Our Outlook for Energy Stocks
Macro concerns could pressure near-term outlooks--creating excellent buying opportunities for energy investors.
The unfortunate confluence of a U.S. supply boom, a European debt bust, and a Chinese reality check has helped knock back world oil prices by roughly 20%, and has served as an ungentle reminder that commodities are, in fact, volatile--as are energy stocks. However, in our view, these kinds of corrections frequently offer the best entry points for investors, so long as you understand the macro backdrop.
The U.S. supply boom is kicking into high gear, with production now more than 6 million barrels a day. We think there's room for tight oil production to add another 2 million barrels a day of incremental production through 2015, as drilling in the Eagle Ford, Bakken, and Permian continues, and new plays--the Mississippi Lime and Utica Shale, among others--are unlocked by the potent combination of horizontal drilling and hydraulic fracturing. These unconventional production gains offset depletion elsewhere and result in a stronger non-OPEC outlook than many forecasters had expected. Meanwhile, within OPEC, Libyan production has ramped back up, Iraqi production continues to build, and Saudi Arabia is producing more than 10 million barrels a day, more than offsetting flagging production in Iran. OPEC is currently producing 31.8 million barrels a day, above its 30 mb/d quota.
Against this backdrop of healthy supply, worries about the eurozone and China are weighing on markets. While Europe really does look like a mess, we think China's slowdown is the greater threat to oil prices. For more than a decade, China has been the marginal buyer of oil, and recent signs of a diminished appetite portend lower global demand growth overall, as no other emerging economy has the scale and demography to compensate. Moreover, as Europe weakens, its ability to import goods from China diminishes, further pressuring Chinese oil consumption. And with the U.S. steadily producing more oil, an increasing amount of crude is available on world markets. In the short run, we could be in for a period of lower prices, which could scuttle nascent oilfield development projects at the higher end of the cost curve.
But the depletion doesn't slow down, and it never rests. If industry takes its foot off the gas, any supply overhangs are likely to be short-lived. We figure the U.S. will have to increase oil-directed rig counts by approximately 20% to add another 1.5 mb/d of tight oil production, a potential boon for the hard-pressed North American services companies. But should oil prices weaken materially from current levels, it may be tough for E&Ps to justify the increased drilling budgets necessary to hit this level of tight oil production. If oil drops below $80, we expect to see some capital expenditure belt-tightening, particularly from smaller independents with less-than-pristine balance sheets.
We're also waiting for the knock-on effects of the shift to liquids drilling to catch up with E&Ps. A veritable glut of natural gas liquids, or NGLs, is building, and pricing is coming down hard--in recent months the price of ethane, the most plentiful natural gas liquid, has fallen from around $0.66 per gallon in January to near $0.30 per gallon today, and propane is down 40%, to $0.75 per gallon. The NGL price pullback hasn't quite made its way through the industry, but lower realized prices for NGLs will translate to reduced returns from "liquids rich" drilling, and likely pressure E&Ps that paid a premium to shift from gas to liquids drilling.
It may also help the economics of gas drilling if liquids drilling levels begin to slow. Wells rich in NGLs also produce quite a lot of gas, so any slowdown in drilling will also translate to less associated gas, alleviating one source of supply pressure. We've seen the first signs of natural gas production flattening out as companies slow or curtail dry gas drilling, and we continue to expect to see gas production roll over in the back half of 2012. Whether or not this will be enough to avoid overfull storage and shut-in production will depend quite a lot on the weather. Year to date, power generation has used 30% more gas than last year, thanks to low gas prices and the overhang of future environmental compliance. If this trend continues, particularly if this summer is another scorcher, the additional demand could be enough to absorb the current excess supply. That, in our view, would bode well for gas producers heading into 2013, when we expect production to trail demand and E&Ps to remain cautious on drilling dry gas, which should result in considerably firmer prices.
As a group, energy stocks have dipped further, with a median price/fair value ratio for the sector of 0.77. As has been the case for several quarters, the greatest pockets of value remain in E&Ps, trading at 0.65 of our fair value estimates, and oilfield services, at 0.75 of fair value. Integrated names are on sale compared with last quarter, having come down from 0.87 to 0.79 of fair value, thanks to lower commodity prices. Midstream and refiners have also sold off in recent months, but remain fairly close to fair value, with price/fair value ratios of 0.90 and 0.91, respectively.
Energy Stocks for Your Radar
We continue to 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 new this quarter, Apache (APA), a major oil player both domestically and abroad.
We continue to see great opportunity in Suncor Energy (SU), which boasts strong cash flow from oil sands and conventional projects. Also, we are adding an oil services name to the list, as we think that Halliburton (HAL) is very attractive at these levels, despite recently lowering our fair value estimate because of lower anticipated margins in North America and potential weakening of international prospects.
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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 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 standalone 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.
Apache Corporation (APA)
Apache is among the leading midmajors, with a balanced portfolio of onshore and offshore oil and gas properties throughout the world. The firm's approach includes exploitation of acquired assets--typically purchased from one of the larger integrated firms--as well as development of internally generated prospects. After a few years of relative inactivity on the acquisition front, Apache has gone on a shopping spree lately, with more than $18 billion in deals completed over the past several quarters. Combined, these deals should provide near-term exploitation opportunities as well as longer-term exploration potential and help the firm profitably increase production and reserves throughout our forecast period. While political risk related to the company's Egyptian operations will likely remain an overhang on the stock over the next few quarters, Apache appears cheap on an absolute basis and trades at one of the lowest forward multiples in our E&P coverage universe, suggesting the possibility for near-term price appreciation.
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 firm is set to deliver oil sands production-capacity growth of about 10% through 2020, which should result in firmwide 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.
The list of challenges Halliburton faces over the next few quarters and years is long, but the firm is best of breed in the key North American oil services market. Some challenges are temporary (guar costs and other supply-chain inefficiencies, pressure pumping oversupply, gas-to-oil rig switching), and some may retard Halliburton's prospects (slowing demand from Europe and China for oil, weaker prospects for further services intensity growth in North America) for a longer time frame. In the short run, we expect guar prices to collapse shortly, which should be a very positive event for the industry, but weak NGL pricing could continue to drive more gas-to-oil rig switching and pressure pumping oversupply. Slower demand for oil from Europe and China could also push down global oil prices, hurting demand and international margins for Halliburton over the next few years. However, Halliburton's industry leadership in North America through its integrated model provides it with a significant edge over peers. Furthermore, we believe investors are mostly focused on the short-term issues while ignoring some of the more attractive secular elements of Halliburton's story, such as the shift toward exploiting more services intensive offshore reservoirs and revitalizing old and mature fields.
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