Our Outlook for Energy Stocks
Following our updated oil and gas mid-cycle prices, we have several 4- and 5-star stocks to recommend this quarter.
Quarter-End Insights
- Oil prices remain elevated despite signs of a weakening global economy. We think the uncertainties around future oil supply growth are likely to continue to place upward pressure on prices.
- Fundamentals for gas-focused E&Ps are likely to remain pressured through 2011, but we expect the large-scale shift toward liquids production, a lessening of held-by-production drilling, and fewer dry gas drilling carries to result in higher gas prices in 2012.
- We recently raised our mid-cycle oil price assumption to $95 per barrel and lowered our gas price assumption to $6.50 per thousand cubic feet.
The past quarter has seen some of the air come out of oil prices, though more from fears of a weakening global economy than from any real abatement of Middle Eastern unrest. Mixed economic news from the U.S. and ongoing concerns about potential eurozone defaults, plus a slight deceleration in China's growth in recent months cast a shadow on global growth prospects.
Meanwhile, the International Energy Agency (IEA) is urging OPEC to increase production to meet growing demand in the back half of 2011, as currently tight oil markets appear likely to become tighter in the coming months. Saudi Arabia unilaterally declared a willingness to increase production, though whether, when, or how much of this increased production translates into additional oil for the export market remains to be seen.
We think the supply and demand tensions are balanced on a pinhead, and any major development in either direction is likely to strongly affect oil prices. Looking forward over the next several years, we continue to see oil 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 will continue to support high oil prices. Reflecting this view, we recently raised our mid-cycle price assumption for West Texas Intermediate crude oil to $95 per barrel from $82/bbl.
In our view, the same supply constraints that support prices also support our thoughts on deepwater drilling. We continue to see deepwater as one of the most attractive plays on oil, as large public companies have a narrow set of exploration opportunities and deepwater is perhaps the most accessible. We think this plays to the strengths of drillers such as Transocean (RIG), which has the greatest exposure to deep- and ultra-deepwater drilling as measured by the number of rigs, and rig equipment providers such as National Oilwell Varco (NOV), which provide both equipment and services for a growing fleet of rigs.
Natural gas, at least in North America, suffers from the opposite problem. Thanks to held-by-production drilling, an influx of foreign capital in the form of drilling carries and joint ventures, and improved drilling and completion techniques, gas producers have created a glut of shale gas that has kept prices low. However, we are beginning to see evidence of our longstanding 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 one- to two-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. However, thanks to shale gas economics, we have moderated our view on gas prices, and lowered our mid-cycle price assumption for Henry Hub natural gas to $6.50 per thousand cubic feet from $8.00/mcf.
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 the shift in drilling from gas to liquids-rich resource plays have contributed to strong services demand from the U.S. E&Ps and put more power in the hands of services providers. Many E&Ps 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 appear to be slightly below our estimates of fair value, with the median price/fair value ratio for the sector at 0.96. The value in energy is currently in large-cap stocks, which boast a median price/fair value ratio of 0.89, while small-cap stocks are a little overvalued, at 1.09, and mid-cap stocks look fairly valued.
Looking to energy subsectors, we see the greatest opportunity currently in E&Ps and integrated names, courtesy of the recent selling pressure on oily stocks and our increased mid-cycle price for oil. E&Ps have a median price/fair value ratio of 0.79 and integrateds are at 0.80. We also think drillers, with a median price/fair value ratio of 0.85, and service companies, at 0.90, look attractive. Midstream stocks appear to be fully valued, at a price/fair value ratio of 1.03, and refiners continue to be overvalued at 1.23 times our fair value estimates.
Energy Stocks for Your Radar
Thanks in part to our updated oil and gas mid-cycle prices, we have several 4- and 5-star stocks to recommend this quarter. Several of the names have made this list in the past and are here again because we like their business models and their valuations. For the first time in recent memory we are not featuring a midstream stock, as we feel there are more compelling opportunities among E&Ps and service companies.
This quarter we are highlighting three E&Ps, all united by a common theme: natural gas exposure. We believe that high-quality gas-focused E&Ps currently offer greater upside potential than most oil-focused E&Ps. Range Resources (RRC) has a dominant position in the southwestern Pennsylvania Marcellus and is one of the lowest-cost producers of natural gas. Ultra Petroleum also has a significant Marcellus position and an unassailable gas asset in Wyoming along the Pinedale Anticline. Talisman , a Canadian E&P with an international portfolio, is in the midst of a strategic shift toward greater shale gas exposure and has built a strong acreage position in the Marcellus and in the Montney, a Canadian shale play.
We are also highlighting two service companies this quarter. We've consistently pounded the table for Transocean, which we believe is worth considerably more than its current stock price based on visible cash flows from existing drilling rigs and our expectation for continued strong interest in deepwater drilling. And this quarter we're adding Baker Hughes to our list, thanks to strong U.S. performance and rebounding international margins.
| Top Energy Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buy | |
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| Range Resources |  | $78.00 | Narrow | Medium | $54.60 |
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| Ultra Petroleum |  | $64.00 | Narrow | Medium | $44.80 |
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| Talisman Energy | | $34.00 | Narrow | Medium | $23.80 |
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| Transocean | | $100.00 | Narrow | Medium | $70.00 |
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| Baker Hughes | | $100.00 | None | Medium | $70.00 |
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| Data as of 06-22-11. |
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 2015, we project Range's Marcellus production will reach 1.6 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 completed 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 F&D costs and could provide upside to our current forecasts.
Ultra Petroleum
Ultra's Pinedale and Marcellus assets represent one of the best one-two punches in the North American E&P space. The firm's sizable inventory and industry-leading cost structure should support a decade or more of profitable, double-digit growth, even in the face of continued low gas prices. A takeout offer from one of the majors or a larger independent could also help fast-track value realization. As a company, Ultra is both scalable enough and "bite-size" enough to attract a wide range of potential suitors. If acquired, Ultra's takeout price could exceed our fair value estimate on a stand-alone basis.
Talisman Energy
We are impressed with how Talisman continues to creatively develop growth prospects. The firm's timely acquisition of BP Columbia will deliver 12-15 mboe/d this year--volumes excluded from the company's guidance of 5%-10% growth in 2011. The company's two Montney transactions with Sasol Ltd. (SSL) have funded the majority of its capital spending in the play for the next five years, and the potential for a gas-to-liquids facility not only includes the intriguing prospect of motor fuel production, but also diluent for the ever-growing list of new oil sands projects. Opportunities in Vietnam, Poland, and Iraq round out the list of current exploration efforts. As the firm continues to branch out with international exploration, funding and political risk remain concerns. Despite this, we think that shares are undervalued when considering the level of opportunity that the firm continues to develop.
Transocean (RIG)
We've sharply reduced our forecasted EBITDA and EPS forecasts for 2011 and 2012, but we're leaving our fair value estimate unchanged for several reasons. First, we believe the Gulf permitting delays are temporary, and 2011 results are not reflective of Transocean's long-term earnings power. Second, in our view, the Street is overly negative on the prospects for a Gulf recovery, and we expect EPS estimates to rise sharply as new permits are issued in the second half of 2011. Third, we believe Transocean's cash-generating power is unrivaled among its peers, and its willingness to sell old rigs gives it an opportunity to remake its old jackup fleet over time. We view the incremental upgrading opportunity and resulting increase in earnings power as underappreciated in an environment where the Street prefers high-spec drillers such as Rowan , which has one of the worst long-term track records of value creation.
Baker Hughes
We believe Baker Hughes represents a very attractive opportunity to benefit from secular trends in the oil services sector, a reboot in international growth starting in the second half of 2011, and ongoing improvements from its own internal reorganization. We expect Baker Hughes to benefit from the trends toward drilling more complex onshore and offshore wells as well as oil and gas companies seeking to boost reservoir recovery rates. The early fruits of Baker Hughes' efforts were seen in first-quarter results, as operating margins in Latin America, Europe, and the Middle East improved 440, 370, and 160 basis points quarter over quarter to 13.3%, 11.8%, and 12%, respectively. Baker Hughes' international profitability still remains well below peak levels, which is a gap that we think will close as the market tightens over the next few years.
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