Our Outlook for Energy Stocks
Short-term volatility has clouded the market's view of longer-term fundamentals in energy.
Quarter-End Insights
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- Recession fears this summer shaved more than $20 per barrel off of oil prices and led to similar percentage declines in many energy stocks, leaving the sector as a whole attractively priced.
- Despite economic noise from Euroland and the U.S., our focus is on China, and specifically whether it can successfully navigate a shift from an investment-driven to a consumption-driven economy, and the implications for oil demand.
Troubles in Euroland and renewed recession fears in the U.S. led to a sharp sell-off of stocks and commodities, hitting the oil patch particularly hard. However, we think short-term volatility has clouded the market's view of the longer-term fundamentals that we believe will continue to be the underlying drivers in the energy sector. In our view, a double-dip recession here and in Europe certainly would reduce developed-market demand for oil, in a reprise of 2008-2009. This would help a market that has been under-supplied since the middle of 2010 come back into balance, suggesting that we could settle into a new, lower equilibrium for oil prices.
Four factors keep us from moderating our view that higher oil prices are likely over the medium term. First, global crude oil supplies have been struggling throughout 2011. While OPEC production is now back to pre-Libya levels, thanks largely to efforts by Saudi Arabia, it is unclear whether this incremental production represents a short-term surge or something more sustainable. Meanwhile non-OPEC production is falling, despite accelerating production offshore Brazil and the resurgence of U.S. production, thanks to shale oil.
Second, we estimate that major OPEC producers and Russia require oil prices around $90-95 per barrel to balance national budgets, suggesting that exporters will again make efforts to defend oil prices in the face of a sustained downturn.
Third, emerging-markets demand growth continues to consume greater than 100% of incremental supply growth. In other words, China and other emerging countries are using every bit of the world's new oil production while requiring developed countries to make due with less.
Fourth, while a "hard landing" in China would be enough to tank oil prices in the short run, it would also result in prices low enough to discourage investment in new production. This would lead to higher oil prices as natural production declines tighten supply in the absence of new investment.
Gas-focused E&Ps, and increasingly, "oil" majors, continue to see low selling prices and little reduction thus far in gas production. For the near term, gas supply and demand fundamentals continue to weigh on prices, but we expect tighter environmental regulations for coal-fired generation to provide a needed catalyst for increased gas demand, suggesting improving fundamentals beyond 2011. On the supply side, gas-directed rig counts have fallen roughly 10% year over year, less than we had hoped to see by this time. Instead of a full gas drilling pullback, we've seen E&Ps shifting rigs from noncore dry gas acreage toward liquids-rich gas plays, where the associated natural gas liquids stream can materially boost netbacks.
We continue to see cash flow strength from integrateds, midstream firms, and services companies. Integrated oil and gas producers with significant international production continue to enjoy higher selling prices thanks to the significant Brent/WTI pricing differentials. Midstream firms, particularly MLPs, benefit from largely fee-based cash flow structures and new projects coming online to support shale development in the U.S. Services firms continue to enjoy significant pricing power in the U.S. and Canada, though a material slowdown in the oil patch would likely pressure currently attractive margins.
Industry-Level Insights
We see the current market as an opportunity for investors who look beyond next quarter's results. As a group, energy stocks are trading considerably below our estimates of fair value, with the median price/fair value ratio for the sector at 0.73, a level we haven't seen since mid-2009. The value in energy is currently in large-cap stocks, which boast a median price/fair value ratio of 0.72, while mid-cap stocks are trading at a price/fair value ratio of 0.82, and small-cap stocks look fairly valued.
Looking to energy subsectors, we see the greatest opportunity currently in E&Ps and integrateds, stocks that tend to be more responsive to commodity price changes. E&Ps have a median price/fair value ratio of 0.67 and integrateds are at 0.73. We also think drillers, with a median price/fair value ratio of 0.74, and service companies, at 0.72, are very attractive. Midstream stocks are closest to fully valued, at a price/fair value ratio of 0.94, and refiners have come down hard since last quarter and now trade at 0.83 times our fair value estimates.
Energy Stocks for Your Radar
At present we have more than 20 5-star stocks to recommend, spanning most energy subsectors. The deepest values can be found among our U.S. E&Ps, where several of our favorite companies are trading around 50% of intrinsic value. This quarter we're highlighting two such companies: Ultra Petroleum and Whiting Petroleum . Both companies are low-cost leaders, and both have large drilling inventories that will support years of drill-bit growth. Ultra is a producer of natural gas, with an unassailable gas asset in Wyoming's Pinedale anticline and a significant position in the Marcellus shale. Whiting, in contrast, is an oil-heavy name primarily focused on developing its massive Bakken shale acreage position.
We are also continuing to highlight two service companies this quarter. We've consistently pounded the table for Transocean (RIG), 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. We also think Baker Hughes is worth much more than its current stock price, thanks to strong U.S. performance and rebounding international margins.
We're adding BG Group to our list this quarter, as we think this stock frequently gets overlooked by U.S. investors. BG's integrated gas model is poised for growth from the global LNG trade, and BG's position in offshore Brazil will transform the company into a major oil producer.
| Top Energy Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buy | |
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| Ultra Petroleum |  | $64.00 | Narrow | Medium | $44.80 |
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| Whiting Petroleum | | $85.00 | Narrow | High | $51.00 |
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| Transocean | | $85.00 | Narrow | Medium | $59.50 |
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| Baker Hughes | | $100.00 | None | Medium | $70.00 |
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| BG Group | | $156.00 | Narrow | Medium | $109.20 |
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| Data as of 09-23-11. |
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.
Whiting Petroleum
With its Sanish Field acreage probably out of runway by 2014, we're glad to see Whiting fast-track its North Ward Estes program and aggressively go after other Bakken/Three Forks prospects. In the Williston Basin, especially, Whiting should be able to take advantage of its geoscientific familiarity, network of land brokers and title attorneys, contracted rigs and frac crews, and existing infrastructure to help drive efficiencies as it moves forward with exploration and development of new fields. Intermittent periods of midstream tightness remain possible in this region in the short term, although longer term we expect this to become less of an issue. As the company proves out acreage and the industry releases additional data points on emerging plays like the Wolfcamp, Bone Springs, and Niobrara, we expect to gain more insight into their longer-term potential.
Transocean (RIG)
For all of its deep-water expertise, Transocean has struggled recently with higher levels of unplanned downtime for its rigs. Revenue efficiency (actual revenue divided by the highest amount of revenue that could have been earned during the quarter) has been below historical levels in the wake of Macondo because of higher levels of unanticipated downtime, due mostly to rig and equipment maintenance issues. The trend has contributed to sharply higher operating expenses and revenue losses. Operators are demanding that any blowout preventer issues be addressed immediately rather than letting the driller rely on the multiple redundancies built into the equipment. Yet, these short-term issues do not change the fact that Transocean is the world's largest and most experienced deepwater driller and is well positioned to benefit from the secular trend toward more offshore and deepwater drilling.
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. Baker Hughes should 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. In addition, we think Baker Hughes will show significantly better results in the second half of 2011 as Canada recovers from a severe seasonal breakup, which hurt Baker Hughes' North American results more than its peers because it is the largest services company in the country. Finally, Baker Hughes' international profitability still remains well below peak levels, which is a gap that we think will close as the market tightens during the next few years.
BG Group
Despite the recent sell-off in the shares, our opinion of BG Group is unchanged, and we see the current price weakness as a buying opportunity. We have always viewed BG favorably because of its unique business model and growth potential, and recent events have only bolstered our confidence in the firm's future. Most notably, BG doubled its estimated recoverable resources in Brazil to 6 billion barrels of oil equivalent. The company thinks it can recover these additional barrels without any material additions to capital, which implies a much greater value for its Brazilian assets than previously thought. It should also be able to achieve plateau production levels earlier than previously anticipated. Combining this with projects in Australia and the U.S., BG offers unparalleled growth for a firm its size.
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