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Quarter-End Insights

Where to Shop in the Energy Sector

U.S. tight oil production continues to set the pace for the industry, but the companies most levered to it are either fully valued or overvalued.

Jason Stevens
  • We continue to see stocks most levered to U.S. tight oil as fully valued or overvalued, but find pockets of value in gas plays and companies still transitioning to liquids.
  • Capital-spending discipline has come home to roost for the Majors, all of which see to boost returns through lower spending.
  • The cold winter was good for U.S. gas prices, but uncertainty on near-term demand and still-growing production from the Marcellus are likely to keep a lid on prices.

 

We see three key themes playing out in the energy sector this quarter. First, tight oil production growth in the U.S. continues to shake supply/demand balances. Most waterborne light crude imports from the Gulf Coast having been backed out, now a glut of crude is developing that will have pricing ramifications for domestic producers.

Second, uncertainty is high, with Crimea in the headlines and continuing unrest shutting in production in Libya, Nigeria, and Sudan and contributing to sustained high oil prices.

And third, the evolution of U.S. and global gas markets continues. Near term, gas markets remain regional, and local effects will dominate economics. However, over the longer term liquefied natural gas has the potential to integrate markets, creating new opportunities.

U.S. crude oil production reached 30-year highs in 2013, with production of 7.5 million barrels a day. The big three tight oil plays--the Bakken, the Eagle Ford, and the Permian--accounted for 35% of total production, a share we expect to increase as conventional oil declines and industry spending remains focused on the superior economics afforded unconventional oil. However, we find that the companies most leveraged to the core liquids plays are fully valued or overvalued at this point, and encourage energy investors to shop among gas-weighted E&Ps or those that are still transitioning to liquids and have the potential to unlock value in existing but underdeveloped onshore assets--firms like Apache (APA) and Devon Energy (DVN) come to mind.

Oil-weighted stocks aren't the only victims of success. The production gains in the U.S. are shaking global crude oil markets. Tight oil has backed out light crude imports along the Gulf Coast, freeing these barrels for other waterborne markets (essentially counting as new supply on the global market). However, U.S. export restrictions prohibit crude oil exports in any significant volume, resulting in a building glut along the Gulf, which we believe is likely to result in another WTI/Brent basis blowout. If this develops as we anticipate, refiners with exposure to discounted crude along the Gulf should stand to gain.

Outside the U.S., geopolitical risk again outweighs fundamentals, for the time being. The IEA raised global demand expectations this year to 92.7 million barrels a day, but robust supply growth and prospects for greater OPEC production this year should result in well-supplied markets. On balance this would pressure oil prices, underscoring the role of geopolitical risk in oil prices. Should Crimean tensions blow off, and impaired barrels in Libya, Nigeria, and elsewhere again flow to market, we expect pressure on oil. Again this quarter, we see greater upside to gas.

One factor that will support U.S. gas prices over the near term is the aftereffects of the cold winter. Gas storage is running 46% below the five-year average, implying the need for an incremental 2.5 billion cubic feet per day of gas injections to storage over the summer to regain historic winter storage levels. This will act as additional "demand" for gas, and should we experience a hot summer (thereby prompting high gas consumption for power generation), prices could stay well above $4/mcf.

Industry-Level Insights
On a price/fair value basis energy again appears to be one of the most attractive sectors at 0.97, or an aggregate 3% discount to fair value. This is up from 0.92 times in December. Within energy, we see the greatest value among E&Ps, equipment and services firms, and in midstream, which are trading at 6%-7% discounts to fair value. Integrateds and refiners appear fully valued currently, and we think oil and gas drillers are modestly overvalued. We're including solar firms in the energy sector this quarter, which we believe to be massively overvalued at 2.1 times our fair value estimate. As always, there is substantial variation among firms, and we encourage investors to seek stock-specific opportunities rather than making purely macro calls.

Energy Stocks for Your Radar
We continue to see upside to Ultra Petroleum and Devon Energy. Ultra is the most leveraged company in our coverage to a rebound in natural gas prices, and Devon is amid a production mix shift toward greater liquids production, which should drive production growth.

Among oil names we're highlighting Denbury Resources , an expert at tertiary oil recovery that aims to deliver steady production growth without chasing the next shale play. Among midstream firms we like Energy Transfer Partners in terms of both valuation and growth potential. Energy Transfer has resumed distribution growth after a series of acquisitions and is developing an LNG export facility that will shore up longer-term growth prospects. Finally, we highlight a refiner, Tesoro . While it's not as leveraged to the Gulf Coast as others, we believe that the market isn't recognizing Tesoro's longer-term potential.

Top Energy Sector Picks
Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
Ultra Petroleum $40.00 Narrow High $24.00
Devon Energy $92.00 Narrow High $55.20
Denbury Resources $23.00 Narrow High $13.80
Energy Transfer Partners $70.00 Narrow Medium $49.00
Tesoro Corporation $70.00 Narrow Very High $35.00
Data as of 03-18-14.

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 tighten further over the next few quarters as hedges roll off, but under current strip prices the company should be fine from a covenant perspective.

Devon Energy (DVN)
Devon has been one of the weakest-performing stocks in the U.S. upstream space over the last several quarters, thanks to a gas- and NGL-heavy production profile, underwhelming near-term growth prospects as a result of a slowdown in gas-directed drilling, and a handful of disappointments in oil-rich exploration plays that were supposed to drive the next leg of growth for the company. We think Devon's stock will continue to come under pressure as long as investors remain skeptical about the firm's ability to deliver oil and liquids growth and until additional steps are taken to highlight the underlying value of the company's assets. While we don't necessarily expect meaningful appreciation in Devon's stock price over the next few quarters, we think a plausible case can be made for the stock to be trading north of $85 by year-end 2015, implying close to 50% upside from today's price. Moreover, at about $60 per share, the risk/reward ratio for Devon remains favorable, with approximately $15 of downside and $30 of potential upside in the name.

Denbury Resources
Denbury has a simple strategy: Acquire extremely mature oil fields on the cheap, inject carbon dioxide into the reservoir (commonly referred to as tertiary recovery), and expand production from nearly nothing to several thousand barrels per day. This is easier said than done, as the process is fraught with logistical challenges and technical barriers. Generally, tertiary recovery projects contain marginal economics, but we think Denbury's strategy of staged projects will provide multiyear production growth at favorable economics.

Energy Transfer Partners
After a series of acquisitions, Energy Transfer Partners is now solidly on a growth trajectory, as evidenced by resumed distribution growth this quarter. Acquired businesses now make up about 40% of cash flows and account for the lion's share of growth. Savvy financial engineering with parent company Energy Transfer Equity reduced units outstanding, supporting faster distribution growth in coming quarters. And the announcement of an LNG export development plan that will require no capital or credit commitments from the partnership supports Energy Transfer's long-term growth prospects.

Tesoro
Over the long term Tesoro will benefit the most from the increased flow of inland domestic and Canadian heavy crude to the West Coast. The firm is already transporting Bakken crude to its Anacortes, Wash., refinery, realizing a feedstock cost advantage relative to ANS as well as $4-$5/bbl in yield improvement. Eventually, Tesoro can replicate this success to a large degree throughout its California system, including its recently acquired Carson refinery. We do not think the market is properly crediting Tesoro for this potential uplift in earnings, cash flow, and returns that is likely to occur over the next few years.

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