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By Josh Peters, CFA | 03-20-2015 02:00 PM

Rethinking Dividend-Paying Energy Stocks

Given our lowered oil-price forecast, fair value estimates for major energy producers such as Chevron and Shell have dropped, but Chevron still has a compelling long-term dividend story, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Our equity analysts recently lowered their long-term price forecast for oil and natural gas. I'm here with Josh Peters--he is the editor of Morningstar DividendInvestor newsletter and also our director of equity-income strategy--to see what impact these changes will have on dividend payers.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: So, can you talk to us a little bit about the lowered forecast and what impact that's had on both fair value estimates and economic moats?

Peters: Well, I can speak about it on kind of a high level. I'm not an energy-industry expert. But over the years, the energy sector has played a pretty good role in the portfolios that I manage. And I've got the advantage of our team of analysts that does a great job tracking what's frankly a really difficult industry. And I like to think of it this way: Chevron (CVX) or Shell (RDS.A) or Exxon (XOM) or Saudi Aramco--you name it--could hire someone and give him an unlimited salary virtually if that person could correctly predict the prices of these commodities. And even they can't do it. So, it is kind of difficult to value these businesses, but that doesn't mean that they don't still have a role to play in portfolios. So, what we've done is revamp our look at the global oil price, as well as natural gas prices in light of the big shift in prices that we've had since the summer of 2014.

Frankly, we didn't see that big shock coming; but what you do as an analyst is if you have been off on something, you go back and you reevaluate. And the biggest change in the story has been fracking in the shale basins in North America. What it's done is it's provided so much incremental production into the global market at a time when global demand growth is not strong--most economies being fairly weak outside of the United States--that it's pushed those higher-cost projects like deepwater offshore off of the cost curve.

Think about it like this: From the bottom, you've got Saudi Arabia that's able to pump oil extremely cheaply; maybe it's less than $10 a barrel. So, everything between that and whatever they can sell it for is profit. But then there are projects that cost $20 a barrel; there are projects that cost $50; there are projects that cost $100. And when there is too much supply growth and not enough demand growth, the price starts to fall, and it's those high-cost projects that you don't need because the supply is coming from lower-cost projects. That's what technology has done in making fracking cost-competitive--not just at the last barrel of oil but at that middle range of the supply curve. And that shifts the whole structure of the oil and gas supply-and-demand downward, such that we've had to reduce our long-term price forecast.

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