Our Outlook for Energy Stocks

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• Record global demand, falling inventories, and a shrinking supply cushion bodes well for oil prices entering 2011. Natural gas fundamentals should improve throughout 2011, as the gas-directed rig count shrinks.
   
•  Chevron (CVX) enters the Pennsylvania Marcellus Shale via its acquisition of Atlas Energy (ATLS), adding to earlier major integrated firm activity in the region from  Royal Dutch Shell (RDS.A) and  ExxonMobil (XOM). We expect this is just the tip of the iceberg.
   
• Valuations in the energy sector appear slightly overvalued as a group, following the large rally this quarter. Large-cap stocks appear slightly undervalued, where mid- and small-cap stocks appear overvalued heading into 2011.

After a year of directionless price movements for energy stocks as a group, a decisive rally took hold in the fourth quarter.  Energy Select Sector SPDR (XLE) was up about 16% year to date as of Dec. 15 and more than 18% since Sept. 30. We continued to see large directional moves from both the oil and natural gas futures market during the quarter, with oil just edging out gas on price gains. So far during the fourth quarter, the front-month contract for crude oil is up 11% while the front-month natural gas contract is up just more than 9%.

As we end the fourth quarter, natural gas demand is transitioning from a period of seasonal weakness to seasonal strength. Gas inventories were quite high entering December, putting greater pressure on cold winter weather to draw down gas storage by next spring. We expect gas-directed drilling will slow considerably in the second half of 2011. A combination of low gas prices, high service costs, less drill-to-hold acreage pressure, and weak internal cash flow generation at exploration and production companies will sap the desire and ability to perpetuate the presently high active gas rig count. Although this still argues for a weak gas price in 2011, it should set up better fundamentals for gas in 2012 and beyond.

Near-term oil price fundamentals continue to contrast sharply with gas fundamentals, and we think the market is largely factoring in better times ahead for those exposed to oil. Oil demand in the third quarter increased to levels last seen in mid-2008, marking a full recovery from the financial crisis and setting a new record at 88.3 million barrels per day, according to Wood Mackenzie. The release of the Internal Energy Agency's oil market report this month confirmed the magnitude of oil-demand growth in the quarter, which increased 3.3 million barrels per day year over year. While U.S. demand has rebounded strongly from 2009 lows, with September demand up 0.9 million barrels per day or 5% from 2009, the majority of demand growth came from China and developing markets.

The IEA sees demand increasing by 1.5 million barrels per day in 2011, to average 88.8 million barrels per day. The IEA sees the call on OPEC increasing by 0.3 million barrels per day over last month's production of 29.2 million barrels per day. In our view, the oil market is beginning to resemble what we saw in late 2007-early 2008, when demand began to call on OPEC spare capacity. Saudi Arabia, which accounts for the vast majority of nominal spare capacity, has stated frequently its intention not to pump more than 10 million barrels per day on a sustained basis, suggesting to us that its functional excess capacity is closer to 1.7 million barrels per day than the 3.8 maintained by the Energy Information Administration and IEA. Given what we know of mega-projects ramping up during the next 12-18 months, and barring a collapse in demand as a result of economic weakness, marketplace fundamentals appear to support another near-term oil price spike.

Longer term, we think the present natural gas fundamentals are unsustainable, and the price should be higher than where we are today. Simply put, we think the U.S. E&P industry needs a higher gas price (or lower costs) to justify current pricing. Further, given the low relative price of natural gas compared with peer energy sources such as oil (on an equivalent BTU basis), we expect the price signal being broadcast by gas won't fall on deaf ears (given the strong economic benefits of switching to gas whenever possible). Although many of the 5-star natural gas investment ideas we've mentioned in past quarterly outlooks have rallied well above our Consider Buying prices in recent weeks, we still think the best long-term values exist among the gas-weighted E&P companies, with  Range Resources (RRC) still at the top of the list.

It's probably worth noting that two management teams are pursuing management buyouts of their gas-weighted E&P companies-- Quicksilver Resources (KWK) and  EXCO Resources (XCO). Longer-term oriented investor Wilbur Ross also recently took a position in EXCO. Most importantly,  Chevron (CVX) entered the Pennsylvania Marcellus Shale by purchasing Atlas Energy (ATLS). This is Chevron's first big step into U.S. shale gas, and not surprisingly it chose properties in an area we expect will have some of the best economics longer term (with much of the property not far from Range Resources' acreage). Chevron's actions continue the trend of major integrated firms taking positions in U.S. shale gas. We view all of these actions as consistent with our longer-term thesis and expect we're in the early innings of a bigger trend.

Given all of the pain being experienced by gas-oriented E&P companies, it's somewhat unusual to note that U.S.-focused oil- and gas-services companies have experienced a period of incredible pricing power in 2010. Service company consolidation and high oil and natural gas liquids prices combined with a desire to drill-to-hold gas prospective acreage (even despite low gas prices) have contributed to strong services demand from the U.S. E&P companies and exceptional pricing power for the services companies. Many E&P companies have thus felt the squeeze from both ends with lower gas selling prices and higher services costs, and earnings power has suffered. However, services companies' profitability has improved. We think these dynamics are unsustainable longer term. Much like we expect higher gas prices in a few years, we question the ability for services companies to maintain present pricing power well beyond midyear 2011. Services giant  Halliburton (HAL) recently offered one solution at its Analyst Day--split pricing--where gas producers would be charged less than those producing liquids and oil.

Industry-Level Insights
As a group, energy was slightly overvalued at the end of the fourth quarter, with the median price/fair value ratio for the energy sector at 1.06. Large-cap energy names stand out as the only undervalued category within the energy sector, with the median price/fair value ratio at 0.99. Small- and mid-cap energy names both look overvalued following the recent rally, with median price/fair value ratios of 1.22 and 1.12, respectively. After five quarters of being fairly to slightly undervalued (and being deeply undervalued before that, in early 2009 and late 2008), currently overvalued energy stock valuations offer a stark contrast with earlier periods.

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,  Energy Transfer Equity (ETE), is a midstream company focused primarily on transporting natural gas in Texas and the southern U.S.

We've also chosen three E&Ps, Range Resources,  Devon Energy (DVN), and  EOG Resources (EOG). Range has a dominant position in the natural gas and liquids-rich Marcellus Shale in Pennsylvania. Devon and EOG both have sizeable North American oil and gas portfolios and fit in with the general theme this quarter of greater value within larger-cap names.

 ExxonMobil (XOM) is our most attractively valued integrated energy firm. Although we found the shares more compelling in the $50s and $60s, this great firm still trades at a reasonable discount to our fair value estimate.

Top Energy Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buy
Range Resources		$86	Narrow	High	$51.60
Devon Energy		$94	Narrow	High	$56.40
EOG Resources		$110	Narrow	Medium	$77.00
Energy Transfer Equity		$51	Narrow	High	$30.60
ExxonMobil		$86	Wide	Medium	$60.20
Data as of 12-17-10.

Our base-case oil price deck is about 11% below the futures market when considering years 2013 and beyond, while our natural gas price deck is about 30% higher than the futures market for 2013 and beyond.

 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 planned Barnett Shale asset shale should reduce its funding uncertainty, and its heavy investment in high-return Marcellus Shale wells should translate into strong returns on capital for many years.

 Devon Energy (DVN)
By early 2011, we anticipate Devon will have closed on almost $10 billion in asset sales as part of its shift toward U.S. and Canadian onshore resource plays. The result for Devon is a broad portfolio of growth-oriented oil and gas assets and a rock-solid balance sheet to aggressively develop these resources during the next several years. The firm's acreage includes sizeable positions in the Permian Basin, the Barnett, Cana-Woodford, Horn River, and Haynesville shale plays, and two large Canadian oil sands projects. Devon's balanced production and reserve mix should help the firm generate attractive economics even in the face of continued low gas prices.

 EOG Resources (EOG)
EOG began its strategic shift from gas to oil in late 2006 with successful drilling and production in the Bakken shale. Since then, the firm has built an impressive collection of low-cost, liquids-rich positions throughout North America--including acreage in the Permian Basin, the Barnett Combo play, and the Eagle Ford and Niobrara regions--that should help drive reserve and production growth during the next several years. Despite recently scaling back its near-term natural gas drilling plans, longer-term the firm's sizeable acreage positions in the Haynesville/Bossier and Horn River Basin areas should provide additional upside potential. Given management's strong track record--achieved, notably, with only modest amounts of debt--we have confidence in their ability to execute, regardless of where commodity prices or input costs trend.

 Energy Transfer Equity (ETE)
We think Energy Transfer Equity is currently one of the few pockets of value in midstream energy. As the owner of general partner interests in both  Energy Transfer Partners (ETP) and  Regency Energy Partners (RGNC), Energy Transfer Equity stands to gain from distribution growth at both underlying partnerships. With two massive pipeline projects coming online at ETP and incremental progress at Regency, including a newly announced Eagleford project, we see distribution growth at ETE accelerating into the double digits during the next few years.

 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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