Energy: Coping With Lower Oil and Gas Prices

• The United States has rapidly become the critical source of incremental supply for global oil markets, and growth has come overwhelmingly from unconventionals. The large increases in U.S. output did not upset global supply/demand balances, largely because significant amounts of supply were disrupted by political/security issues (for example, Libya and Iran). But in 2014 the scales finally tipped: Combined with weakening demand and OPEC's decision not to reduce its own production, major supply imbalances resulted that, as of today, have yet to dissipate.
• In the current market environment of high costs/low oil prices, upstream firms face extremely challenged economics where new investment is not value-creative. Such conditions are not sustainable over the long term, however, and we expect the combination of rising oil prices and falling costs to provide significant relief in the coming years.
• Despite our belief that tight oil has considerable running room from here, it can't completely meet future global demand. The marginal barrel, therefore, will come from higher up the global cost curve. Our forecasts show higher-quality deep-water projects will be the highest-cost source of supply needed during the rest of the decade. As a result of this meaningful move down the cost curve, we are lowering our Brent midcycle oil price forecast to $75/bbl (WTI: $69/bbl).
• Although U.S. gas production is likely to slow in the near term as oil-directed drilling hits the brakes, the wealth of low-cost inventory in areas like the Marcellus points to continued growth through the end of this decade and beyond. Despite our expectation for continued growth in demand, there is more than enough low-cost supply to justify a reduction in our midcycle U.S. natural gas price estimate to $4/mcf from $5.40/mcf.

Higher-Cost Oil Sources Being Crowded Out and Domestic Gas Staying Lower for Longer Given both its remaining growth potential and ability to scale up and down activity quickly, tight oil has effectively made the United States the world's newest swing producer. Drastic spending cuts will lead to a meaningful decline in near-term production, but the strong economics of the major U.S. liquids plays mean production will again begin growing as soon as oil prices recover.

Based on our belief that U.S. unconventionals will continue to be able to meet 35%–40% of incremental new supply requirements in the coming years, we believe additional volumes from high-cost resources such as oil sands mining and marginal deep-water will not be needed for the foreseeable future. This disruptive force that already has upended global crude markets isn't going away anytime soon. U.S. shale once again is proving truly to be a game changer.

Meanwhile, demand tailwinds from exports and industrial consumption will help balance the domestic gas market, but ongoing cost pressures from efficiency gains and excess services capacity--as well as the crowding out of higher-cost production by world-class resources such as the Marcellus Shale and associated volumes from oil-rich areas such as the Eagle Ford and Permian--justify our revised outlook. Even under our lower price deck, however, undervalued, cost-advantaged investment opportunities remain.

Encana

ECA

Encana (fair value estimate: $18, 0.64 times) is our top pick within the U.S. oil-focused E&P group. The company's growth is underpinned by high-quality Permian and Eagle Ford acreage, and the firm also possesses a rock-solid balance sheet. The company has transformed dramatically in the past 12 months with two major acquisitions and a string of divestitures, and is emerging leaner and meaner. The company now has a footprint in several top-quality oil plays in the United States and Canada.

ExxonMobil

XOM

We view ExxonMobil (fair value estimate: $98, 0.86 times) as offering the best combination of value, quality, and defensiveness. Exxon will see its portfolio mix shift to liquids pricing as gas volumes decline and as new oil and LNG projects start production. The company historically set itself apart from the other majors as a superior capital allocator and operator, delivering higher returns on capital relative to peers as a result.

Cabot Oil & Gas

COG

On the gas side, Cabot Oil & Gas (fair value estimate: $43, 0.65 times) controls more than a decade of highly productive, low-cost drilling inventory targeting the dry gas Marcellus shale in Pennsylvania. Fully loaded cash break-even costs are less than $2.50 per mcf.

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