a shortage.