This Stock's Strategy Is Riskier Than the Market Thinks

With almost 60% of oil production now U.S.-based (up from 26% in 2010) and almost all near-term growth coming from the Bakken,  Hess (HES) has become increasingly leveraged to the U.S. crude market. With West Texas Intermediate and Louisiana Light Sweet both trading above $100/barrel and at narrow differentials to Brent, some might conclude that this exposure isn't a concern. We disagree. The potential for oversupply of light crude oil in the Gulf Coast could materially weaken all U.S. light crude oil prices relative to Brent. With pricing risks clearly skewed to the downside and with no hedges in place for its U.S. oil production, we believe Hess is more likely than not to disappoint the market's expectations for 2014-15.

U.S. Oil Pricing Dynamics and Hess' Position in the Bakken: A Brief Overview
To summarize U.S. crude oil supply/demand dynamics during the past 12 months, rapidly growing U.S. light oil production from shale plays such as the Bakken led to light crude supply exceeding demand in the Mid-Continent, depressing the price of WTI oil relative to both global (Brent) and U.S. Gulf Coast benchmarks (LLS). WTI pricing is set in Oklahoma, and that's a lot closer to demand centers than the Bakken (North Dakota) is. Consequently, Bakken pricing has been even more depressed than WTI, since it is the most geographically disadvantaged light crude in the lower 48 (at least with respect to major oilfields). During 2013 and thus far this year, Bakken light oil was discounted by more than $20/barrel versus Brent for much of the year.

For Hess, Bakken oil price dynamics matter, given that its 600,000 net acres in the play is easily its most valuable asset, the largest use of capital expenditures (40% of 2014 total), and an ever larger percentage of total production. By 2018, the Bakken will make up 43% of Hess' total production compared with 24% in 2013. The company also has hedged none of its U.S. oil production. Finally, the company has no plan B for increasing production during the coming years: All other options are too long-dated (the Valhall field redevelopment in Norway or Hess' Ghana oil discoveries, for example) or are too small (Utica). In other words, Hess is all in on the Bakken for driving its 2014-15 performance.

Periods of strength or weakness in both Bakken and related U.S. oil price benchmarks (WTI and LLS) thus have a material impact on Hess' near-term cash flows, and the importance of this will only increase as Hess furthers its Bakken output in the coming years. For 2014, each $5 per barrel change to the company's average Bakken realizations equates to roughly $125 million in operating cash flow (assuming Hess' Bakken oil production averages 70 mb/d).

Until now, Hess has been able to weather weak Bakken oil prices as well as could be expected, largely because the company made the wise decision to construct a 54 mb/d crude rail loading terminal (Tioga Rail) in the heart of its Bakken acreage. This has allowed the company to ship its North Dakota crude by rail to higher-priced markets. This has been predominantly the Gulf Coast, where Bakken crude can fetch pricing tied to LLS, which for the most part has been at parity with Brent in recent years, in stark contrast to WTI and Bakken. The average pricing uplift (after subtracting incremental rail costs) has been volatile, but for the most part has fetched materially higher prices than crude shipped by pipeline (as we'll show later, the pricing uplift from rail is likely to be substantial going forward).

Why Hess' Bakken Pricing Is Likely to Weaken From Here
Unfortunately for Hess, weak oil price realizations is a problem that's not going away for the Bakken; indeed, it appears to us likely to become even more challenged in the near term (something we don't believe many Hess investors fully appreciate). There are two issues in particular that could worsen Hess' Bakken realizations in 2014-15:

1) Pipeline shipments priced off Bakken oil indexes are increasing now that Tioga Rail is fully utilized. Last year, Hess shipped almost all of its production via its Tioga Rail terminal. But Tioga is now fully utilized, and management confirmed in late January that oil production above 54 mb/d (Tioga Rail's capacity) will be shipped via pipeline (Hess has contracted 70 mb/d of pipeline capacity from Tesoro and Enbridge). This means that going forward an increasing portion of Hess' output will be priced off the Bakken crude benchmark, in contrast to its rail volumes fetching LLS pricing (or Brent for the small quantity of rail volumes Hess has thus far sent to the East Coast). We currently forecast that Bakken shipped via pipeline will price $7-$15 less than rail shipments during 2014-15.

Because transportation costs for the Bakken are higher than almost all other oilfields (North Dakota is the farthest from major U.S. crude markets), Bakken pricing is always discounted relative to both LLS and WTI. Should LLS prices weaken relative to Brent (discussed below), this will put pressure on all other light crude benchmarks in the central U.S. and further weaken WTI and by extension Bakken pricing compared with global benchmarks.

2) LLS is likely to experience periods of widening discounts to Brent. As discussed above, Hess has benefited from shipping Bakken crude via rail to the Gulf Coast, where it fetches prices based off of the higher-priced LLS benchmark.

In summary, light crude supply to the Gulf Coast is expected to grow by more than 1 mmb/d in 2014 as a result of new pipeline additions being brought on line (these pipelines of course are underpinned by growing oil production in shale plays). With Gulf Coast demand for light crude more or less fixed at 5 mmb/d, it's increasingly likely that supply will outstrip Gulf Coast demand at points in 2014-15. While rail is likely to remain the best way to fetch the highest prices for Bakken crude, prices tied to LLS--including railed Bakken volumes--face meaningful downside risk in the coming quarters.

East and West Coast Rail Demand Unlikely to Arrive in Time
One issue worth addressing is the feasibility of Bakken producers shipping increasing amounts of crude by rail to the East Coast, West Coast, or both. These regions both remain more firmly tied to global light oil prices (i.e., Brent), and at least in the short term will not be affected by LLS pricing weaknesses. By our estimates, Bakken crude railed to the East or West Coast will fetch $5-$7 per barrel more than the Gulf Coast in 2015. Hess has stated that rail volumes heading to the East and West Coasts increased toward the end of 2013 and now make up a third of its crude-by-rail volumes; is it reasonable to assume it can increase this proportion if the Gulf Coast becomes oversupplied?

Unfortunately, there are a few reasons these markets won't be able to provide an immediate solution to this issue. To begin with, East Coast rail offloading capacity is reported to be more than 700 mb/d today, equal to about 70% of the region's demand for light crude oil. But this capacity remains far from fully utilized, likely because of the region's refineries today having less receiving ability than this headline figure. Also, a small portion of this rail capacity is likely to be used to ship Canadian heavy oil, not U.S. light crude.

As far as the outlook for shipping crude by rail to the West Coast, more than 700 mb/d of incremental rail offloading capacity could be operational by 2016. Investors should remember three things, however. First, almost all of this capacity is due to arrive in 2015 or later, so its ability to offset Gulf Coast weakness this year is nil. Second, West Coast refiners are likely to be just as interested in sourcing Canadian heavy oil via rail as light oil from the Bakken; the capacity on the West Coast is certainly not being constructed solely with North Dakota in mind. Finally, environmental studies are delaying some rail projects ( Valero's (VLO) Benicia offloading development, for example), which is not particularly surprising given the political leanings of California. This is increasing the uncertainty as to both the timing and volumes that will be shipped west in the coming years.

Make no mistake: We fully expect increasing volumes of Bakken crude to make their way to the East and West Coasts in the coming years and that more extreme pricing scenarios would probably last only for a short time (our Brent-LLS differential assumption beyond 2015 remains $2-$6). But as of today, there's a good chance that we will see demand for railed crude shipments materially increase after the Gulf Coast tips into oversupply, not before.

Gulf of Mexico/Permian Assets Layer on Further Exposure to the Gulf Coast
Beyond its Bakken acreage, Hess has additional U.S. oil production, namely, 55 mb/d in the Gulf of Mexico and 9 mb/d from its mature Permian (Texas) properties. This represents 26% of the company's total 2014 oil production; combined with the Bakken, the U.S. currently makes up about 60% of Hess' oil output and a similar amount of the company's operating cash flow.

Hess' Gulf of Mexico pricing on average was 4% below LLS in both 2012 and 2013 owing to some of its crude production being medium as opposed to light (all else being equal, these fetch lower prices). We assume a 4% differential to LLS in 2014-15.

The good news is that Hess' Gulf of Mexico and Texas light oil commands much higher realizations than Bakken ($10-$15 per barrel in most recent quarters). But both are tied to the Gulf Coast, and hence will also see realizations weaken in step with LLS if the region tips into oversupply. This represents an additional exposure to U.S. oil prices, which has the potential to reduce the company's near-term operating cash flow.

Risks Outweigh the Rewards at Present, but a Buying Opportunity Could Soon Emerge
We recently lowered our Hess fair value estimate to $80 from $90, largely because of lower U.S. oil price realizations reducing our near-term cash flow projections. Given the oil price risks Hess faces from its U.S. production, we think downside risks are likely to overwhelm the potential near-term positives of the Hess story (turning its midstream assets into master limited partnerships or spinning off its retail stations, for example). We recommend staying on the sidelines for now, but our long-term differentials assumption for Brent-LLS remains $4 at the midpoint; thus, if Hess does sell off on falling LLS and Bakken pricing, an attractive entry point could very well present itself.