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Quarter-End Insights

Energy: Oil Price Collapse Takes Center Stage

The rapid decline in oil prices has created significant investment opportunities, but downside risk remains in the short term.

Jason Stevens
  • Oil's dramatic collapse--down 45% from June--has had a tremendous impact on energy stock valuations, driving the whole sector lower. While this has created significant investment opportunities, downside risk remains in the short term.
  • The central cause of the price collapse is a supply and demand imbalance. While short-term excess supply weighs on prices, over the longer term we continue to expect $90-$100 oil prices to balance supply and demand.
  • What to watch for: capex budgets. As upstream firms release 2015 capital spending plans we'll get a better idea of whether current low prices will result in a meaningful near-term supply response. Even if it does, it will be months before evidence will be seen in the numbers.
  • There's been no safe haven in natural gas. A warm winter has pressured gas-weighted stocks, leaving few alternatives for energy investors.

 

Price Collapse Causes and Outlook
What a difference six months makes. The collapse of oil prices has been one of the more dramatic turns of events in the energy industry in recent years, rivaling the 2008-09 collapse. While the surge of crude oil production from U.S. shale was well anticipated by markets, the return of 500,000 barrels a day of OPEC crude to export markets in August, coupled with signs of weakening demand, prompted a wholesale sell-off in crude oil. OPEC's decision over Thanksgiving to maintain existing production quotas removed the last real hope for a quick recovery, and sent prices tumbling. 

By our estimates, the crude oil market is oversupplied by about 1 million barrels a day (mmb/d), against a total demand of around 93 mmb/d. While demand next year looks likely to increase by roughly 1 mmb/d, supply is likely to increase as well, unless the price drops enough to prevent it. But most supply additions stem from projects with long lead times, and much of next year's growth is baked in. That leaves U.S. shale, where companies can more easily drop a rig and dial back production growth. Thus we've seen prices decline below the average industry breakeven price of around $70/bbl. Companies are beginning to respond, announcing cuts in 2015 capital spending. 

In theory, reduced capex should drive lower production growth. In practice it takes time for capex reductions to flow through to drilling activity, and even then producers tend to focus their budgets on their most productive acreage, and drive hard bargains for oilfield services, the largest component of capital spending for upstream producers. This in turn results in lower well costs, allowing producers to develop economic wells under lower prices and maintain production growth. There's a lower limit to this, and to be sure 2015 production growth will be lower than it would have been at $100 oil, but U.S. production is still likely to increase in 2015.

2016 and beyond is a larger question. In the best of conditions it's difficult for the oil industry to increase global production materially, and lower crude oil prices provide little incentive for investment in currently uneconomic projects that will be required to meet demand in 2016, 2017, and beyond. 

Top Energy Sector Picks

Star Rating Fair Value
Estimate 		Economic
Moat 		Fair Value
Uncertainty 		Consider
Buying
Whiting Petroleum $84.00 Narrow High $50.40
BP $54.00 Narrow Medium $37.80
Santos Ltd $18.00 Narrow High $10.80
Data as of 12-15-2014

 Whiting Petroleum
Whiting has a 10-year drilling inventory in the Bakken with an emerging position in oil-rich Colorado and a breakeven around $60/bbl, and it trades at one of the cheapest 2016 forward multiples in the E&P space thanks to meaningful production growth. With the Kodiak acquisition now complete, leverage is a bit higher than historically, but should be fine even under a low oil price scenario, and production growth will rapidly deleverage the firm.

 BP (BP)
BP's decision to fortify its balance sheet post-Macondo is looking increasingly smart: The firm today is in a position where it can absorb $80-$90 oil pricing for multiple years while continuing to fund its dividend, investment plans, and legal liabilities. Underscoring its financial strength, the company announced alongside third-quarter results that it is raising its dividend by a further 1.5%. BP continues to have one of the most promising free cash flow outlooks of the oil majors, and remains our top pick of the group. 

 Santos Ltd (STO) (Australia)
Production at narrow-moat rated Santos should near double during the next two years and earnings rise threefold as new liquefied natural gas, or LNG, plants at Port Moresby in Papua New Guinea and Gladstone in Eastern Australia commission. Santos also faces the enjoyable prospect of higher domestic gas prices on its existing domestic infrastructure, a powerful valuation enhancer given limited additional capital spend required. Rising earnings and dividends, reduced capital-spend, and higher free cash flow should drive convergence toward our fair value estimate, underpinned by higher LNG volumes and higher domestic gas prices.

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