Our Outlook for Energy Stocks
We're finally seeing some catalysts that could drive natural gas and associated firms much higher during the next 12 to 18 months.
Quarter-End Insights
- The European Central Bank appears to have damped investors' fears over a European collapse. Accordingly, oil prices jumped about 20% during the quarter as they responded to the reduced level of downside around the global GDP outlook for 2013, and a tighter oil supply/demand balance. Still, we don't think Mario Draghi's plan is enough and see downside for oil prices in the near term.
- Spot natural gas prices have spiked nearly 60% since mid-April as a heat wave in the United States has boosted gas demand by nearly 25% over 2011 levels. As a result, natural gas storage levels are returning to normalized levels, which is a remarkable turnaround given earlier fears that natural gas storage would top out, forcing producers to shut in wells.
- Low natural gas liquids prices are creating uncertainty around late 2012 and 2013 capital spending budgets, forcing drilling activity levels lower. However, we see this as part of a series of catalysts that holds great potential for natural gas and related companies during the next 12 to 18 months.
In our last quarterly outlook, we wrote that a U.S. oil supply boom, uncertainty over Europe, and slowing demand for oil from China caused world oil prices to drop 20%. In a perfect example of simply how volatile commodity prices can be, global oil prices bounced back 20% this quarter as investors' worst fears around Europe appear to have been allayed.
In Europe, Mario Draghi, head of the European Central Bank, or ECB, announced his latest plan to save the euro and various European economies. The ECB's plan is to make unlimited purchases of bonds that have been issued by struggling members of the euro, effectively lowering the borrowing costs for the euro's weakest members. The bank also won't claim senior creditor status, unlike what it did in Greece earlier this year, where it left private creditors to take write-downs while the ECB's paper was kept whole. Countries that would like to participate in the initiative would need to meet certain conditions, including economic reforms, which are intended to nudge the countries toward healthier economic actions. Whether the effort will be a success (it's the third major plan the ECB has introduced in recent years to resolve the European issues), depends on whether investors become comfortable with providing financing to governments in Spain and Italy.
In a nutshell, Draghi has managed to provide a backstop for investors worried about the euro falling apart, which would have likely led to sharp decline in GDP growth and oil demand. However, Draghi's initiative doesn't do much to boost growth prospects in the eurozone, meaning global GDP growth and oil demand growth will remain somewhat muted at around 2.7% in 2013 and 1% in 2013 per the IEA (note real GDP growth in the eurozone is expected to be a decline of 0.2%-0.6% in 2012, according to the ECB). China also remains an issue, and the IEA recently indicated that year-over-year oil demand growth in the country was approaching zero, and a continued weak Europe (which places further pressure on demand for Chinese imports) doesn't help matters. That said, oil production capacity remained tight, and recently OPEC's spare production capacity was at a four-year low at around 3.1 million barrels per day, due to lower output levels from Angola, Iran, and Libya. However, we're more concerned about the demand side of the equation rather than the supply of oil, particularly as lower-than-expected oil demand could rapidly build a large supply cushion. We think the continued use of tough austerity measures in Europe will choke off any recovery efforts and a return to a healthier level of oil demand. Notably, Draghi's latest plan indicated that all bond purchases would be "sterilized" by taking in an equivalent amount in deposits to avoid inflation. A nonsterilized bond purchasing policy would lower borrowing costs for the worst-off countries, expand the supply of the euro, and lower its exchange rate, increasing the competitiveness of the same countries. Overall, we consider investors' enthusiasm over Draghi's latest plan to be misplaced, and see fairly high potential for downside in oil prices over the near term.
On the natural gas side of things, the outlook certainly brightened while the U.S suffered through the worst drought to hit the nation in more than 50 years, thanks to warmer than average temperatures. Natural gas demand for power generation is up 24% year over year, and 17 of the 25 highest-demand days since 2005 occurred between June 28 and Aug. 9. It is no surprise that spot natural gas prices are on a tear so far this year, up roughly 60% since April to around $3 per mcf. Natural gas storage levels, which once peaked at 60% higher than the five-year average in late 2011 are currently only 11% higher than the average; we'd expect storage levels to return to normalized levels later this year. At the same time, U.S. natural gas production levels are stabilizing at around 72 bcf a day this year (which is still about 3 bcf a day higher than 2011 levels), which indicates that the 40%-plus decline in natural gas drilling activity levels this year (or about 350 rigs), among other actions by natural gas producers, is finally having an effect on the supply of U.S. natural gas.
There's more positive news to be had on the natural gas front, even though it comes with a short-term cost to producers and services firms. Natural gas liquids, or NGLs, pricing remains at fairly low levels, with recent ethane pricing at around $0.32 per gallon, down more than 50% from the $0.66 per gallon posted in January, and propane is at $0.94 a gallon, a 30%-plus drop over the same time frame. We only saw a very limited impact to oil and gas E&P's bottom lines in second quarter, as most of the declines in liquids prices took place in May, but third-quarter numbers should fully reflect the damage. The knock-on effect here for oil services firms has been a considerable amount of uncertainty around oilfield spending plans in the second half of 2012, and we're already seeing U.S. oil-directed drilling rig activity drop to 1,413 active rigs as of Sept. 14, from 1,427 in July, in addition to another nearly 75-rig drop in natural gas directed drilling activity to 448 active rigs over the same time frame. Going into the fourth quarter, where E&Ps traditionally share details around 2013 capital spending and production plans, we're primed for more negative news for producers and services firms in North America.
The flip side of all this short-term pain is much healthier natural gas prices further out, which benefit both producers and services firms. Given current trends, we're now positioned to see natural gas production roll over in the latter stages of 2012 and further cuts in oil-directed rig activity from E&Ps, which ensures that flat to declining natural gas production levels will be unable to meet continued high levels of power generation demand in 2013. Overall, we'd expect these trends to benefit natural-gas focused E&Ps as well as North American-focused oil services firms, leading to share price outperformance during the next 12-18 months.
Industry-Level Insights
As a group, energy stocks have rebounded this quarter with a median price/fair value ratio of 0.88 this quarter versus 0.77 last quarter. There's been no change to our long-standing conviction that E&Ps are among the cheapest stocks within our coverage, as they trade at 0.76 of our fair value estimates, compared with 0.65 last quarter. As a group, the rest of our coverage looks closer to fairly valued, with oil services moving to 0.91 of fair value from 0.75 of fair value, and integrated names now trading at 0.90 of fair value compared with 0.79 last quarter. Midstream and refiners continue to offer very limited opportunities, in our view, as the subsectors are trading at 0.94 and 1.11 price/fair value ratios, respectively.
Energy Stocks for Your Radar
Most of our favorite names are making a repeat appearance this quarter as some of the best opportunities within the energy sector. Ultra Petroleum , Devon (DVN), Suncor (SU), and Halliburton (HAL) continue to offer some of the best risk/reward prospects on our coverage list per our analysts' careful assessments. However, we're adding one new and very timely name this quarter-- Talisman Energy --in the wake of CNOOC's bid for fellow Canadian peer Nexen . In short, we think that Chinese interest in Canadian E&Ps is unlikely to diminish, and if the Nexen deal is approved by Canadian regulators, Talisman is highly likely to be next on the target list. Still, even without the potential of a lucrative Chinese acquisition offer, Talisman owns attractive acreage positions in the Marcellus, Eagle Ford, and southeast Asia; and has a new CEO who can potentially revitalize the firm's prospects.
| 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 |  | $47.00 | Narrow | High | $28.20 |
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| Devon Energy | | $110.00 | Narrow | High | $66.00 |
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| Talisman Energy |  | $17.00 | None | High | $10.20 |
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| Suncor Energy | | $52.00 | Narrow | Medium | $36.40 |
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| Halliburton |  | $50.00 | Narrow | Medium | $35.00 |
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| Data as of 09-18-12. |
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 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.
Talisman Energy
Talisman Energy has a large, internationally diversified portfolio that includes unconventional plays in the Marcellus and Eagle Ford, oil production in the North Sea, and a huge position in southeast Asia rivaled only by the super major integrated oil and gas firms. What's more, the company trades at a low multiple to forward earnings relative to comparable E&P firms, and just had a change in CEOs. If this sounds familiar, it's because fellow Canadian E&P Nexen was in nearly the same position shortly before CNOOC bid a whopping 61% premium for the firm this July. Should the Canadian and United States governments approve the Nexen transaction, we think there is a high likelihood that Talisman will receive a takeout bid from either PetroChina or Sinopec in response.
Suncor Energy (SU)
While Suncor is up approximately 20% since last quarter, we still think it remains attractive at these levels. The firm continues to deliver strong oil sands production results, with August numbers coming in at 373,000 barrels per day, 41,000 bpd higher than this time last year. Even though September volumes will come in lower as Suncor is undergoing some planned maintenance on the upgrader, refining crack spreads continue to benefit Suncor as they have remained strong throughout the third quarter.
The firm remains on track 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 mining projects if necessary (and transfer capital to in situ projects) to avoid higher costs, which may otherwise damage returns.
Halliburton (HAL)
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, the collapse of guar prices 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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