Our Outlook for Energy Stocks
Headlines focus on oil, geopolitics, and $4-per-gallon gasoline. We're more focused on natural gas below $4 per mcf.
Quarter-End Insights
- Geopolitics dominate oil markets, masking an underlying supply tightness and supporting high prices.
- U.S. natural gas prices collapsed further this quarter, a sign in our eyes that E&Ps have finally capitulated. Now all that's left is the pain, as the industry works its way through the supply glut.
- Producers might not be quick to switch back to gas drilling, given the economics in liquids plays. This might support higher gas prices during the next several years, as we think producers will require strong pricing signals before once again ramping up gas production.
West Texas Intermediate oil prices have remained above $100 a barrel here in the United States, but Brent, a better index for world pricing, has held around $125 this quarter, pressuring gasoline prices, which are now flirting with $4 on average. Although there's certainly some degree of fear premium baked into prices because of Iran and the possibility of a closure of the Straits of Hormuz in the event of a war, our read is that supply is only just covering demand, and spare capacity is getting tight.
On the supply side, unconventional oil production is helping the U.S. deliver material production gains and help reduce imports to levels not seen in a decade. December oil production is at 5.9 million barrels a day, levels not seen since 2002, reigniting talk of energy independence. We think that's a stretch, but it's certainly boom times in the oil patch, as Bakken and Eagle Ford Shale production is joined by a renaissance in Permian Basin activity and as producers begin targeting the Utica Shale in Ohio and the Mississippian Lime in Oklahoma and Kansas. Globally, production reached all-time highs in December, despite production losses in Libya, Sudan, and Yemen.
Demand, though, has demonstrated just as much strength despite structural weakness in Europe and a slowdown in China. The market continues to absorb every bit of new production, and Saudi Arabia, which appears to be running flat out at just more than 10 million barrels a day, now has roughly the same spare capacity as it did back in 2008, the last time demand outpaced supply. With only 2 million barrels a day of effective excess capacity, versus global oil demand of 75 million barrels a day, it's no surprise to us that prices would remain elevated, particularly so long as acute concerns over Iran persist. Any escalation there that threatens the availability of Middle East oil will likely lead to dramatic oil price spikes. On the flip side, if the Iran situation cools off, we see some room for oil prices to contract, particularly if investors turn their attention back to Europe and China. So once again, we see oil prices carefully balanced between fears of a supply shock, on the one hand, and implications of slowing growth, on the other.
In contrast to oil, which has been remarkably stable despite the underlying supply/demand tug-of-war, the U.S. gas market has been anything but. This quarter has witnessed gas prices falling to 10-year lows as a result of a glut of gas and exceptionally warm winter weather. By our estimates, spot gas prices around $2.30 per thousand cubic feet are now well below full-cycle production costs for every exploration and production firm we cover. Although some producers continue to benefit from hedges and from high liquids content, which increases the selling price of the gas stream, most gas-weighted E&Ps have responded to the current oversupply by sharply cutting back on drilling. In our view, we're finally at capitulation.
It certainly took long enough; we've been arguing for some time that sub-$4 gas is largely uneconomical, but hedges, drilling carries, liquids netbacks, and drilling-to-hold acreage had buoyed activity for the last few years. Now, with storage levels 50% higher than average for this time of year and production still near record levels, the odds that some gas production will be shut-in this fall are high, and we might see some interesting price dynamics in the spot market come October as producers attempt to find a buyer for gas as pipelines and storage will likely be full. We think we'll see enough of a slowdown in gas drilling activity this year for production to roll over in the back half, but likely not enough to avoid some shut-in production.
The real question is what happens next year. As lower production begins to bring supply back in balance with demand, prices will rise. But will E&Ps respond to gas-price increases by bringing on more production? The fear is that the industry would add enough new production if prices got back to $4 per mcf to swamp prices again, effectively capping gas prices for years. We don't think this is an immediate concern, for a couple reasons. First, at $4 most dry gas remains uneconomical to produce. Second, producers targeting oil and rich gas are drilling wells that generate 60%-plus returns. We don't see the industry turning away from that to drill dry gas, where the returns in the best sweet spots are closer to 20% at $4 gas. We think E&Ps will have to see materially higher prices before they'll commit the capital to really ramp up gas production again.
Industry-Level Insights
As a group, energy stocks continue to trade below our fair value estimates, though the median price/fair value ratio for the sector of 0.84 has increased a bit from the fourth quarter. We see the greatest value in E&Ps and in oil services, where our median price/fair value ratios are 0.78 and 0.76. There's also still value in our integrated oils coverage, which is trading at a price/fair value ratio of 0.87, and in drillers, coming in at 0.88. Midstream looks fairly valued, at 1.02, while refiners are just a hair overvalued, with a price/fair value ratio of 1.06.
Energy Stocks for Your Radar
Again this quarter, we find the greatest opportunities in our E&P coverage. This quarter we're highlighting three quality E&Ps: Ultra Petroleum , which we continue to believe offers the best risk/reward prospects among gas-weighted E&Ps; Devon Energy (DVN), a large E&P turning sharply toward greater liquids production; and Peyto Exploration & Development (PEY), the lowest-cost producer in Canada and one that is tightly focused on shareholder returns. We're also profiling Suncor Energy (SU), another name from north of the border, which boasts strong cash flow from oil sands and conventional projects. Lastly we think investors looking for income and growth should consider Energy Transfer Equity (ETE), a midstream master limited partnership that will benefit from recent deals and new investments.
| Top Energy Sector Picks | |||||
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| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
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| Ultra Petroleum |  | $50.00 | Narrow | High | $30.00 |
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| Devon Energy |  | $105.00 | Narrow | High | $63.00 |
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| Peyto Exploration & Development | | CAD 30.00 | Narrow | High | CAD 18.00 |
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| Suncor Energy | | $49.00 | Narrow | Medium | $34.30 |
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| Energy Transfer Equity | | $54.00 | Narrow | Medium | $37.80 |
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| Data as of 03-21-12. |
Ultra Petroleum
Ultra's Pinedale and Marcellus assets represent one of the best one-two punches in the North American E&P market. 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.
Devon Energy (DVN)(
)Unlike some other E&P firms, Devon isn't new to the oil- and liquids-rich game, having had a fairly balanced production mix throughout its history. We expect a similar mix going forward, given the firm's sizable liquids opportunity set. Devon's superior financial footing should help the firm weather the current low-gas-price environment and provide flexibility to both aggressively develop existing inventory and capture acreage in emerging plays. The firm's acreage includes sizable positions in the Permian Basin, the Barnett, Cana-Woodford, Granite Wash, and Utica shale plays, as well as a handful of Canadian oil sands projects. Despite a number of Devon's oil and liquids-rich plays being in the early innings, we're bullish on their ability to meaningfully contribute to the firm's production and reserve growth in the years ahead.
Peyto Exploration & Development (PEY) (
)Our favorite pure-play natural gas producer in the Canadian energy sector, the firm adheres to a contrarian business strategy and exhibits extremely solid fundamentals. The firm is the low-cost producer in North America, has ample opportunity for production growth, and has a management team focused on investor returns. Peyto operates exclusively in the Deep Basin region of Alberta, where its extensive knowledge of the area's geology has allowed the company to cherry-pick its acreage positions that will yield the best wells. The high heat content in Peyto's produced gas allows the firm to collect premium pricing of about 20% over AECO gas, and continue drilling even at current natural gas prices (or lower). With low natural gas prices forcing competitors to drill oil wells, the cost for Peyto to drill natural gas wells is continuing to recede, allowing the firm to build production capacity at a historically low cost of upfront investment. We expect Peyto to take advantage of this and increase production by 32% in 2012 and 36% in 2013.
Suncor Energy (SU) (
)We think Suncor looks attractive at these levels as the market does not appear to be properly crediting the company for its growth prospects. The company is set to deliver oil sands production-capacity growth of about 10% through 2020 which should result in firm wide production growth of 8% per year, well above that of other integrated firms. Despite the growth potential, the market seems overly concerned with cost inflation in our opinion. Although we expect cost inflation to return to the region with the acceleration of development, most of the oil sands players appear ready to avoid the rampant rise in costs that accompanied the last investment cycle. For its part, Suncor has expressed willingness to delay projects if necessary to avoid higher costs which may otherwise damage returns. Also, its recent partnership with Total (TOT) to develop oil sands properties and construct an upgrader reduces risk and capital investment. Meanwhile, the deal demonstrates the consolidation that has occurred in the region, leaving fewer companies in control of more projects, which should also help alleviate cost pressures. Conversely, if oil prices fall and development slows, Suncor should be able to continue construction unlike during the last downturn as a result of the acquisition of conventional assets which should continue to provide cash flow. Finally, Suncor's integration strategy is proving beneficial in the current environment. Its advantageously located refining capacity allows Suncor to capture the currently wide discounts on Canadian heavy and light sweet crudes that might otherwise be lost as a pure oil producer. Although Suncor has had its share of negative headlines lately because of operational issues with its upgrader, we think these are largely short-term in nature and do not affect the company's long-term outlook.
Energy Transfer Equity (ETE) (
)Energy Transfer Equity went through a pivotal year in 2011, with the entry into natural gas liquids transportation and fractionation through the purchase of Louis Dreyfus' Texas NGL business, the acquisition of Southern Union--which we expect to close by the end of March--and the sale of its retail propane operations. These transactions will shift Energy Transfer's contract mix more strongly toward fee-based cash flows, provide access to new markets, particularly Florida, and allow the partnership to compete across the midstream value chain. Energy Transfer Equity will also realize outsized benefits from pursuing a drop-down strategy, selling
Southern Union's acquired assets to Energy Transfer Partners , which is ETE's controlled MLP subsidiary.
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