Our Outlook for Energy Stocks
Energy stocks rally in the third quarter, looking past many of the present difficulties.
Quarter-End Insights
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Energy stocks rallied along with the broader market during the third quarter, continuing to allow companies to tap equity and debt markets on better terms (much like we saw in the second quarter). A growing enthusiasm toward natural gas producers' stocks marked one of the biggest changes in the marketplace, despite the storage glut and very low spot prices for gas. As investors look past the current glut, we expect they're seeing the potential supply correction looming in 2010 following a dramatic decline in the active rig count in 2009. We think that view makes sense, and it describes some of the recent market price convergence with our fair value estimates. Near term, winter weather will play a large role in the shape of the emerging gas price recovery. An especially cold winter could put a bigger dent in gas in storage, arguing for a sharper recovery in gas prices in 2010, while a milder winter could prolong the inventory glut, pushing price recovery hopes out into late 2010 or 2011.
Regardless of the near-term path gas prices follow, when taking a longer-term view, we'd suggest that higher gas prices will ultimately be required to lift drilling activity in any meaningful way (considering producers' costs). And, given that we've worked through most of the inventory of wells awaiting completion from 2008, we're now relying exclusively on existing drilling activity to support supply. However, with the Baker Hughes U.S. gas rig count resting at roughly 700 (versus a peak above 1,600 in 2008), we don't think current drilling activity can maintain existing supply levels (considering underlying declines). So we'd expect supply to continue to shrink until the price is right to support more drilling.
Could gas producers get caught off-guard, leading to much higher gas prices in 2010 or 2011? Though we wouldn't rule out a shorter-lived spike if winter weather proved bitter cold and industrial demand surprised on the upside, we think a sustained price spike (i.e., gas prices sustained in the double digits) is not especially likely. Large shale plays have been discovered and are being delineated and evaluated--and a large number look very economic with $6-$8 natural gas with top-tier plays economic at $4-$6 gas, suggesting gas supply can be increased substantially if the price is right and financial markets are healthy enough to fund expanded drilling.
Crude oil and refined products also face the head wind of a sizeable inventory overhang, though it hasn't stood in the way of a sustained recovery in crude oil prices thus far in 2009. Unlike natural gas, we think the oil industry would be far more challenged to significantly boost supply much beyond the roughly 87 million-barrel-per-day level reached in 2008 without a great deal of time, effort, and investment (especially considering recent reductions and deferrals in investment). And, if demand recovers back into the 85 million- to 86 million-barrel-per-day range, we could see the case for sustained higher oil prices as the OPEC supply cushion shrinks.
However, one part of the energy value chain that continues to look very weak to us is the refining industry. Globally, refiners are suffering from severe overcapacity, and the potential for additional strategic refining investments in Asia and the Middle East threatens to add to the problem in the years ahead. Even U.S. independent refiner Valero's (VLO) once highly profitable strategy of gearing up refineries to process cheaper, heavier crudes has been neutralized recently, as the spread between heavier and lighter crudes has narrowed considerably.
Despite losing some steam from when we first wrote about it in the first quarter, higher taxes and greater regulation still lurk in the background for the U.S. energy industry. Higher taxes could still come in the form of repealed intangible drilling costs (IDCs). Hydraulic fracturing--key to developing new shale gas resources, could be brought under the clean water act--adding additional costs and slowing the pace of development. Regulators could also disrupt the present hedging practices, making it more expensive for oil and gas producers to maintain their hedge books. Carbon legislation could disadvantage U.S. refiners by considerably increasing their costs.
Valuations by Industry
Energy stocks continued to rally for a second consecutive quarter. In a continuation of what we observed during the second quarter, market valuations for E&P companies' stocks matched or outpaced the prices of assets in recent deals (based on comparing companies' enterprise value/reserves versus dollars spent per mcf of reserves in the marketplace). Perhaps the relatively attractive stock and credit market conditions partly explain the rush for firms to issue equity and debt. Also, it supports the idea that energy stocks are more fairly valued today than they have been in a while. We'd need to see continued oil and gas price strength or multiples improvement to justify significant stock price improvement from here, in our opinion.
As a group, energy was very close to fairly valued at the end of the third quarter, much like it was toward the end of the second quarter, with the overall price/fair value ratio for the energy sector at 0.95. Recent valuations contrast sharply with where we stood in the fourth quarter of 2008 and first quarter of 2009. Higher oil prices, improving sentiment about future natural gas prices, and healthier credit markets have combined to drive the second and third quarter 2009 rally.
| Energy Industry Valuations | |||||
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| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty Percentile** | |
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| Oil & Gas - Drillers | 2.94 | 0.97 | 1.07 | -9 | 66.0 |
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| Oil & Gas - E&P | 3.06 | 0.93 | 0.92 | 1 | 45.7 |
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| Oil & Gas - Equipment & Services | 2.47 | 1.19 | 1.18 | 1 | 96.8 |
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| Oil & Gas - Major Integrated | 3.28 | 0.93 | 0.95 | -2 | 29.8 |
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| Oil & Gas - Pipelines | 3.37 | 0.94 | 0.81 | 16 | 25.5 |
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| Oil & Gas - Refining & Marketing | 3.24 | 0.88 | 0.94 | -6 | 34.0 |
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| Data as of 09-14-09. |
Our oil and natural gas price decks are just a hair above the futures market when looked at longer term, marking the second consecutive quarter where our long-term price deck has nearly converged with the futures curve, much unlike the first quarter of 2009 and fourth quarter of 2008, when our long-term price deck stood well above the futures curve.
Energy Stocks for Your Radar
We've picked five stocks from our 4- and 5-star list to keep on your radar. Two of our picks, Spectra and Enterprise GP Holdings , are midstream companies focused primarily on transporting natural gas in the U.S. Both have attractive existing asset footprints and valuations. We've chosen two E&Ps, Range Resources (RRC) and XTO Energy . Range has a dominant position in the natural gas-producing Marcellus Shale in Appalachia, which should be a source of profitable growth and reinvestment for the firm for many, many years. Range's existing development positions in the Barnett Shale and Nora should help fund some of this growth. XTO's low-cost, expansive U.S. asset base is well positioned for profitable growth on both the oil and natural gas front. Plus, XTO's financial position is strong thanks partly to hedges the firm secured before oil and gas prices fell considerably. Finally, we've included a major integrated firm, ExxonMobil (XOM). Exxon has been flirting with 5 stars recently and we think it offers a lower risk, moderate return potential below our Consider Buying price.
| Top Energy Sector Picks | |||||
| | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Spectra Energy |  | $25 | Wide | Medium | $17.5 |
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| Enterprise GP Holdings | | $53 | Wide | Medium | $37.1 |
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| Range Resources | | $78 | Narrow | High | $39 |
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| XTO Energy | | $53 | Narrow | Medium | $37.1 |
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| ExxonMobil | | $87 | Wide | Low | $69.6 |
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| Data as of 09-23-09. |
Spectra Energy
Spectra 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 when processing margins are favorable, in our view.
Enterprise GP Holdings
We continue to think Enterprise GP Holdings is one of the savviest ways to invest in midstream energy. As the general partner of both Enterprise Products Partners and TEPPCO Partners, we think Enterprise GP Holdings stands to gain from the pending merger of Enterprise and TEPPCO, which in our view will allow for more rapid growth of post-merger distributions. Also, in our view Enterprise GP Holdings' 17% stake in Energy Transfer Equity (ETE), the general partner of Energy Transfer Partners , gives the holding company a significant claim on cash flow growth from one of the sector's most attractive natural gas pipeline MLPs.
Range Resources (RRC)
Range Resources is a first-mover into the potentially prodigious Marcellus Shale in the Appalachian Basin. With over 1 million net acres in the play, Range stands to extract significant value from the Marcellus over the next several years. Due to its early entry into the play, Range's lease terms are very favorable, which, coupled with the attractive cost structure and production profile of individual, make the play very economical at natural gas prices as low as $4 per mcf. Range's low corporate decline curve and its exposure to the Marcellus Shale reduce reinvestment risk and should translate into strong returns on capital for many years.
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.
ExxonMobil (XOM)
Exxon has flirted with 5 stars recently, a point where we think it offers decent return potential with less risk than many of its peers. 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.
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