Our Outlook for Energy Stocks
Oil and gas producers scale back in the face of tight credit and weak pricing.
Quarter-End Insights
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The credit crisis and lower commodity price environment continued to rip through the energy industry in the fourth quarter. Last quarter, the carnage was largely contained to the equity and debt values of energy companies, as hedge funds and investment banks engaged in coordinated forced selling of these securities. Although still present from time to time, these bouts of forced selling began to ease in December. The credit crisis entered new territory this quarter, directly impacting companies' present operations and next year's budgets.
Oil and gas producers big and small scaled back drilling plans for 2009. Bigger companies such as Chesapeake Energy grabbed headlines--it scaled back its budget multiple times in the fourth quarter, not unlike many other exploration and production (E&P) companies. Mega oil projects were canceled or deferred across the globe--from the oil sands to the Manifa project in Saudi Arabia. Although some of these disruptions could be opportunistic on the part of resource owners--hoping to rebid projects to capture lower raw materials and engineering and construction (E&C) costs that have just recently emerged--some projects have been truly mothballed. Active rig counts began to fall over the course of the quarter--most notably onshore natural gas rig counts in North America--and rig rates and service costs have started to soften.
In the short run, oil prices are caught in the middle of a tug of war between falling demand due to global economic weakness and producers racing to cut back supply--falling demand has been the dominant force thus far, dragging oil prices much lower. Over the next few quarters, supply cuts from OPEC and reduced output from higher-cost non-OPEC suppliers should help oil markets find some balance. OPEC has announced cuts of 4.2 million barrels per day thus far. Combining OPEC cuts with non-OPEC declines could bring supply down from a high point of roughly 87 million barrels per day this past summer to 80 million to 82 million barrels per day in the first half of 2009, which matches up better with present demand.
Entering 2009, North American natural gas prices will be largely influenced by winter weather and related heating demand. Extended periods of extremely cold temperatures in the northeast would be bullish for demand. As we've discussed in previous industry reports, natural gas producers have been successful in finding and producing new shale gas resources in recent years, helping to boost overall supply. However, recent budget cuts are translating into reduced drilling activity. Lower drilling activity, combined with steep initial decline rates at newly drilled wells, should help moderate supply growth until a better credit and gas price environment spurs greater levels of activity.
Budget cuts and project delays have not been contained just to E&P companies; midstream players like pipelines and processors--especially those utilizing a master limited partner (MLP) structure, have also been affected. We've written extensively on this topic in recent Analyst Notes (click here and here). Reduced midstream investment will likely postpone projects critical to hauling natural gas out of emerging producing regions (i.e., shale plays where large volumes of gas are expected to be produced over the next decade but where midstream infrastructure is still scarce) and delivering it to key consumer markets. This is likely to reduce the price producers will receive at the wellhead for their gas and ultimately slow the pace of supply growth in the intermediate term (two to three years out).
In light of rapidly deteriorating demand fundamentals for oil and natural gas related to the global economic slowdown, we reduced our long-term oil and natural gas price outlooks in October. In our individual company valuations we shifted our weighting more toward our low and base cases, putting less emphasis on our high case. These decisions reduced our fair value estimates for E&P companies, oil services firms, and drillers.
Valuations by Industry
Presently all of the subsectors in the energy sector appear undervalued. Drillers and service companies, refiners (oil and gas products), and pipelines are trading at the steepest discounts to their fair value estimates. However, drillers and service companies and refiners have far fewer 5-star rated stocks in their respective subsectors than the E&P (oil and gas) and pipelines subsectors do. This is due to the higher uncertainty ratings we assign to drillers, services, and refiners. In general, we require greater returns from companies in these subsectors to achieve equivalent risk-adjusted returns to pipelines and E&Ps.
| Energy Valuations | |||
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| Segment | Price/Fair Value* | Three Months Prior | Change (%) |
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| Oil & Gas | 0.72 | 0.60 | 20 |
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| Oil & Gas Services | 0.59 | 0.69 | -14 |
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| Oil & Gas Products | 0.61 | 0.82 | -26 |
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| Pipelines | 0.61 | 0.68 | -10 |
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| Data as of 12-15-08. *Market-Weighted Harmonic Mean |
Energy Stocks for Your Radar
We've picked five stocks from our 5-star list to keep on your radar. One of our picks is Chevron (CVX), a large, integrated oil major that is a well positioned company for a turbulent operating and financing climate like the one we face today. Two picks are pipeline companies, Energy Transfer Equity (ETE) and Enterprise (EPD). We've been especially impressed with the way Energy Transfer has assembled a great set of midstream assets within Texas, the Midcontinent and the Southwest--a position that adds a lot of value to its E&P customers in the region and one with a lot of potential for healthy growth. We're also highlighting two E&P companies, XTO Energy and Ultra Petroleum . Ultra's conservative financing strategy over the past few years gives it a relatively attractive financial footing compared with peers, and we think current market conditions offer investors a great way to get a stake in the company's low-cost natural gas resource in Wyoming. XTO may slow down a bit on the acquisition front in today's rough environment, but we think the share price is compelling given its high-quality U.S. natural gas properties. XTO's extensive hedging program should help the firm better weather low oil and gas prices in 2009.
| Stocks to Watch--Energy | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying |
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| Chevron (CVX) |  | $109 | Narrow | Medium | $76.30 |
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| Energy Transfer (ETE) | | $51 | Narrow | High | $25.50 |
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| Enterprise (EPD) | | $39 | Narrow | Medium | $27.30 |
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| XTO Energy | | $67 | Narrow | High | $33.50 |
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| Ultra Petroleum | | $82 | Narrow | High | $41.00 |
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| Data as of 12-19-08. |
Energy Transfer Equity (ETE)
We're big fans of Energy Transfer Partners and think that its general partner, Energy Transfer Equity, presents an attractive opportunity for investors who are interested in natural gas pipeline plays and are looking more for growth than yield. We think unitholders of ETP will see distributions increase at an 8% average annual rate during the next decade, and because of the general partner MLP structure, ETE should be able to boost its distributions by at nearly twice that rate. In the past year Energy Transfer has demonstrated an ability to grow through partnerships, with joint ventures such as the Midcontinent Express Pipeline and Fayetteville Express Pipeline, both partnerships with Kinder Morgan . Also, we note that ETE is currently yielding more than ETP, which makes little sense given that incentive distribution rights give ETE an increasing claim on ETP's growing cash flows. We think investors stand to see greater unit price appreciation from ETE than from ETP, and in the meantime, collect a slightly higher yield on a distribution that will increase more rapidly than ETP's.
Enterprise Products Partners (EPD)
By any metric, Enterprise Products Partners is one of the largest master limited partnerships, and to our eyes, one of the more attractive investment opportunities in midstream energy. Under the leadership of Dan Duncan, Enterprise has assembled a set of assets stretching from the Rockies into the Gulf of Mexico, providing midstream services for natural gas, natural gas liquids (NGLs), and crude oil. But because the majority of its revenues stem from fee-based contracts, Enterprise has relatively little commodity price exposure, and in our view the combination of its natural gas and its NGL businesses results in a bit of a natural hedge. We also think that Enterprise's solid liquidity position, with $2.2 billion available, places this MLP in a great position to weather capital and commodity markets downturns or to pursue opportunistic acquisitions.
XTO Energy
XTO possesses one of the best portfolios of natural gas producing properties in the United States. The firm has assembled this portfolio through hundreds of deals over the past two decades, many of which were negotiated deals. XTO's toehold positions in multiple high-quality producing regions in the United States give it a scale advantage over peers to bid competitively and add value through acquisitions in the future. Its organization is geared to this acquire-and-exploit strategy, giving it the ability to execute dozens of deals, or more, in a given year. Because it has been so successful over the years, XTO has developed a reputation as a preferred acquirer.
Ultra Petroleum
Ultra's enviable position in the Pinedale Anticline in the Green River Basin in Wyoming gives it a formidable competitive advantage. Ultra built its position before economic production was proven, providing it a low-cost entry price. Over the past five years, the firm's unit costs have been among the lowest in the U.S. natural gas industry and well economics have been fantastic--costing about $5 million to $6 million to complete and accessing 7 billion to 8 billion cubic feet in reserves. We expect Ultra's unit cost structure will remain among the lowest in the industry over the next five years. Ultra has the potential to reinvest in its Pinedale assets for many years, reducing the reinvestment risk that many exploration and production companies regularly face. Of the approximately 125,000 Pinedale acres in which Ultra owns an interest, only 17,000 are developed.
Chevron (CVX)
Chevron's position as the second-largest oil company in the U.S. gives it the resources to explore for and produce hydrocarbons throughout the world. The majority of its portfolio of projects is located outside the United States and involves partnerships with national oil companies. Chevron presents itself as an expert in exploration and production, which makes it attractive to governments looking to capitalize on their resource base. Ongoing offshore drilling and natural gas infrastructure projects that require heavy investment are often out of the reach of smaller competitors, though they are readily available to Chevron. Chevron's recent investments in deep waters offshore should start to pay off through higher production volumes in upcoming years.
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