Energy: OPEC Adds a Plot Twist, but Ending Is Unchanged

• U.S. production growth will lag any increase in rig activity by six to nine months, which is why we’re now more bullish on 2017 oil prices. But once it gets rolling, shale production should start to grow briskly, which means that much softer industry fundamentals are likely to return once OPEC unwinds its production cuts.
• Based on current 2017 supply/demand fundamentals, our new base case for the United States is a 500-rig scenario, in which the horizontal tight oil rig count increases 30% from today's 380 over the next six months. Our forecasts demonstrate that U.S. shale growth can be substantial at activity levels that remain well below predownturn levels.
• The short-term nature of OPEC's cuts and the long-term problem for oil prices that is U.S. shale mean our bearish $55/bbl WTI long-term price outlook is unchanged.
• Energy sector valuations remain a bit frothy at current levels with an average price/fair value estimate of 1.14.

OPEC's recently announced production cuts represent a positive near-term development for world oil markets, removing more than 1 million barrels per day from an oversupplied system. Even after factoring in the inevitable U.S. shale response to higher crude prices, OPEC's cuts point to a meaningful supply deficit next year. Consequently, we are raising our 2017 West Texas Intermediate price to $60 per barrel from $50.

Improved near-term fundamentals come at a cost, however. Even a modest recovery in oil prices will encourage U.S. shale producers to further ramp activity so that they eventually replace almost all "removed" OPEC barrels with their own. Increased near-term shale activity means that oil prices are unlikely to remain elevated for long. The industry is awash in low-cost oil, and temporary OPEC cuts cannot alter this reality. Our long-term oil price assumption of $55/bbl WTI is unchanged.

Sharp curtailments in oil-directed drilling activity could reduce U.S. natural gas production growth in the near term, but the wealth of low-cost inventory in areas like the Marcellus and Utica ultimately points to continued growth through the end of this decade and beyond.

Based on a more optimistic outlook for low-cost production--primarily as a result of slowing declines in associated gas volumes, as well as improved productivity and resource potential from the Marcellus and Utica--we are reiterating our long-term marginal cost for U.S. natural gas of $3 per thousand cubic feet. We see more and more evidence that U.S. shale producers can survive (and in a few cases thrive) at much lower prices than we previously assumed.

We view energy sector valuations as frothy at current levels, but we do think the names below are worth further investigation from investors.

Tesoro

TSO

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $124

Fair Value Uncertainty: High

Five-Star Price: $74.40

We see Tesoro's competitive position improving over the next several years as the firm gains greater access to cost-advantaged crude. Given this, combined with operational improvements including increasing distillate yields, integrating the acquired Carson refinery, and leveraging its marketing and retail operations, Tesoro should become one of the better-positioned refiners in the challenging California market. Meanwhile, the acquisition of Western Refining diversifies its refining asset base, further strengthens its retail network and adds additional midstream growth opportunities in the Permian Basin for a reasonable price.

HollyFrontier

HFC

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $44.00

Fair Value Uncertainty: High

Five-Star Price: $26.40

HollyFrontier operates a high-quality set of refining assets located solely in the Midcontinent, Rockies, and Southwest regions. Currently, it's suffering from weak product margins, narrow crude spreads, and high renewable fuel supply costs. Although we do not expect these poor conditions to persist, the market appears to be discounting a continuation for several years. Furthermore, we think it is not fully crediting Holly with its self-improvement initiatives. As a result, we think the shares are significantly undervalued. We expect product margins to improve with continued strong demand and a rebalancing of inventories. Meanwhile, crude spreads should widen with future U.S. production growth. Renewable fuel supply costs are likely to persist into 2017, but a new administration increases the probability of reform that ultimately reduces compliance costs. At a price/fair value estimate of 0.70, the current stock price offers an attractive entry point for long-term investors.

Antero Resources

AR

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $32

Fair Value Uncertainty: Medium

Five-Star Price: $22.40

Antero Resources is the most active driller in the Appalachia region (Marcellus and Utica plays). We believe it is also one of the most attractively priced. The stock currently trades at a 25% discount to our fair value estimate. Although natural gas still constitutes around 75% of the firm's production, a substantial portion of its acreage is situated in areas with a fairly high liquids content, differentiating the company from its peers that are predominantly targeting dry gas.

The profitability of Antero's inventory continues to trend higher. Drilling and completion costs have declined steadily over the past two years in the Marcellus and Utica plays, and there is scope for further efficiency gains that could lower costs further. Meanwhile, the productivity of Antero's wells is likely to increase across the portfolio, due to the widespread adoption of high-intensity completions (using at least 1,300 pounds per foot of proppant). Finally, despite perennially weak natural gas prices in the Appalachia region, Antero's extensive firm transport and sales portfolio is enabling it to sell the majority of its production at premium, out-of-basin prices (the firm's realized third-quarter natural gas price was $0.05 above Henry Hub).

More Quarter-End Insights

Market Outlook: New Expectations Set the Tone for 2017

Economic Outlook: More of the Same Anemic Growth

Credit Insights: Global Rates on the Rise

Basic Materials: China-Led Rally of 2016 Rests on a Shaky Foundation

Consumer Cyclical: Poised (and Priced) for a Strong 2017

Consumer Defensive: Cooking Up a Bit More Value

Financials: What Will Really Drive Interest Rates?

Healthcare: What Does a Trump Administration Mean for Healthcare Stocks?

Industrials: Baking In Too Much Optimism

Real Estate: Through the Noise, Opportunities Exist

Technology: This Firm Is the Newest Software Empire

Utilities: Still High Even After Bonds’ Withdrawal