E&P Mid-Year Outlook 2010
Valuations appear more attractive for gas producers.
For the fourth consecutive quarter, energy stocks failed to move decisively, though there was plenty of volatility as in past quarters. 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 to oil producers looks quite attractive.
Still Waiting for a Gas Supply Contraction
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 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.
Eric Chenoweth has a position in the following securities mentioned above: CVX, XOM, RRC, RDS.A. Find out about Morningstar’s editorial policies.