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Quarter-End Insights

3 Key Themes, and 3 Picks, in the Energy Sector

Geopolitical tensions have sent oil higher amid a rising tide of U.S. crude.

Jason Stevens
  • During the quarter investors found energy stocks; for the first time since 2011 the sector is trading above fair value, at 1.02 times. Higher oil and gas prices and rising production among U.S. independents are largely responsible for the revaluation.
  • Oil prices strengthened as geopolitical concerns in Libya, Nigeria, Iraq, Iran, and Ukraine threatened supplies. Outside of the North America, crude oil supply growth has remained anemic, but rising U.S. tight oil production has freed up barrels for other nations, counteracting some of the supply concerns.
  • A cold winter in the U.S. sent natural gas prices significantly higher, and record gas storage additions have done little to rein in prices. That said U.S. natural gas prices remain below our estimate of marginal cost and near the low end on the global supply curve, supporting calls for increased approvals of LNG projects.

 

Again this quarter, we think three key themes dominate the energy landscape. First, U.S. tight oil production continues to set new records and unseat supply/demand balances. Second, geopolitical tensions continue to shape energy markets outside of the U.S. And third, players around the world are positioning themselves for the coming impact of liquefied natural gas (LNG).

U.S. crude production averaged 8.4 million barrels a day, the highest since 1988 and over 3 million barrels a day higher than 2011. Virtually all of this increase has been from light, sweet crude, resulting in more light crude oil than domestic U.S. refineries are configured to handle. We believe that continued tight oil production is likely to result in a glut of light crude along the U.S. Gulf Coast, eventually pressuring local prices--and driving windfall profits for refiners. However, if the U.S. lifts or revises its existing ban on virtually all crude oil exports, we'd expect U.S. and world crude benchmarks to revert to more historical relationships.

Because of rising domestic crude oil production, the U.S. has reduced imports dramatically. Since peaking at 10 million barrels a day in 2007, imports have dropped by 2.4 million barrels a day, with light crude leading the way. These barrels instead went to other nations, accounting for roughly half the incremental demand for crude oil outside the U.S. since 2007. Even without crude oil exports, then, U.S. tight oil is affecting global oil markets.

But global markets remain concerned about supply risks, as geopolitical concerns continue to flare up and send prices higher. Markets no longer show much faith in Libya restoring production to Gaddafi-era levels, and outlooks for production from Nigeria and Sudan seem similarly dim. The biggest worry of recent weeks is intensifying conflict in Iraq, which threatens to slow or reverse the progress the country has made to date in restoring oil production. Should fighting escalate there, the outlook for production growth outside of North America looks dire, in our view.

We think gas markets look rosier. With LNG mega-projects coming online this year in Papua New Guinea and Australia, and politicians clamoring for increased approvals of LNG export projects from the U.S., we believe gas markets are maturing toward regional integration. By 2020 we'd expect multiple LNG export facilities to be operational in the U.S. and Canada, supplying LNG cargoes to Asian or European markets and effectively transforming what have been up until now stranded markets. The convergence of gas pricing toward a world price, courtesy of LNG, promises to be one of the more dynamic themes in energy over the next five years.

Top Energy Sector Picks
Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
Tullow Oil GBX 1,300 Narrow High GBX 780
Ultra Petroleum $40.00 Narrow High $24.00
Technip EUR 98.00 Narrow Medium EUR 68.60
Data as of 06-23-2014

 Tullow Oil (TLW)
London-based Tullow Oil is an independent oil and gas producer that targets oil in underexplored areas of the world. The company focuses largely on Africa; its key assets/acreages are in Ghana, Kenya, and Uganda. Beyond Africa, the company is also active in South America (Suriname, French Guiana) and the Norwegian portion of the North and Barents Seas. We think its current stock price is in line with existing assets but excludes any upside from future exploration successes.

 Ultra Petroleum
Ultra Petroleum is an independent oil and natural gas company with operations in the Green River Basin of Wyoming, the Uinta Basin in Utah, and the Appalachian Basin of Pennsylvania. At year-end 2013, proved reserves were 3.6 trillion cubic feet equivalent, with net production of 636 million cubic feet equivalent per day. Natural gas represented 94% of reserves and 97% of production. Ultra's Pinedale and Marcellus assets represent one of the best one-two punches in North American upstream. The company remains well positioned to take advantage of a secular recovery in natural gas prices, thanks to its low-cost structure and long runway for growth.

 Technip
Technip is one of the largest oil and gas engineering and construction firms, with 2013 revenue of EUR 9.3 billion. The company provides onshore and offshore services and specializes in subsea projects. Technip owns a large fleet of vessels capable of installing offshore pipelines and associated subsea infrastructure in shallow and deep waters. A sizable backlog will propel 10% average annual revenue growth and support strengthening margins.

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