Our Outlook for Energy Stocks

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• We think the consensus view favoring oil-dominant producers' stocks to natural gas-dominant producers' stocks is likely at a tipping point.
   
• Last quarter, we spilled a page of ink over why we think Transocean (RIG) shares offered a compelling risk/reward trade-off. Data and sentiment are shifting in favor of our thesis, and we remain positive on the stock.
   
• Valuations in the energy sector have changed very little, and appear slightly undervalued as a group. We view (RRC), , (RIG), , and (XOM) as excellent companies to own over the long term.

For the fourth consecutive quarter, energy stocks failed to move decisively, though there was plenty of volatility, as in past quarters. The  Energy Select Sector SPDR (XLE) was down about 3.7% year to date as of Sept. 15. However, we did see some larger directional movement in the oil and natural gas futures markets, with oil reclaiming its dominance over natural gas. So far during the third quarter, the front month contract for crude oil is up just over 1% while the front month natural gas contract is down more than 13%.

As we end the third quarter, natural gas is in the midst of a seasonally weak period for demand (as summer cooling demand dissipates but winter heating demand hasn't yet ramped up), a time when gas prices have been historically at their lowest points within a given year. We'd expect to see significant improvement in natural gas relative to crude oil by the end of the fourth quarter. Not surprisingly, sentiment toward natural gas producers' stocks has also deteriorated, and we think the relative value proposition of gas producers compared with oil producers looks quite attractive presently.

We continue to view the supply-side fundamentals supporting low gas prices as unsustainable longer term. If it weren't for an influx of foreign capital supporting drilling to hold acreage leased during the boom (much of it expiring in 2011 if drilling commitments aren't met), the U.S. gas rig count would be much lower today, in our opinion.

At about 980, the U.S. gas rig count is well above the 700 gas rigs that were active at this time last year. This rising gas rig count flies in the face of what we expect will be lower gas prices in the fourth quarter of 2010 compared to 2009. Very few of the E&P companies we cover have been able to fund their drilling budgets through internally generated cash flow during 2009-2010. More than $40 billion has come in from foreign JVs, and those that haven't participated in JVs have mostly sold assets and issued long-term debt. If we assume half of the $40 billion raised in JVs went to immediate balance sheet repair (as many companies that signed JVs were among the most financially distressed), then the remaining $20 billion could help explain how drilling held up so well despite very low gas prices.

If we assume the average horizontal gas well costs $5 million, and it takes 50 days to drill and complete these wells (which we think is a reasonable average of Haynesville, Eagle Ford, Fayetteville, and Marcellus Shale wells), then each rig running would drive $36.5 million in capital spending annually for an E&P company. So how much are the extra 280 rigs (980 minus 700) requiring E&P companies to spend each year on new wells? That's an extra $10.2 billion per year, or roughly our $20 billion estimate of excess cash raised from the JVs spread over two years. With the new JV money sunk largely in the ground now (or used in debt repayment), and lease expiration pressures set to subside as we push through 2011, we are likely to see a different set of U.S. supply fundamentals taking over. Those fundamentals will be driven largely by companies living within cash flow, which suggests a falling gas rig count. And higher gas prices will be required to lift cash flows and fund greater drilling activity. 

One clear challenge to our thesis could be the past repeating itself--namely, the E&P industry has done an incredible job raising capital in the past. E&P firms were even able to secure the big financial JVs during the lean years of 2008-2009, which few saw coming in such size. Why won't they raise a lot more money and drill beyond cash flow for the next few years? We view this as the key risk to our thesis.

The first threat on this front would be more large financial JVs being created, i.e. a continuation of the present financing trend via financial JV. We think this is unlikely as many foreign firms interested in taking a strategic position in a shale play have likely done so, and many of the E&P companies wishing to enter into large financial JVs have done so. So, even though we anticipate a few more JVs could be in the works (most notably, we may see one or two more from  Chesapeake --it really initiated the financial JV trend and has been at the forefront of financial innovation within the E&P industry for over a decade, given its propensity to outspend cash flow), we expect this avenue to raise large funds will start drying up.

We believe asset sales will probably be among the most common method for companies to fund spending beyond cash flow over the next year, but we see this as a much smaller event, and many of the buyers are likely to be other E&P companies (making it a wash of sorts), with some new private equity money possibly entering through these transactions, too. As long as the asset market holds up, we expect light equity issuance.

Finally, we think management teams are starting to realize that missing previously issued growth guidance isn't as damaging to the share price as it used to be. In fact, given the frustration many investors have had over the industry's desire to drill ferociously in the face of low gas prices, we wouldn't be surprised if some companies were rewarded for announcing reduced spending plans in the face of lower natural gas prices. With the gas futures curve lower and flatter, management teams won't be able to lock in higher prices like they have in the past, removing another support beam and justification for greater drilling.

 

Industry-Level Insights
Energy stocks mostly ran in place during the third quarter. Companies have leaned more heavily on debt markets and asset sales relative to equity markets to improve liquidity, conduct deals, and fund budgets. This activity possibly supports our view that energy sector equity appears a bit undervalued presently, though not by much. 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 slightly undervalued at the end of the third quarter, with the market-cap-weighted price/fair value ratio for the energy sector at 0.85. The median price/fair value ratio was 0.95, illustrating a continued disconnect 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 more fairly valued, in aggregate. Recent valuations contrast sharply with where we stood in early 2009 and late 2008, but are just slightly cheaper than where we've been over the past four quarters.

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. and Canada. Spectra has an attractive existing asset footprint to capitalize on rising gas production volumes from new shale gas-producing regions in the U.S. and Canada.

We've also chosen two E&Ps,  Range Resources (RRC) and  Ultra Petroleum . Range has a dominant position in the natural gas-producing Marcellus Shale in Pennsylvania. Ultra has a dominant position in the Pinedale Anticline in Wyoming and a large, emerging position in the north central Pennsylvania Marcellus Shale. We think both companies have decades of high-return reinvestment opportunities within their portfolios.

 ExxonMobil (XOM) is our most attractively valued integrated energy firm. We think the pullback in Exxon's stock following the acquisition of XTO Energy has provided a unique opportunity to acquire a great firm at a reasonable discount to our fair value estimate.

Finally, we continue to mention  Transocean (RIG), whose case we made at great length in last quarter's outlook. Since then, market sentiment has improved toward the stock, taking it to four stars. Investors and analysts are cutting Transocean's oil spill liability expectations more in-line with our own thinking. And, should the Gulf of Mexico drilling moratorium end in November as anticipated, it could lead to improving earnings power. We continue to think the upside from potential long-term robust deep-water drilling demand is enough compensation for the murkier downside threat of an uncertain liability, but given the improvement in the stock price, it is becoming less compelling.

Top Energy Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buy
Spectra Energy		$27	Wide	Low	$21.60
Range Resources		$78	Narrow	High	$39.00
Ultra Petroleum		$63	Narrow	Medium	$44.10
ExxonMobil		$86	Wide	Medium	$60.20
Transocean		$116	Narrow	High	$58.00
Data as of 09-22-10.

Our base case oil price deck is about 8% below the futures market when considering years 2013 and beyond, while our natural gas price deck is about 22% 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 about 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.

 Ultra Petroleum 
For over five years, Ultra has been one of the lowest cost producers of natural gas in the U.S., thanks to its Pinedale Anticline asset in Wyoming. The company is now in the early innings of developing its second low-cost asset, its Marcellus Shale properties in north central Pennsylvania. Together, these two regions should provide Ultra with plentiful low-cost drilling opportunities that will allow the firm to steadily grow production and reserves while generating high returns on invested capital over the decade ahead.

 Transocean (RIG)
As one of the largest deepwater rig operators, Transocean is ideally positioned to benefit from the secular trend toward more offshore drilling, thanks to attractive well economics and several large discoveries. We believe demand far outstrips supply for the industry's ultra-deepwater rigs, which only numbered around 35-40 in 2009. For example, Brazil has indicated a need for another 60 deep-water rigs. We believe the market currently undervalues Transocean's substantial cash-flow-generating power as well as the relatively stable earnings outlook provided by a backlog of $28 billion.

 ExxonMobil (XOM)
Exxon is close to 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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