Success in real estate is all about “location, location, location.” But in the oil and natural gas markets it’s all about “supply, supply, supply.”

There’s an old adage in the commodity markets, especially in oil and natural gas trading circles: supply issues always trump demand issues. And no matter what anyone says, Europe and perhaps to a lesser degree the U.S. are both facing a major energy supply problem this winter just as slack in the system vanishes.

The catalyst for this supply-and-demand imbalance was the Russian invasion of Ukraine. But the combination of a change in U.S. policy toward carbon energy and the effects of a complete stalling in U.S. oil exploration and production resulting from the pandemic were crucial contributors to the situation.

No Slack in the System

Consider the following:

• The U.S. Strategic Petroleum Reserves (SPR) are at their lowest level since 1985;
• Saudi Arabia’s oil minister recently noted that OPEC+ is considering a cut in production; and
• The active oil rig count is plateauing, suggesting that there is little new production likely to come online just as the SPR will eventually need refilling, a development which will raise prices when it begins.

Moreover, as the sanctions related cutoff date for European buying of Russian oil, December 5, approaches, Bloomberg reports Europeans are accelerating their purchases of Putin’s oil.

Meanwhile, confirming the U.S. active rig count stall highlighted above, U.S. fracking companies have made it clear that they are not likely to increase production anytime soon as they look to reduce debt and increase shareholder returns by increasing dividends and buying back their own shares.

Below, I review the energy market variables and how to make sense of them, for smarter investment decisions. First, let’s look at the weather.

Dark Winter Ahead?

Meteorologists are busy forecasting the upcoming winter season and they seem to agree on one thing, the likelihood of a third La Nina weather pattern. La Nina patterns are the product of colder than usual Pacific Ocean waters and their effect on the jet streams.

The official NOAA forecast is for fairly normal temperatures and levels of precipitation for most of the U.S., with the exception of below normal precipitation for the Southwest and above average precipitation for the Northwest In addition, La Nina patterns usually deliver cooler North and warmer South temperatures.

But record droughts in the U.S. have essentially dried up major reservoirs such as Lake Mead in Nevada. This reservoir is central to the power and agricultural needs of the Southwest and Southern California. A dry Lake Mead will increase natural gas and oil demand in the winter.

Europe is in a tight space as well, due to the combination of reduced natural gas supplies and severe drought that hampers hydroelectric power generation. Moreover, the phasing out of nuclear power has removed yet another backup system. When you add the reduction and possible cutoff of Russian natural gas flows as winter approaches, you have the makings of a huge mess.

According to Accuweather.com, it could take until November for temperatures in Europe to return to a normal pattern, meaning that warmer temperatures than normal are expected until later this year.

This may reduce demand for natural gas for heating in the fall and allow for an increase in fuel storage which would be available when winter arrives. On the down side, there is little hope for drought relief, although some of the northern latitudes in the U.K. may finally get some seasonal rains.

Meanwhile, wildfires are unlikely to slow throughout most of Europe, especially in the early fall. Accuweather.com grimly notes: “Prolonged dryness will continue to put stress on food and water supplies, as well as the transportation of goods across Europe due to extremely low river levels. Agriculture stands to take a hit, too.”

If there is a glimmer of hope it may lie in the Mediterranean where a late in the season increase in storms (“medicanes”) may lead to at least partial drought relief.

U.S. Winter Fuel Supply Assessment

Europe’s troubles are well documented. Nor is the U.S. out of the woods, for two reasons. With tight supplies going into winter, any extraordinary event would lead to supply shortages in the U.S. This would trigger rapid price increases for natural gas, which could spill into crude, diesel, heating oil, propane, and gasoline as people look for alternatives.

Natural gas supplies in the U.S. are 10.5% below last year’s levels and 12.7% below the five-year average according to the latest report from the U.S. Energy Information Administration (EIA). The EIA summarized the current supply as “within the five-year historical range.” All of which suggests that supplies are tight, but could be worse.

Natural gas prices seem to be capped at $10/MMBtu for now. But any move above that price would put prices in uncharted waters.

U.S. crude oil inventories are 6% below average, while gasoline is below normal by 8%, diesel and related fuels are 23% lower than normal, and propane is 8% below its norm. Meanwhile, U.S. refineries are operating at maximum levels, just below 95%.

West Texas Intermediate crude (WTIC) recently found support at $90 per barrel. But current price trends suggest a move above $95, the 200-day moving average, would take them back to the $100 area.

Neither U.S. fuel supplies or refining capacity are anywhere near levels which could compensate for any sustained winter weather or other surprise.

Energy Equities Remain in Focus

It would seem logical that with an almost certain winter supply crunch in Europe, owning energy stocks would be a slam dunk. Unfortunately, although the odds of success are titled toward the sector, there are still no guarantees, which is why choosing a diversified trading vehicle such as the Energy Select Sector SPDR ETF (XLE) makes sense for the current market.

XLE offers diversification among energy firms such as super major Chevron (NYSE: CVX), natural gas exploration firm EOG Services (NYSE: EOG), oil and gas driller Pioneer Natural Resources (NYSE: PXD), and many others. This diversification takes the guesswork out of investing in a tricky sector such as energy.

Moreover, the price chart has, as would be expected, a generally bullish appearance which can be summarized as poised to move higher. Specifically note the following:

• XLE is trading above its 20, 50, and 200 day moving averages which means that it’s in a solid uptrend;
• Accumulation Distribution Indicator (ADI) is rising, which means short sellers are not present;
• On Balance Volume (OBV) is consolidating after a nice move higher, which means sellers are not in control; and
• The ETF is holding above an important support level at the $75 price range, which means that smart money is quietly buying shares.

The risk/benefit ratio is tilting toward placing a bet on the energy sector.

In the Energy Markets, It’s Always About Supply

There are no guarantees that energy stocks will rally, because a global recession could easily undercut demand for oil and natural gas. Yet fuel supplies are nowhere near where they can support negative surprises.

As Europe accelerates last minute purchases of Russian oil and OPEC+ reduces future supplies, and U.S. producers focus on maximizing their earnings instead of increasing production, the odds of further significant price drops in crude are falling as supplies tighten into the winter.

The take home message is that until proven otherwise, tight supplies will always override softening demand, which is why a position in the energy sector makes sense at the moment.

Editor’s Note: Knowing your risk tolerance will help you decide which investment strategy is right for you. For example, if you have a low risk tolerance, you may want to emphasize safe haven investments even though your time horizon indicates you could be more aggressive.

If you’re investing for income, your focus should always be on the health of the underlying business. The best dividend stocks are the ones that are in good shape and growing, so they can maintain and raise their payouts. For our special report on safe, high-income stocks, click here.