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By Matthew Coffina, CFA and Jeremy Glaser | 03-17-2015 02:00 PM

New Energy Outlook Brings Fair Values Down

After lowering our forecast for oil and gas prices, fair values across the energy sector have generally dropped, but some E&P and midstream names are reasonably valued, says Morningstar's Matt Coffina.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Matt Coffina--he is the editor of Morningstar StockInvestor newsletter. We're going to look at some notable rating changes in our equity-research universe that have occurred over the last month.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: The biggest change we saw in the month were the updates to our forecast for oil and gas prices and the impact that had on a number of different companies. Could you talk to us about what the new forecast is and how the analyst arrived at these numbers?

Coffina: Unfortunately, we were behind the ball when it came to energy. Energy prices have been declining really since the last summer, and it took us a while to realize the structural and fundamental underpinnings of that decline in energy prices. So unfortunately, we stuck with our old energy price forecast much longer than we should have. Now, we've gone back and done a very comprehensive review of the supply-and-demand outlook for energy, and we've concluded that our former price forecasts were just much too high.

Our new assumptions are really for the long term, so 2018 and beyond. Those are the major drivers of our valuation models. In the near term, we just use futures prices, which are observable in the market. But the cash flows in 2018 and beyond are much bigger drivers of fair value. Our new assumptions are for $75 per barrel Brent crude oil and $4/mcf Henry Hub natural gas. That compares with previously using $100 per barrel of oil and $5.40 natural gas.

The main drivers of the change, I would say, is, on the oil side, U.S. shale-oil production has been very robust, coming in at lower cost than we previously thought possible. At the same time, costs are coming down now, as we have an oversupply of rigs and labor and all the things that go into drilling an oil well. So, marginal costs are coming down. But more importantly, the highest-cost resources that are out there--things like oil sands mining or ultradeepwater--those have been kicked off of the cost curve.

So previously, we thought that those things, which maybe cost $100 a barrel to extract that very-high-cost oil, it's no longer needed to meet global demand. Partly, that has to do with weakening global demand, but it has a lot more to do with increases in lower-cost sources of supply and especially U.S. shale oil. So, once you kick those highest-cost resources off of the cost curve, the next-highest-cost resources are about $75 a barrel in our view, and so that's our new long-term oil-price forecast.

It's a similar story for natural gas. It really has mostly to do with U.S. shale plays, especially the Marcellus Shale in Pennsylvania. There's just an abundance of low-cost natural gas in this country right now. Supply is growing very quickly. And even though demand is also starting to pick up and take advantage of some of that supply, whether it's increased electricity generation using natural gas or--down the road--increased exports of liquefied natural gas and another demand opportunities, still we see an abundance of low-cost gas supply and certainly enough to keep gas prices as low as $4/mcf for the foreseeable future.

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