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New Energy Outlook Brings Fair Values Down

Matthew Coffina, CFA
Jeremy Glaser

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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Glaser: When you roll these new lower prices into our forecast, what did that do to fair value estimates? Can you give a sense of the magnitude of some of the changes?

Coffina: So, I would say the fair value changes have been all over the board, but generally in the downward direction. Generally speaking, I would say producers--especially smaller, more leveraged exploration-and-production companies--have seen the steepest cuts. In some cases, 30% or more is certainly possible. The larger integrated, diversified oil companies--the ExxonMobils (XOM) or Chevrons (CVX) of the world--have also seen reductions of 10% or more in fair value. Twenty percent or more in some cases, but not quite as affected as the smaller, less diversified, and more leveraged E&Ps.

Services companies, also. Those fair values had already been coming down even before this reduction to our oil and gas price forecast, but services companies are also seeing similarly large cuts to fair value estimates.

I'd say the one area that's holding up the best would be midstream energy. Most of these companies are focused exclusively or mostly on the United States, and our forecast for booming production out of the U.S. means that there is going to be more and more investment opportunities and more and more transportation opportunities for midstream companies. For the most part, these companies are relatively well insulated from lower prices. So, more production at lower prices is a good thing for midstream. In some cases, we even saw midstream fair value estimates go up marginally, despite the lower commodity price forecasts.

Glaser: Do we still see energy sector, as a whole, looking undervalued? And if so, where are some of the best opportunities?

Coffina: As a whole, I think energy right now is trading at about a 10% discount to fair value. It's not quite as wide of a discount as we saw before. But our current commodity price forecasts are still well above market prices. Oil today is trading somewhere in the low to mid-50s; natural gas is somewhere below $3/mcf. So, we're still projecting a substantial recovery over the next several years, and that's largely driven by the fact that it's just not economic to continue producing oil or gas at current commodity prices.

We think prices are going to have to come up to some extent to justify incremental investment in these resources. We are seeing companies dramatically slash capital-spending budgets, and it takes a while for that to show up in terms of lower production. But sooner or later, it will result in lower production. And in order to incentivize continued investment in these resources, including U.S. shale, we're going to need to see some kind of recovery in commodity prices--though, certainly not to the highs that we saw before last year.

In terms of opportunities, I would say, for our portfolios, I'm most interested in midstream. We have some companies like Magellan Midstream Partners (MMP), Enterprise Products Partners (EPD), which I recently added to, Spectra Energy (SE), which we don't own but also looks relatively interesting. A lot of those midstream companies, I think, offer the most favorable risk/reward trade-offs. You can certainly find undervalued opportunities as well in the exploration-and-production or integrated side. Some names that come to mind would be Cabot Oil & Gas (COG), Range Resources (RRC), ExxonMobil. These are some of our analysts' favorite names.

But in general, I would say the discounts to fair value, in some cases, are a bit wider than you can find in midstream. But also, in general, they have a fair bit more risk and much more reliance on our long-term commodity price forecasts. I would say I've been getting more and more disappointed with and pessimistic about the outlook for services. This is certainly my fault when it comes to our portfolio. We own, in the Hare portfolio, National Oilwell Varco (NOV) and Schlumberger (SLB). Both of those have turned out to be mistakes on my part.

We were expecting a much more robust commodity-price environment. And in the current commodity-price environment, capital-spending investment over the long run is going to be much lower than we previously believed. Those stocks are down a lot. I think the risk/reward still justifies holding, but certainly the opportunity is nowhere near as great as I originally believed. In both cases, we will be lucky to escape with even a decent or even a positive return at this point.

Glaser: Moving away from energy, we also had some moat changes--first, at Hewlett-Packard (HPQ). Why did we take this from narrow to none?

Coffina: So, Hewlett-Packard is on its way to a split of the company. They are going to separate it into two divisions. One, the enterprise business, which we think is in a somewhat better competitive position. They focus especially on enterprise hardware, servers, and things like that. They also have a fairly large consulting and IT services business. They're one of the largest players in IT services. But even so, on the enterprise side, we don't think the company has a moat anymore. It tends to be more focused on the commodified parts of the market. And those parts are becoming increasingly commodified--servers, for example, especially with the shift to cloud computing. You have larger and larger customers who are increasingly sophisticated, able to use more white-box equipment, do their own programming or write their own software. So, that business is becoming increasingly less attractive.

Then, you have the part of HP that consumers are probably more familiar with. That would be the printers and PC side of the business, and that's already been very highly commodified, intensely competitive, and it's just very hard to earn economic profits over the long run in that segment. So, [their situation] is really a continuation of a trend that's been going on for a while. We already had a negative moat trend rating on HP, and that moat has just continued to erode to the point where now, looking at the two segments separately, we don't think either one has a competitive advantage going forward.

Glaser: On the other hand, we recently upgraded Charles Schwab (SCHW) to wide. What was driving that upgrade?

Coffina: Charles Schwab is a company we actually own in our Hare portfolio, and I always love to see a company go from a narrow moat to a wide moat. That's really what I hope for when buying a narrow-moat company. I hope that, at some point, it's going to turn into a wide-moat company. In the case of Schwab, the company's been very successful at gathering assets. They have more than $2 trillion in assets under management now, which has given them a cost advantage, especially in the asset-management side of the business. Sometimes, you're dealing with ETFs or index-tracking, passive kinds of products where you might only be collecting 5 or 10 basis points in fees and, [in those cases,] having scale is really essential to covering your cost and earning a decent return on that business. The same holds for some of the other parts of the business--brokerage and banking.

The other aspect of the moat story for Schwab is really that they've increased customer switching costs over time by cross-selling multiple products. So, a customer who banks with Schwab also has a brokerage account, maybe also participates in one of their investment-advisory solutions, or works with an advisor that works with Schwab. The more hooks that you have into the customer, the stickier that relationship is going to be, the more of a hassle it's going to be to switch away from Schwab. So, that's really enhanced their switching-cost advantage.

So, similar to HP where they had a negative moat trend that just continued going negative until the company didn't have a moat anymore, we think Schwab is having the opposite effect. That company had a positive moat trend, and the moat has been continuing to strengthen as they gather additional assets, increase their cost efficiency, and increase their switching costs by cross-selling more products. They finally breached that threshold and now have a wide moat, in our view.

Glaser: Matt, I appreciate your updates today on these ratings changes.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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