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Integrated Oils May Offer Safe Harbor

Large gas production and downstream operations will help mitigate the earnings impact of lower oil prices and should allow higher-quality firms to avoid dividend cuts, writes Morningstar’s Allen Good.

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Integrated oil stocks sold off in the aftermath of OPEC's Thanksgiving Day meeting. At the meeting, OPEC elected to maintain existing production quotas, dashing the market's hope that the cartel would step in and remove excess crude oil supply from the market. By our estimates, oil markets are oversupplied by roughly 1 million barrels a day, which may increase into early 2015 absent a production response. We think the market's reaction is overdone, particularly if you consider that 1 million-2 million barrels a day of excess supply is equivalent to 1.1%-2.2% of daily consumption, and depletion alone removes roughly 4% of total production each year. Moreover, the supply surge from U.S. shale oil has been well anticipated by the market, leaving us to wonder what has changed fundamentally in the market's awareness that has dropped the energy sector as a whole by 20% since Sept. 1. We suggest investors pay attention to oil demand, as any further weakness could spark another leg down in oil markets. That said, over the medium term we expect lower crude prices to stimulate demand, supporting our expectation of higher prices in the future.

While we plan to update our fair value estimates to reflect current crude oil strip prices, reductions should be modest for the oil majors. We think the market reaction among integrated firms has been overdone based on our long-term outlook. The integrated group is generally more insulated from oil price movements because of their large gas production and downstream operations, which can act as an earnings offset. Also, we do not think dividends from the higher-quality firms will come under threat thanks to relatively strong balance sheets and managements' aversion to cuts.

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Allen Good does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.