Our Outlook for Energy Stocks
Presidential budget concerns add to the industry's present woes.
Quarter-End Insights
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You'd think the energy industry might be numb to bad news by now, after absorbing both a collapse in oil and natural gas prices and a credit crisis of historic magnitude. Last quarter, we wrote about how the carnage had spread from equity and debt markets to companies' budgets. Unfortunately the bad news kept coming, as the president's recently proposed budget places the U.S. energy industry in its crosshairs, attempting to squeeze what little blood remains in the stone today. Additionally, we hear rumblings of greater regulation in the background, the most important of which concerns clamping down on hydraulic fracturing, thus taking aim at the speedy, economic development of one of the final frontiers of natural gas drilling in the U.S.--shale gas.
The budget and regulatory rumblings add a new wrinkle for energy investors. Before this news, there was a clear upside to the credit crisis, oil and gas price collapse, and capital spending reductions--future supplies would be curtailed, sowing the seeds for higher oil and gas prices someday. This budget and regulatory news clearly adds to the ability of the already existing shakeout to force weaker producers out of business and curtail oilfield activity, thus further strengthening the case for higher natural gas and oil prices in the future. However, it also reduces the ability of healthy U.S. energy firms (the survivors) to thrive in a higher-priced environment. Burdened with new taxes and regulations that would retard investment and development of some of the industry's brightest growth prospects, U.S. oil and gas producers may not be able to transform the higher oil and gas prices into meaningful profit expansion, as they could during the last boom.
We've written about the M&A environment for oil and gas prices recently, as our outlook is for more activity at lower prices this year. Many of the weaker players are facing reduced borrowing capacity and some may be overdrawn, pushing them to look to asset sales to improve their liquidity. Uncertainty stemming from the budget proposal is likely to further negatively impact the U.S. M&A marketplace, as bidders face greater difficulty estimating future oil and gas property economics, leading many of them to lower their bids further. We view the 2009 M&A market as an opportunity for firms with financial flexibility and a sizeable hurdle for firms facing financial distress.
In the short run, we still see oil prices caught between OPEC's efforts to reduce supplies (with help from high-cost producers in non-OPEC countries shutting down operations, too) and very weak demand. However, since our last quarterly outlook, we have grown more impressed with OPEC's ability to curtail output. Further, we expect incremental reductions in demand are shrinking and the potential for demand to stabilize and potentially start to creep upward is becoming more likely than it was a quarter ago. Oil inventories remain very high, however, and spikes in the oil price are likely to be met with waves of oil flowing out of storage. Over the longer term, once inventories slim down and demand strengthens, we expect higher oil prices.
North American natural gas prices failed to gain support from winter weather as it was offset by incredibly weak industrial demand, so inventories look primed to be higher than average in 2009. We expect natural gas supply will remain strong in the first half of 2009, as sizeable levels of investment committed in 2008 flow through the system, supporting weaker prices in the short run. However, we expect domestic output to begin declining in the second half of 2009 as the dramatic reduction in the natural gas rig count starts to manifest itself. This supply view supports a rebound in gas prices beginning sometime in the second half of 2009 and gaining steam in 2010. One wild card still exists--LNG shipments--and it could extend the weak natural gas pricing environment a few quarters. LNG cargos were few and far between in 2008, as strong Asian demand kept cargoes from drifting west. With Asian economies weakening there is a different story emerging in 2009, as we see cargoes shifting westward to Europe and the U.S. So we expect significant growth in LNG imports to the U.S. versus 2008, but the ultimate magnitude remains unclear and we're watching it closely.
One of the offshoots of lower natural gas drilling activity in the U.S. is reduced capacity utilization in the drilling rig and services market. We think this overcapacity could persist for a number of years, especially if the proposed budget and stricter regulation prevail. We reduced our long-term natural gas price assumption in February as the potential for lower well costs became more clear to us. Further, in light of the budget proposal, we increased our uncertainty ratings for U.S.-focused oil and natural gas producers in March.
Valuations by Industry
Presently all of the subsectors in the energy sector appear undervalued. Pipelines are trading at the steepest discount to their fair value estimates, followed by drillers and service firms (oil and gas services). It's important to note that drillers and service firms rated similarly compared with refiners (oil and gas products) when considering average star rating. This is because of the higher uncertainty ratings that drillers and service firms receive--as shown by looking at the high uncertainty percentile. Pipelines, E&Ps, and major integrated firms (oil & gas) garner our highest average star ratings and offer the best and most abundant selection of investment ideas in the energy sector.
| Energy Industry Valuations | |||||
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| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty | |
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| Oil & Gas | 3.90 | 0.71 | 0.72 | -1 | 41.7 |
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| Oil & Gas Services | 3.60 | 0.74 | 0.59 | 25 | 83.5 |
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| Oil & Gas Products | 3.60 | 0.68 | 0.61 | 11 | 90.6 |
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| Pipelines | 4.30 | 0.58 | 0.61 | -5 | 7.9 |
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| Data as of 03-13-09. *Market-Weighted Harmonic Mean |
Our Top Energy Picks
We've picked five stocks from our 4- and 5-star list to keep on your radar. Two of our picks, Chevron (CVX) and ExxonMobil (XOM), are large, integrated oil majors that are well-positioned companies for a turbulent operating and financing climate like we face today. Two picks are pipeline companies, Energy Transfer Equity (ETE) and Spectra Energy . 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. Spectra also possesses an attractive set of long-haul natural gas pipelines that connect high-demand regions in the Northeast with supply centers in Texas and the Gulf Coast. Canadian Natural Resources (CNQ) is a Canadian-focused E&P determined to drive costs down within its operations. It could benefit if its U.S. competitors are forced to curtail drilling activity due to new taxes and greater regulation.
| Top Energy Sector Picks | |||||
| | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Exxon Mobil |  | $87 | Wide | Low | $69.6 |
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| Chevron | | $91 | Narrow | Medium | $63.7 |
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| Energy Transfer Equity |  | $51 | Narrow | High | $25.5 |
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| Spectra Energy | | $25 | Wide | Medium | $17.5 |
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| Canadian Natural Resources | | $77 | Narrow | High | $38.5 |
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| Data as of 03-18-09. |
Energy Transfer Equity (ETE)
We're big fans of Energy Transfer Partners and we 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 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's current yield is similar to ETP's, 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, they can collect a similar yield on a distribution that will increase more rapidly than ETP's.
Canadian Natural Resources (CNQ)
Canadian Natural Resources has a cost-conscious approach to value creation. In addition to long-term investments that will result in significant production gains, the company has shown a knack for making complementary acquisitions at reasonable prices. If it can continue to effectively manage its capital costs, this dominant Canadian energy player should experience years of outsized returns.
Exxon Mobil (XOM)
Although we believe several buying opportunities exist in the major integrated space, Exxon is our first choice for a turbulent market environment. Exxon's returns on capital regularly exceed its peers'. Its ability to choose from among some of the best mega-projects around the globe helps it drive these higher returns. Its track record of delivering projects on time and under budget makes it a preferred partner on mega-projects. Exxon's ability to integrate its global network of oil and natural gas production, transportation, refining, and chemicals manufacturing, and drive costs down throughout the system, further underpin its high returns and buffer it during weaker commodity price environments.
Spectra Energy
Spectra Energy operates one of the largest midstream footprints in North America, touching many of the continent's most prolific producing areas. Stable fee-based cash flows from pipelines, storage, and distribution operations comprise roughly 80% of cash flows, largely insulating Spectra from commodity price and volume fluctuations. More specifically, customers pay Spectra reservation fees for the right to use a specified amount of transportation or storage capacity, regardless of actual usage. We think the stock currently trades for less than the value of these fee-based cash flows alone. The remaining 20% of cash flows, which stem from commodity-sensitive gathering and processing operations, offer free upside potential whenever commodity prices rebound, in our view.
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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