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Quarter-End Insights

Our Outlook for Energy Stocks

We've introduced a new marginal cost estimate for domestic natural gas.

  • There has been no real progress on the ongoing eurozone crisis. Oil and gas prices remained in a fairly tight band over the last quarter, while politicians in Europe generally didn't contribute anything substantial toward resolving the crisis. Economic data points out of the region tended to be poor, keeping the scenario of lower oil demand and weak oil prices on the table.
  • China, as typical, took center stage again this quarter. The Canadian government approved the $15.1 billion Nexen/CNOOC deal as well as the Petronas/Progress merger after its initial rejection of Petronas' deal to acquire Progress placed both deals in regulatory limbo. However, the government has indicated that future oil sands acquisitions will be subject to intense regulatory scrutiny. In addition, Chinese economic data points continued to indicate a slowdown is at hand, pointing to weaker demand for oil.
  • We've introduced a new marginal cost estimate for domestic natural gas of $5.40 per thousand cubic feet versus our prior projection of $6.50 per mcf. Despite the lower price forecast and the negative gas demand implications from the warm winter, we're seeing positive data points at the industry, state, and company levels that support a more bullish out-year take on natural gas prices.


Since our last quarterly outlook, there has been virtually no progress on resolving investors' concerns around the eurozone's struggles, and China has continued to make headlines for a variety of reasons. We've also introduced a new estimate for the marginal cost of domestic gas after updating our analytical approach. During this time frame, oil and gas have traded between $85 and $95 per barrel (West Texas Intermediate oil) and $2.80 and $4.00 per mcf.

In Europe, there has been very little progress on resolving the ongoing crisis. At best, the can has been kicked down the road yet again. We can't expect up-and-to-the-right progress here, and European Central Bank President Mario Draghi's plan last quarter to purchase unlimited amounts of bonds issued by struggling members of the euro was effectively a line in the sand by the ECB against the euro falling apart. This quarter, the news out of the European Union was generally poor. Per Eurostat, the eurozone is officially in a recession, as GDP fell 0.1% in the quarter following a 0.2% decline in the prior quarter. The weakness in the peripheral nations (Greece admitted its debt load will be around 190% of GDP in 2013, making a 2020 goal of reaching 120% of GDP unrealistic) is spreading to the core nations. For example, Germany's industrial production was down 1.8% for September, and the United Kingdom's outlook is weak enough that the credit agencies are considering rating downgrades. The ECB and Bundesbank have made substantial cuts in their growth forecasts for the EU as a whole (to negative 0.3% from positive 0.5%) and Germany (to 0.4% growth from 1.6% growth) in 2013.

Furthermore, Italian Prime Minister Mario Monti said he intended to resign following the loss of party support. Monti was asked to form a government last year following the resignation of former Prime Minister Silvio Berlusconi, and now as Berlusconi appears to be attempting to return as the leader of the country, more turmoil seems to be the only reasonable forecast. In the wake of the resignation, Italian borrowing costs widened, as the bond market worried about Italy's commitment to the reforms needed solve its crisis. Thanks to these concerns from Italy as well as the wider EU, the risks of slowing demand for oil from Europe and the subsequent negative impacts on oil prices still seem very much in play.

China also continued to be a source of headlines this quarter. The $15.1 billion acquisition of Nexen by the state-owned CNOOC and the Petronas/Progress merger were approved by Canadian regulators after their initial rejection of Petronas' takeover offer for Progress Energy placed both deals in regulatory limbo. However, Canadian Prime Minister Stephen Harper indicated that future investments by state-owned companies would only be approved under "exceptional circumstances" without detailing what those circumstances would be. The government has indicated that it no longer sees any net benefit to Canada from these types of deals. Harper is treading a very fine line between encouraging international investment and relations with China, which will be a key source of incremental demand for Canadian oil, and letting it get too much influence over a national asset. Minority stakes and joint ventures, particularly around gas assets, seem to be acceptable, but controlling stakes in oil assets will be receiving much tougher levels of scrutiny going forward. Of note is the fact that CNOOC has promised to provide the Canadian government with an annual compliance report that promises increased transparency while at the same time U.S. securities regulators are in a brutal stand-off with their Chinese counterparts over access to the auditors' files for the largest Chinese American depositary receipts.

Despite the excitement over Canadian oil this quarter, Chinese data points continue to indicate a slowdown in growth, with the latest numbers (export growth of 2.9% in November versus expectations of 9% and October growth of 11.6%) indicating that weaker, not stronger, demand for oil is likely to be a key energy theme. This situation presents a headache for OPEC, where social tensions are continuing to promote unrest, with conflicts in Syria, nuclear ambitions in Iran, and a fragile oil recovery in Iraq. Many OPEC members need oil prices in the range of $90-$120 per barrel in order to meet social commitments made to their citizens lest more governments topple.

Lower demand combined with a potentially higher oil supply cushion could equate to a nasty scenario for OPEC and oil prices. For example, the International Energy Agency indicates that global oil demand growth could average around 660,000 barrels per year to 2020 versus average annual demand growth of 1.3 million barrels per day over 2000-08. While that is a fairly low bar, there are still unresolved oil supply challenges for the industry that have largely remained in the background, given the focus on the oil demand side of the story. For example, some of the largest oil and gas companies ( ExxonMobil (XOM), Shell (RDS.A), BP (BP), Total (TOT), and Chevron (CVX)) plan to lay out a little more than $120 billion in capital spending as a group in 2012, which is roughly triple the amount they spent in 2001, yet production for the group remains well below 2001 levels.

We're more sanguine about our outlook for natural gas this quarter, thanks to our updated natural gas price deck and recent industry events. First, we've lowered our estimate of the marginal cost of domestic natural gas to $5.40 per thousand cubic feet from $6.50 per mcf, driven primarily by our updated analytical approach. We examined production, reserves, assets, capital spending, and operating results of the top 25 U.S. gas producers over the past 15 years and divided costs for each firm into three buckets: production, development, and capital charge. We then employed a statistical method, maximum likelihood estimate, to isolate costs associated with natural gas from costs associated with oil production. Our approach is distinct from that of most other research firms, which rarely go beyond estimating break-even levels for the major U.S. unconventional plays (and such analysis unfortunately ignores the majority of domestic production). Moreover, cost estimates (or estimated returns) tend to be presented on a blended oil-gas basis, which fails to isolate the "true" cost of natural gas production, and, in the case of returns, requires an additional assumption regarding oil or natural gas liquid prices. Over the long run, we believe our model is a more reasonable predictor of prices; accordingly, we think natural gas prices will move toward our $5.40 per mcf forecast over the next few years.

However, following one of the warmest summers in recent memory, we're setting up for an unusually warm winter as well, which could put a damper on the improving natural gas story. In fact, per the National Climatic Data Center, we are in line for the warmest winter in the United States on record (since 1895), which points to a weak outlook for natural gas demand. Despite this scenario, natural gas storage levels have continued to fall and are now only 5% above five-year averages versus an 11% difference last quarter. The Baker Hughes natural gas rig count has also continued its steady decline in the fourth quarter, with another 31 natural gas rigs being laid down as of Dec. 7, following a 75-rig decline in the third quarter. In fact, the natural gas rig count has been nearly cut in half since the start of the year, with almost 400 rigs being laid down. In our view, the natural gas rig count, while not a perfect indicator, is certainly a leading one with regards to U.S. natural gas production, which as of September 2012 is at 73 billion cubic feet per day, up 2.7 bcf since last September.

At a more granular level, we're already seeing production declines. For example, monthly gas production in Texas was down 15% year over year in August; in Louisiana, gas production was down 19% over the same time frame; and in Colorado, gas production was down 11% as of September. Combined, these states make up more than 40% of U.S. natural gas production. At a company level, we are also seeing positive data points for natural gas prices. In the third quarter, BP's U.S. gas production declined 15% year over year, Chevron saw a 6% decline, and ExxonMobil's production dropped 5%. We're seeing declines because the majors are seeing poor returns. For example, Shell indicated that it had earned $1.2 billion over the past 12 months from shale gas, whereas its capital employed is around $50 billion, indicating unacceptable levels of returns on capital. We don't think the majors are alone in their assessment of the returns available in today's natural gas price environment, so we expect natural gas prices to improve as companies continue to pursue rational economic outcomes, which include reallocating capital away from poor-performing gas plays and dropping rigs.

Given current trends, we reiterate our bullish take on natural gas prices. The industry, state, and company data points indicate we are getting closer to an inflection point around natural gas production; we expect natural gas volumes to eventually flatten and decline, leading to higher U.S. natural gas prices and increased levels of drilling activity as gas producers seek to produce more gas to meet stronger U.S. gas demand. Overall, we believe these trends will benefit natural-gas weighted exploration and production companies and North American-focused oil services firms the most, leading to share price outperformance over the next 12-18 months.

Industry-Level Insights
As a group, energy stocks have remained modestly undervalued this quarter with a median price/fair value of 0.86 compared with 0.88 last quarter. E&Ps remained among the cheapest subsectors with a median price/fair value of 0.78 compared with 0.76 last quarter. The biggest shifts on a quarterly basis came from the oil services and refining subsectors, where the price/fair value ratios moved to 0.83 from 0.91 and to 0.93 from 1.11. The integrated and midstream subsectors continue to offer limited opportunities to investors with price/fair value ratios of 0.88 and 0.91 versus 0.94 and 0.90 last quarter.

Energy Stocks for Your Radar
Most of our favorite names are making a repeat appearance this quarter as some of the best opportunities in the energy sector. Ultra Petroleum UPL, 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. We are adding Occidental Petroleum ((OXY)) to our favorites list this quarter. Oxy has stumbled recently on its plans to develop its attractive Californian and Permian acreage, but it is going all out to fix the issues. We think as Oxy executes on its returns improvement plan, which involves dropping rigs, cutting capital spending, and driving cost improvement, shareholders will eventually be rewarded.

Top Energy Sector Picks
Star Rating Fair Value
Fair Value
Ultra Petroleum $40.00 Narrow High $24.00
Devon Energy $99.00 Narrow High $59.40
Occidental Petroleum $107.00 Narrow Medium $74.90
Suncor $52.00 Narrow Medium $36.40
Halliburton $50.00 Narrow Medium $35.00
Data as of 12-13-12.

Ultra Petroleum
Ultra's Pinedale and Marcellus assets represent one of the best one-two punches in North American upstream. The company remains well positioned to take advantage of a secular recovery in natural gas prices, thanks to its low cost structure and long runway for growth. Ultra's balance sheet could experience further tightness over the next few quarters as hedges roll off, although under current strip prices the company should be fine from a covenant perspective. A takeout offer from one of the majors or a larger independent could 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 Ultra is acquired, its takeout price could exceed our fair value estimate on a stand-alone basis.

Devon Energy (DVN)
Unlike some of its competitors, 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, with the help of two recently closed joint ventures, should also provide enough dry powder to aggressively develop existing inventory and capture acreage in emerging plays. The firm's acreage includes sizable positions in the Permian, Barnett, Cana-Woodford, Granite Wash, Mississippian, and Utica 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 contribute to the firm's production and reserve growth in the years ahead.

Occidental Petroleum (OXY)
Occidental's plan to develop the promising unconventional discoveries on its existing California and Permian has been more difficult than originally anticipated. With returns suffering and the stock underperforming peers, Oxy is dropping rigs, cutting capital spending, and driving cost improvement. Additionally, management has signaled a willingness to increase returns of capital to shareholders to compensate for the lagging share price. The ongoing sell-off of Oxy's stock has pushed it into 5-star territory, making shares compelling, in our opinion. Ultimately, we think Oxy delivers reduction in capital and operating costs that lead to improved returns. As a result, we are also maintaining our positive moat trend as the resource potential in California still exists, which, combined with an improved cost structure, should allow Oxy to improve its competitive position relative to peers.

Suncor (SU)
While Suncor production growth to 2016 has been trimmed to reflect delays to the oil sands mining expansion plans, it remains on track to delivery robust growth in liquids production. Over the next five years (2012-16), in situ production is expected to see an 18% compound annual growth rate as expansions at Firebag come on line. Growth from its offshore assets is expected in 2014-15, contributing to an expected 5% production CAGR for the company, offsetting an expected negative 15% CAGR from natural gas. By 2016, we look for total production of 682,000 barrels per day.

Despite the growth potential, the market seems overly concerned about 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. Continued near-term strength is expected from its downstream operations, which are able to sell refined products at global prices, while securing a significant amount of feedstocks at depressed Mid-Continent prices.

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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