Energy: No Rapid Rebound for Oil Prices

• The United States has rapidly become the critical source of incremental supply for global oil markets, and growth has come overwhelmingly from unconventional drilling. The large increases in U.S. output did not upset global supply/demand balances over the past few years, largely because significant amounts of supply were disrupted by political/security issues (Libya and Iran, for example). 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 and 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 that 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, our midcycle oil price forecast for Brent is $75 per barrel (WTI: $69/bbl), meaningfully below 2014 highs.
• 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. Abundant supply is holding current prices low, but in the long run we anticipate relief from incremental demand from LNG exports as well as industry. Our midcycle U.S. natural gas price estimate is $4/mcf.

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 means production will begin growing again 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 that 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 eventually, 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--are weighing on near-term prices. Even under these circumstances, however, undervalued, cost-advantaged investment opportunities remain.

Encana

ECA

Encana is our top pick within the U.S. oil-focused exploration and production group. The company's growth is underpinned by high-quality Permian and Eagle Ford acreage. 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 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 liquefied natural gas 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 than its peers as a result.

Cabot Oil & Gas

COG

On the gas side, Cabot 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.

More Quarter-End Insights

• Stock Market Outlook: Pick Your Spots Carefully
• Economic Outlook: Stuck in Neutral as We Cling to Cash
• Credit Markets: Investment Grade Struggles, While High Yield Outperforms
• Basic Materials: China Slowdown Weighs on Commodities (With One Exception)
• Consumer Cyclical: Assessing Disruptions in Restaurant, Retail, and Travel
• Consumer Defensive: Top-Shelf Picks for a Cautious Spending Environment
• Financial Services: A Favorable Outlook for Insurance
• Health Care: A Few Stocks Still Offer Upside
• Industrials: Stronger U.S. Dollar, Weaker Energy Activity Weigh
• Real Estate: Rising Interest Rates Wreak Havoc on REITs
• Tech & Telecom: M&A Heats Up, and the Cloud Changes the Landscape
• Utilities: Starting to Look Attractive After a Woeful 2015 Start