Our Outlook for Energy Stocks
Challenging the oil versus gas consensus.
Quarter-End Insights
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- While the current outlook for supply/demand fundamentals favors oil, we believe that higher full-cycle shale gas extraction costs and potential fuel price arbitrage will better balance the scales with gas in the longer term.
- However, in the near term, we are cautious on smaller E&P firms with high operating/financial leverage as they may struggle to weather temporarily depressed gas prices and/or potentially higher interest rates during the next 12-24 months.
- While valuations in the Energy Sector appear fair, presenting few attractive near-term investment opportunities, we view XOM, RRC, SE, DVN, and BRGYY as excellent companies to own over the long term.
After initially stalling out in the fourth quarter (after a large, long rally), energy stocks continued to run in place during the first quarter, with market valuations still resting very close to our fair value estimates in most cases. An investor preference for oil-weighted exploration and production companies to natural gas-weighted E&P companies remains firmly entrenched, despite a cold winter. And, as North America's largest gas-weighted E&Ps take aim at bold production-growth targets, could highly leveraged, smaller gas-weighted E&Ps become casualties of these ambitious plans?
For about the past year, it has been our observation that a strong consensus view has been building and is now firmly entrenched within the investment community favoring oily companies to gassy companies. During the past couple of years, we've probably helped contribute to that consensus view by discussing the disconnect between oil and gas supply and demand fundamentals.
In a nutshell, the world appears far more supply constrained on the oil side compared with the gas side, especially when looking specifically at the North American natural gas marketplace (where the bulk of investable opportunities exist). This fundamental supply disconnect stems from the discovery, delineation, and early development of multiple new shale gas plays in the United States during the past five years and expectations for greater development (and therefore supply) coming from these shale gas resources during the next decade.
With the entrenched consensus view now being reinforced by near-term seasonal factors that favor oil over gas (as winter heating demand for gas fades and the summer driving season beckons to refiners and excites oil demand), we think it's a good time to reflect back on this widely held consensus view.
Let's first challenge the idea that gas will be both abundant and cheap during the next decade in North America. On the abundance side, we won't bother to argue with the assertion that natural gas shale resource potential is huge in North America. Instead, we'd suggest that some of the factors that will contribute to converting resource potential into gas for sale could prove more limiting.
First, we see potential shortages of midstream infrastructure where it will be needed most from a volume-growth standpoint. Although we may have excess pipe and processing in the Rockies and North Texas, areas likely to experience the most explosive growth during the next decade--the Haynesville/Bossier Shale, Marcellus Shale, Horn River Basin, and Eagle Ford Shale--face greater midstream hurdles. Cheap funding for both midstream and upstream development could also occasionally prove elusive, especially if investor enthusiasm for gas wanes or rates rise.
Water, a key component of the technology unlocking shales, could also be an issue. Each horizontal shale well can require between 1 million and 8 million gallons of water in the hydraulic fracturing process, most of which is absorbed. Water returning to the surface needs treating and disposal/recycling, which requires more above-ground water investment.
Finally, we'd caution against extrapolating out cost savings achieved by the industry in 2009. Although some very real cost-saving breakthroughs occurred this past year, we also experienced an incredibly depressed rig and services environment that will likely mark a trough in the prices for rigs and drilling and completion services. One of the biggest wild cards, in our opinion, is the ultimate, full-cycle cost structure of various shale gas resources. Ultimately, we think the long-run price of gas depends on the cost of developing the abundant shale gas resources many have identified and now fear could flood the market. We think that full-cycle cost is higher than present gas prices.
Assuming all of our supply-related concerns can be overcome, the demand side of the equation must still be probed. If gas proves cheap and abundant during the next decade, that suggests it will steal markets from oil and possibly coal (if their respective cost structures can't keep pace). During the past two decades, gas has already begun to steal share from coal on the North American power generation side but still only owns about 20% of the overall market. Gas has yet to steal share from oil-based refined products on the transportation side. So both markets appear ripe for greater natural gas penetration.
Considering North American natural gas production currently sits at 78 billion cubic feet per day, spread fairly evenly between legacy commercial- and home-heating, industrial, and electricity-generation markets, how big an opportunity could new market penetration present? Well, the U.S. and Canada consume 79 billion cubic feet per day equivalent in transportation, where gas has almost no share. And the electric-power-generation market in the U.S. and Canada uses about 110 billion cubic feet per day equivalent (of which gas already owns about 20% to coal's roughly 45%). So it appears that cheap and abundant gas could have some running room, and significant volume growth could be absorbed in time.
But we all know that oil-based refined products are incredibly entrenched in the transportation supply chain, and it's a superior transportation fuel in many ways. So is that really a market gas could penetrate? Instead of tackling this question in the broader auto fleet, where we'll concede much time would likely be required, we'd point to smaller transportation markets with largely self-contained supply chains that could be more quickly overrun by natural gas.
First, consider freight trucks, which need about 13 billion cubic feet per day equivalent in the U.S. and Canada. Freight trucks are likely the most cost-conscious part of the transportation sector, and most likely to take advantage of significant, persistent fuel-price arbitrage. Second, consider fleet vehicles (cabs, busses, municipal fleets, and so on), which use about 3 billion cubic feet per day. Finally, consider rail, air, military, and international shipping, which consume about 16 billion cubic feet equivalent in fuel in the U.S. and Canada.
Another idea gaining steam during the past couple quarters is that the biggest E&Ps are going to cause some ripple effects on smaller, more leveraged peers, as they rapidly ramp up supplies during the next few years. Even if the longer-term demand picture looks bright for gas, many see a near-term collision between increasing gas volumes and yet relatively weak gas demand. This fear has gained support in the first quarter, as some of the largest gas-focused E&Ps have fortified their finances and refocused investments on North American gas properties. Devon Energy (DVN) is selling offshore and international oil assets and will likely raise more cash than it has debt. Encana (ECA) separated off its oil assets to create a low-debt, North American gas-focused juggernaut. And, even once beleaguered Chesapeake pulled off a string of deals in 2009 to bring in financial backers and improve internal liquidity to develop its vast North American acreage holdings.
Combining the renewed production growth from these large caps with persistent aggressive growth from mid-cap E&Ps such as Range Resources (RRC), Petrohawk , and Ultra Petroleum , we can see reason for alarm. In the near term, we still hold out some hope that strong underlying decline rates might help offset some of this more visible shale gas growth. But taking in all the data, we'd be cautious of smaller E&P firms with high debt levels, and large maturities in the 2010-13 time frame.
If interest rates were to rise during the next few years, as some fear, it could place further pressure on smaller, leveraged firms. If one owns or is considering owning one of these smaller, leveraged E&P companies, it might be prudent to include some downside scenarios in one's analysis.
Industry-Level Insights
Energy stocks mostly ran in place during the first quarter. For the fourth consecutive quarter, E&P companies' stocks largely 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). We continue to see relatively modest debt yields, after watching them fall considerably during the past year.
Companies continue to take advantage of healthy debt and equity markets and more recently strong asset markets to improve liquidity, conduct deals, and fund greater budgets. All told, we continue to view marketplace activities as further evidence that energy stocks remain fairly valued as a group. We'd need to see sustained oil- and gas-price strength or further multiples improvement to justify significant stock-price gains from here, in our opinion.
As a group, energy was very close to fairly valued at the end of the first quarter, much like it was toward the end of the fourth quarter, with the market-cap-weighted price/fair value ratio for the energy sector at 0.94. Recent valuations contrast sharply with where we stood a year ago and in late 2008, when market prices appeared much cheaper to us. Higher oil prices, and healthier debt and equity markets have combined to drive up market valuations when compared with our fair value estimates. Also of note, the median price/fair value ratio is 1.06, illustrating the disconnect we see between some of the larger- and smaller-cap names in energy. In general, we see larger-cap energy names slightly undervalued and many smaller names slightly overvalued, in aggregate.
Energy Stocks for Your Radar
We've picked five stocks from our 4- and 5-star list to keep on your radar. One of our picks, Spectra , is a midstream company focused primarily on transporting natural gas in the U.S. Spectra has an attractive asset footprint to capitalize on rising gas production volumes from new shale gas-producing regions in the U.S. and Canada.
We've chosen two E&Ps, Range Resources and Devon Energy. Range has a dominant position in the natural gas-producing Marcellus Shale in Appalachia. Devon has positions in multiple North American shale gas resources, that it acquired at relatively attractive prices. Finally, we've included two global integrated firms, ExxonMobil (XOM) and BG Group . We think the recent pullback in Exxon's stock following its announced acquisition of XTO Energy is providing a unique opportunity to acquire a great firm at a reasonable discount to our fair value estimate. We think BG Group's global gas assets could become more attractive during the next decade, and its stake in Brazil's deep-water exploratory oil region is underappreciated in its current market valuation.
| Top Energy Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Spectra Energy |  | $25.00 | Wide | Medium | $17.50 |
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| Range Resources | | $78.00 | Narrow | High | $39.00 |
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| Devon Energy | | $94.00 | Narrow | High | $47.00 |
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| BG Group | | $124.00 | Narrow | High | $62.00 |
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| ExxonMobil | | $87.00 | Wide | Low | $69.60 |
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| Data as of 3-23-10. |
Our oil price deck is about 5% below the futures market when considering years 2013 and beyond, while our natural gas price deck is about 15% higher than the futures market for 2013 and beyond.
Spectra Energy
Spectra operates one of the largest diversified midstream footprints in North America, with core long-haul pipelines touching many of the continent's most prolific natural gas plays, including the Haynesville, Marcellus, Horn River, and Montney shales. Spectra's massive pipeline network creates opportunities for low-risk organic growth projects that leverage the entire network, bringing incremental volumes to market at attractive rates of return. Stable fee-based cash flows from Spectra's pipelines, storage, and distribution operations constitute roughly 80% of cash flows, largely insulating Spectra from commodity price and volume fluctuations. The remaining 20% of cash flows, which stem from commodity-sensitive gathering and processing operations, offer cheap upside potential with rising commodity prices.
Range Resources (RRC)
Range Resources is a first-mover into the potentially prodigious Marcellus Shale in the Appalachian Basin. With more than 1 million net acres in the play, Range stands to extract significant value from the Marcellus during 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 wells, 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.
Devon Energy (DVN)
Devon's plan to sell offshore and international properties is going better than expected and should raise more cash (after taxes) than the firm had debt at year-end 2009, putting it in an especially strong financial position. Devon could deploy its newfound financial flexibility in a couple of ways, acquiring smaller players if gas prices remain low or accelerating development of its large onshore North American portfolio should prices rebound. Given its early entry points into numerous shale plays, including the Barnett Shale, Haynesville/Bossier Shale, Horn River Basin, and Cana Woodford Shale, Devon has low-cost positions with plenty of room for growth. It has also recently added to its position in the Canadian oil sands.
BG Group
BG Group became a leading global integrated natural gas player by utilizing liquefied natural gas to export low-cost resources to high-value markets. By using its own LNG infrastructure, BG gains flexibility and directs the gas to markets that generate maximum profitability. Full integration of the process, from reserve to burner tip, affords the company the ability to drive efficiencies, control costs, and capture value along the entire chain. In the next decade, BG should see strong production growth as it develops additional LNG volumes from low-cost coal seam gas in Australia for export to Asia. More transformational though is BG's position in Brazil's offshore presalt discoveries from which it could add reserves of more than 3 billion barrels of oil equivalent and production of 400,000 barrels by 2020.
ExxonMobil (XOM)
Exxon recently entered 5-star territory, 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 ability to drive costs down throughout the system further underpin its high returns and buffer the firm during weaker commodity-price environments.
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