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Quarter-End Insights

Our Outlook for Energy Stocks

Geopolitical events are amplifying underlying oil market tightness.

  • Geopolitical events and the disaster in Japan exacerbate the upward-sloping trend in oil prices.
  • Natural gas fundamentals should improve over the course of 2011, as the gas-directed rig count continues to shrink.
  • Major integrated firms and foreign national energy companies continue to support U.S. E&P shale drilling through joint ventures, although JVs are shifting more toward liquids-rich plays.
  • Energy stocks appear slightly overvalued as a group. Small-cap stocks seem the most richly priced, while large- and mid-cap stocks are close to fairly valued.

Almost from the get-go, geopolitical events have shaped energy news in 2011. Popular uprisings in Tunisia, Egypt, Bahrain, and other Middle-East / North Africa nations fueled fears of contagion as oil markets priced in a steep political risk premium. Events in Libya, which produced 1.4 million barrels of oil a day in 2010, further raised concerns after Western oil firms pulled out of the country and oil and gas exports plummeted. In response Saudi Arabia began to increase oil production, and the market appears well-supplied; however, increased Saudi production has likely resulted in decreased global spare production capacity, lessening the market's ability to weather additional shocks.

The earthquake and tsunami that struck Japan earlier this month continue to have aftershocks in energy markets. Roughly 30% of Japan's refining capacity and 10% of power generation was offline as a consequence of the tsunami, some of which, like the Fukushima nuclear power plant, is likely to be impaired permanently. In the immediate term, Japan will require refined products imports to power recovery efforts. We expect power companies and factories will turn to crude oil and diesel to make up for lost nuclear power, but it is unclear in the short term whether incremental demand will outweigh lost demand from the disaster. In the medium term, we think Japan will likely meet power generation needs with increased crude oil and LNG shipments.

Prices for West Texas Intermediate crude ran up nearly 11% year to date, largely on geopolitical developments. Brent crude prices, a common benchmark outside of the U.S., increased by 21%. At the beginning of the year, Brent enjoyed a $2 premium to WTI, but the spread increased to as much as $16 as Brent prices responded to macro events, and it is still above $12 today. The key driver here is crude oil storage. Large inventories of crude oil in Cushing, Okla. (the settlement location for physical WTI contracts) combined with limited pipeline takeaway capacity to the U.S. Gulf Coast depressed the value of crude at Cushing, shielding WTI prices from the full brunt of this year's price spike.

Last quarter we discussed our rationale for a near-term oil price spike, though we had not expected popular uprisings nor tsunamis. We continue to see demand growth outpacing new supply, and barring a collapse in demand as a result of economic weakness (potentially caused by high oil prices), marketplace fundamentals support continued oil price strength.

Looking to natural gas, we are beginning to see evidence of our thesis playing out as companies aggressively shift capex dollars to liquids-rich plays. Falling gas-directed rig counts are a precursor to flattening, then declining, gas production in the U.S., though a 1-2 quarter drilled-but-uncompleted well backlog will support gas volumes after we've turned the corner. We continue to expect gas-directed drilling to slow considerably in the second half of 2011. The 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.

Moreover, the shift toward liquids production will, in our view, force higher gas prices over time, as E&P companies will require attractive pricing before redirecting capex from high-returning liquids plays. Despite the continued support for high oil and liquids prices, we think oily stocks as a group present more downside risk than gas-levered names such as  Range Resources (RRC).

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 over the past several quarters. 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. Meanwhile, services companies' profitability has improved. While we think these dynamics are unsustainable longer term, we anticipate that services companies will be able to maintain present pricing power throughout 2011.


Industry-Level Insights
As a group, energy stocks are sitting just above our estimates of fair value, with the median price/fair value ratio for the sector at 1.03. Large- and mid-cap energy stocks fall right in this range, while small-cap stocks, the largest beneficiaries of the runup in energy names that really got started in the third quarter 2010, appear overvalued, with a median price/fair value ratio of 1.20.

Looking to energy subsectors, midstream and integrated oil and gas names look fairly valued, while E&Ps and service companies appear moderately overvalued. Refiners are the most overvalued subsector, with a median price/fair value ratio of 1.26, while oil and gas drillers are our only undervalued subsector, with a median price/fair value ratio of 0.94.

Energy Stocks for Your Radar
With the recent run that energy stocks have enjoyed, we have no 5-star stocks to recommend. However, we've picked five stocks from our 4-star list to keep on your radar.

Several of these names have made this list in the past and are here again because we like their business models--and their valuations. This quarter we are highlighting one midstream name,  Spectra Energy , which is focused primarily on transporting natural gas and enjoys limited exposure to commodity price movements.

On the E&P front, we are again highlighting Range Resources, which has a dominant position in the Marcellus Shale in Pennsylvania and is one of the lowest-cost producers of natural gas;  Petrohawk Energy , a leader in the Haynesville and Eagle Ford shales; and also Canadian company  Talisman Energy , which is rapidly shifting its North American portfolio toward shale gas. We round out our picks with  Transocean (RIG), which we believe still presents the most compelling risk-reward prospect among drillers.

Top Energy Sector Picks
   Star Rating Fair Value
Fair Value

Consider Buy

Spectra Energy $30.00 Wide Low $24.00
Range Resources $78.00 Narrow High $46.80
Petrohawk Energy $30.00 Narrow High $18.00
Talisman Energy $31.00 Narrow High $18.60
Transocean $100.00 Narrow High $60.00
Data as of 03-23-2011.

Our base-case oil price deck is about 25% 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.

 Spectra Energy 
Spectra Energy's transportation, storage, distribution, gathering and processing assets across the United States and Canada cover the spectrum of the natural gas value chain, reflecting the company's name. While diverse, Spectra's cash flows are roughly 80% fee-based, mostly regulated, and thus pretty steady in almost any economic environment. However, surging natural gas liquids prices can supercharge earnings from  DCP Midstream (DPM) (a joint venture with  ConocoPhillips (COP)) in a hurry, as we saw in full force in 2008. If recent prices for NGLs, condensate, and gas hold steady, we'd see significant upside in DCP's earnings power, and further upside in Spectra's share price. Even without red-hot commodity prices, Spectra should grow at a steady pace, as it develops its ideally positioned pipeline network and fee-based gathering-processing in the Marcellus, Horn River, and Montney shales. Few competitors enjoy Spectra's access to supplies and markets.

 Range Resources (RRC)
We're bullish on Range's long-term growth prospects given the nearly 800,000 fairway acres it holds in the heart of the Marcellus Shale. Range has completed less than 5% of its estimated wells in southwest Pennsylvania, and recently brought on line first production in the northeastern part of the state. By 2014, we project Range's Marcellus production will reach 1.3 Bcfe/d. Longer-term, the firm should benefit from the option value of its stacked pay horizons in Virginia and Pennsylvania, each of which looks increasingly positive given recent drilling results. Range recently announced the sale of its Barnett Shale assets and anticipates additional noncore sales this year, which will help fund its Marcellus play and minimize the need for external funding. Ongoing efficiency improvements should help drive down operating and finding and development costs and could provide upside to our current forecasts.

 Petrohawk Energy 
Though challenged by low gas prices, Petrohawk's prospects to successfully execute on its build-to-sell strategy remain bright for the longer term. The firm's large acreage positions in the emerging core areas of the Haynesville/Bossier and Eagle Ford Shale continue to offer low-cost growth potential. Low natural gas prices that could continue to pressure Hawk's balance sheet in 2011 sit between Petrohawk and the finish line, in our opinion. Even if gas pricing doesn't improve in 2011, successful asset sales and drilling results would improve Petrohawk's valuation, all else equal. Recently completed asset sales have furthered the firm's financing strategy, enhanced value, and reduced Petrohawk's need to tap equity markets for funding. We see two more asset sales coming to help fund the 2011-12 budget--Fayetteville Shale and the rest of Kinderhawk.

 Talisman Energy 
Talisman is concentrating expansion efforts in North America and Southeast Asia as it seeks to expand reserves and establish a long-term, predictable production base. The company under CEO John Manzoni is now investing more actively in liquids-rich North American shale gas, forming development partnerships in the Montney and Eagle Ford, and is currently one of the largest producers in the Marcellus by volume. The firm continues to branch out internationally, with exploration in Columbia and Iraq, taking on greater political risks, especially relative to its size. Talisman has avoided relying heavily on debt funding by divesting noncore assets and forming joint ventures. This financing strategy gives Talisman some flexibility, but planned investments in its larger global exploratory and development activities should absorb most of its cash flow.

 Transocean (RIG)
At around $80 per share, we think Transocean's share price has benefited from numerous favorable catalysts, including the lifting of the Gulf deep-water moratorium, the plugging of the Macondo well, and the release of the Bly and National Commission Reports, among others. As a result, the stock price is up roughly 90% off its post-Macondo lows. Future catalysts include the potential release of Transocean's own investigative report, the completed analysis of the blowout preventer, and the results of the DOJ/EPA criminal and civil investigations into the spill. We think future share gains from these catalysts will be more modest, and more substantial future upside from today's share price will be due to the attractive long-term secular picture for deepwater drilling. As the largest and most experienced deepwater driller, Transocean remains extremely well-positioned to benefit from this secular trend.

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Jason Stevens has a position in the following securities mentioned above: RRC. Find out about Morningstar’s editorial policies.