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Our Outlook for Energy Stocks

Rumbling clouds on the horizon overshadow relative strength in energy stocks.

Jason Stevens, 12/27/2011

--Macroeconomic concerns trumped stock fundamentals again this quarter and will likely dominate markets throughout 2012.

--Despite persistently low gas prices, we see more potential for upside here than with oil.

--Given the prospects for increased energy price volatility, we favor companies with relatively steady cash flows, like pipelines and deep-water drillers, and upstream companies with large drilling inventories of low-cost production.

Despite looming financial storm clouds on nearly every horizon, oil prices have remained persistently high and relatively stable during 2011. We're less sanguine that this will be the case in 2012. Currently strong emerging markets demand has OPEC producing flat out, and there's very little spare capacity in the system, supporting high prices. Geopolitical tensions have also helped support prices since the Arab Spring, most recently with renewed fears over possible Iranian retaliation over trade embargos. But with Europe apparently entering a major recession and China bracing for a potential hard landing, we fear that 2012 could be a rough ride for energy investors.

A European recession could pull several million barrels a day of demand off the market, relieving some pressure on supply growth and increasing pressure on crude oil prices. However, the European economy is less oil-intensive than the United States, and most of the fat in Europe's transport sector has already been excised; barring a massive recession or an outright depression, we don't think Europe will shed as much demand as it did in 2008.

The bigger bogey is China. Here we note that a so-called hard landing does not mean that growth stalls or declines but that merely the pace of growth drops down to a lower gear. Gross domestic product growth of 5% for China would still result in incremental crude oil demand growth but would diminish China's ravenous appetite and thereby relieve pressure on supplies. The larger risk here is that China's central planners fail to anticipate knock-on effects of a slowing economy, and a lack of financing or a surfeit of unrest results in sharply lower industrial demand. This could potentially result in the marginal buyer of oil stepping away from the table, driving prices sharply lower.

Most economists we read point to the U.S. as a sole outpost of light, however dim. We disagree. It seems challenging to us to accept current conventional wisdom that the U.S. can manage close-to-trend growth in the face of a eurozone recession and slowing economic activity in China. In our view, the U.S. has only narrowly averted another recession this year, and we note that at current levels of consumption and at $100 per barrel, oil costs the U.S. economy approximately 4.5% of GDP, a level at which the U.S. has historically gone into recession.

In short, we see multiple threats to oil prices going into 2012 and expect higher volatility next year as headlines compete with fundamentals.

Jason Stevens is an associate director of equity research at Morningstar.

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