Our Outlook for Energy Stocks

• Oil prices have remained in a tight range over the past few months, despite a surging oil supply picture in North America, which has been offset by supply cuts by Saudi Arabia and the negative impacts of tough sanctions on Iran. In addition, new data points from China and Europe suggest that we're simply circling in a holding pattern regarding oil supply and demand, keeping Brent prices in a tight range over the past few months.  
• Chavez's death creates uncertainty around Venezuelan oil policies. While we think Chavez's hand-picked successor, Nicolas Maduro, will succeed him, little else is clear. There's a potential fat-tail opportunity for ExxonMobil and ConocoPhillips to perhaps regain access to some lucrative assets that were nationalized in 2007 in exchange for much-needed capital. It remains to be seen if Venezuela is willing to accept the likely tough terms offered by the majors.  
• The domestic natural gas picture is improving. Natural gas production growth has begun to flatten, with declines likely in the next few quarters, thanks to a dry gas rig count that remains at its lowest level since the late 1990s.

 

Oil prices have remained in a tight range over the past few months, despite a surging oil supply picture in North America, which has been offset by supply cuts by Saudi Arabia and the negative impacts of tough sanctions on Iran.

In 2012, U.S. oil supply increased nearly 1 million barrels per day over 2011 levels to 6.71 million barrels per day per the IEA, and the agency estimates that U.S. oil production can reach 7.33 million barrels per day in 2013. In the face of this significant supply shift, even the mighty Saudi Arabia has recognized the change in global oil dynamics, and cut its own production levels 500,000 barrels per day to 8.9 million barrels per day in December 2012. Iran has also lost nearly a million barrels per day of production since 2011, thanks to stiff international sanctions. Without the production cut by Saudi Arabia and the Iranian production losses, we think the world oil market could be dangerously oversupplied, which is still a scenario on the table as U.S. production continues to surge.

On the demand side of the equation, new economic data points since our last quarterly outlook don't offer a significant amount of clarity regarding the economic outlooks in Europe and China, in our view. The recent Italian election failed to produce a clear winner, and it called into question the willingness of the country to support any austerity reforms required by regulators.

In addition, Moody's downgraded the United Kingdom's credit rating to Aa1 from Aaa, which could potentially indicate that the firm plans to downgrade other weak European countries such as Spain and Italy. A wave of rating downgrades by Moody's and the other major credit agencies would merely add to the negative drumbeat and potential for lower oil demand from Europe.

In China, the incoming president, Xi Jinping, has suggested the potential for significant reforms around China's usage of clean energy, which is a potential negative for oil demand. For example, Beijing is offering free license plate registrations for electric vehicles. Furthermore, the government is calling for the installation of 21 gigawatts of hydro power (a 10% increase over 2012 levels), 3.2 gigawatts of nuclear, 10 gigawatts of solar, and 18 gigawatts of wind (a 17% increase from 2012) this year. Yet, China has also set its 2013 GDP growth target at 7.5%, which is the same as 2012's target (actual 2012 growth was 7.8%), but down from recent targets of 8% annual growth. As China continues to try and rebalance its economy, and deals with a still-considerable debt load, we think the risks of a slowdown in growth and therefore oil demand remain very real. As a result, we still consider the respective oil demand outlooks in Europe and China challenging.

However, perhaps the most pivotal story this quarter within the energy sector was the death of Venezuelan president Hugo Chavez, and its potential impact on the Venezuelan oil industry. We do not see any issues with Chavez's handpicked successor, Nicolas Maduro, being elected. Beyond this fairly straightforward call, uncertainties abound within the country with the world's second-largest oil reserves.

Maduro is generally regarded by Venezuelan analysts to lack Chavez's natural charisma, which means it is an open question whether he can maintain the tight control over the oil industry that Chavez enjoyed. There's no doubt that the Venezuelan oil and gas industry is challenged, as Chavez reallocated earnings from the industry toward social initiatives over time, starving the industry of needed capital to maintain and replenish oil production. For example, electricity has to be rationed, the country is importing gasoline from the United States because its refineries are in such poor shape, and oil production stands at around 2.5 million barrels per day versus 3 million barrels per day in 1998, when production could easily be 6 million-9 million barrels per day with the appropriate investments per industry analysts. PDVSA, which was once one of the world's most innovative oil and gas companies, is a shadow of its former shelf, with thousands of experienced oil hands having been purged over the past decade and replaced by political appointees. There's little positive to say about the Venezuelan oil and gas industry today.

Although we fear little will change, we note there is a potentially sizable opportunity for selected oil and gas firms to re-establish relationships with the new Venezuelan government. The key players here are China (as expected), and  ExxonMobil (XOM),  Chevron (CVX), and  ConocoPhillips (COP). Over the past decade, as PDVSA has struggled, China has become an increasingly important partner. Given Chavez's absence, we see a potentially increased role for China in the country, which could result in more of Venezuela's oil being shipped to China. Over the past few years, China has lent $36 billion to PDVSA to be repaid with oil shipments. More recently, Venezuela and China have been in the midst of working out terms for another $4 billion cash-for-oil loan. At the same time, Venezuela devalued its currency by a third in early February, the fifth time it has taken this step over the past decade, in order to ease the pressure on the country's finances. Obtaining capital is becoming particularly critical for Venezuela's oil industry, as debt issuance for PDVSA dropped off to just $3 billion in 2012 from $17.5 billion in 2011.

Fortunately, capital is something that oil majors ExxonMobil, Chevron, and ConocoPhillips can supply. Venezuela was actually in discussions with Chevron for a $2 billion loan recently that seems to have stalled because Chevron has demanded more punitive loan terms. There's some healthy incentive on ExxonMobil's and ConocoPhillips' parts to take another look at the country, if they can potentially regain access to the assets that were nationalized in 2007. However, we note that the recent split of ConocoPhillips may have cooled the firm's ardor for heading back into Venezuela. ExxonMobil was awarded in January 2013 just $908 million by an arbitration panel for assets that the company deemed worth $12 billion. ConocoPhillips lost assets that at the time were worth around $4.5 billion in book value, but it valued the assets as worth more than $20 billion. These numbers are likely inflated, given the size of the valuation gap, but if Venezuela is desperate enough for capital, we think these two firms could realize substantial gains.  

More than just social spending needs, there are projects in the Orinoco fields that need ExxonMobil's and ConocoPhillips' capital. Over Chavez's 21-month battle with cancer, the government struggled to move infrastructure-related funds through the system. One casualty of this distraction was the Orinoco fields where PDVSA originally expected production to reach 195,000 barrels per day at the end of 2012, but instead it was just 6,000 barrels per day. Three fields (Junin 2, Junin 6, and Carabobo 1) are stymied by the lack of pipelines, which is forcing the companies to truck crude to distant refineries and export terminals. Other fields (Junin 4, Junin 5, and Carabobo 3) simply remain inactive. Chevron (the potential PDVSA lender) owns a stake in the currently inactive Carabobo 3 field. PDVSA plans to make the needed investments in pipelines and refineries over the next few years, but given the new political leadership and PDVSA's need for capital, there could very well be a small, yet compelling window for the majors to extract value from their previously painful ventures into the country.

Skipping across the ocean to North America, we're once again seeing more positive data points for natural gas. December 2012 dry gas natural gas production was about 66 billion cubic feet per day, which is a 1% increase over 2011 levels. In fact, dry gas natural gas production growth rates have slowed down sharply over the past year, as February 2012 production levels increased 13% from 2011. At 2,083 billion cubic feet (as of March 1) natural gas storage levels are down nearly 15% from year-ago levels, but still about 15% above the five-year average. However, as dry gas drilling activity has completely collapsed to just 407 active rigs (as of March 8) from over 800 active rigs at the start of 2012, we think a turning point is nearing for natural gas production, and therefore prices. In short, as natural gas production growth rates turn negative, storage levels will decline, pushing the natural gas market into an under-supplied situation, resulting in sharply higher natural gas prices. We're expecting meaningful movements upward in natural gas prices over the next 18 months assuming current conditions hold, and the share prices of natural gas producers should follow.   

Industry-Level Insights
As a group, energy stocks have remained modestly undervalued this quarter with a median price/fair value of 0.90 compared with 0.86 last quarter. E&Ps remained among the cheapest subsectors with a median price/fair value of 0.82 compared with 0.78 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 0.92 from 0.83 and to 1.12 from 0.93. The integrated and midstream subsectors continue to offer limited opportunities to investors with price/fair value ratios of 0.90 and 0.98 versus 0.88 and 0.91 last quarter.

Energy Stocks for Your Radar
Once again, we've shaken up our recommendations as our analysts constantly look for some of the best risk/reward plays in the oilfield. Companies that are returning as old favorites include  Ultra Petroleum ,  Occidental Petroleum (OXY), and  Suncor (SU). New additions this quarter include  National Oilwell Varco (NOV) and  Apache (APA). We think a somewhat pedestrian outlook for 2013 has dinged National Oilwell Varco rather unfairly, and political unrest has punished Apache's stock as investors have decided to exit stage left rather than dig a bit deeper into the name.

Top Energy Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Ultra Petroleum		$40.00	Narrow	High	$24.00
Occidental Petroleum		$107.00	Narrow	Medium	$74.90
Suncor		$52.00	Narrow	Medium	$36.40
Apache		$110.00	Narrow	Medium	$77.00
National Oilwell Varco		$98.00	Wide	Medium	$68.60
Data as of 3-18-13.

 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.

 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. Recent weakness has pushed Oxy's stock close to 5-star territory again, making shares compelling, in our opinion. Ultimately, we think Oxy delivers the 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 Energy (SU)
While Suncor production growth to 2017 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 (2013-17), in situ production is expected to see a 10% 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 4% production CAGR for the company, offsetting an expected negative 15% CAGR from natural gas. By 2017, we look for total production of 689,000 barrels per day.

Despite the growth potential, the market seems overly concerned about cost inflation, in our opinion, and the recent impairment of the Voyageur Upgrader. 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.

 Apache (APA)
Apache is one of the largest independent E&Ps, and also one of the most unloved. Apache's shares are down 30% over the last year, badly trailing its peer group, thanks to concern over two issues: 1) whether the company's cash flow machine in Egypt will be negatively affected by ongoing political unrest, and 2) whether management's growth target of 6%-9% per year can be achieved without acquisitions. Based on our work, which includes a deep dive on the macro situation in Egypt and the company's portfolio in the U.S., we think concerns over these issues are overblown, and that the risk/reward ratio for Apache is as favorable now as it's been in recent memory. Moreover, we think there exists a handful of catalysts that could drive the stock north of $100 by the end of next year.

 National Oilwell Varco (NOV)
For a company with a wide moat and stellar capital allocation that is also run by Morningstar's reigning CEO of the Year, Pete Miller, it is puzzling that the market has dinged the firm following fourth-quarter earnings for its currently margin-dilutive investments and mix shift. Ultimately, today's margin-dilutive investments around international rig markets and floating production, storage, and offloading, or FPSO, units should support National Oilwell Varco's wide moat and open up new markets for it to dominate. Even if 2013 performance from its rig technology segment might be a bit weaker than what the Street initially expected, the Petroleum Services and Supply segment's outlook appears more in line with the Street's and our expectations. However, the Street may still be missing the company's aftermarket opportunity in 2013 and onward, given the return of the initial 2004-07 rig orders for aftermarket work at higher-than-average margins (we estimate 30%-35%).

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