Energy: Coming Shale Growth a Major Threat to Oil Prices

• Short-term oil market fundamentals are the best in years, but underlying supply dynamics make plain that such conditions are unlikely to be sustainable. Rapid U.S. shale growth in the next six to nine months is now all but inevitable, which will meaningfully increase U.S. oil supply.
• It's very possible that OPEC will extend its production cuts to Dec. 31 at its May meeting, because although shale activity increases to date are enough to generate strong U.S. crude growth, this incremental supply will take time to flow through. Supply responses from rising (or falling) U.S. shale investment take about six months--the time it takes for the average well to begin production after it is drilled. We thus believe it's likely that onshore U.S. production won't begin meaningfully increasing until the second quarter, and it's possible that it could be summertime before it becomes apparent to all market participants that U.S. crude production is on a very dangerous trajectory.
• OPEC has said that production cuts are unlikely to extend past December. The exact timing is uncertain, but the math is clear: Full OPEC production and rapidly growing U.S. output are likely to outstrip near-term demand growth and could easily tip the industry back into oversupply in 2018.
• Energy sector valuations remain a bit frothy at current levels, with an average price/fair value estimate of 1.13.

OPEC's production cuts and strong demand growth have 2017 crude fundamentals in their best shape since oil prices crashed two years ago. The consensus is that market fundamentals are now strong enough to remain healthy even after OPEC returns to higher production.

This might have been possible a few months ago, but the odds of this scenario playing out have markedly worsened. Major increases in shale activity now have U.S. oil production on a path toward rapid growth, even if shale rig counts don't increase from current levels. This growth--plus the eventual production increases from OPEC--is probably enough to erase any market tightness and throw crude markets back into oversupply within the next 12-18 months.

Current oil prices provide economics that are very attractive to the major U.S. shale producers. This has created the conditions that will allow tight oil to grow rapidly and is a reality that even forthcoming cost inflation will not change. Unless shale producers become more disciplined or OPEC resigns itself to permanently ceding share to U.S. producers--neither of which is likely to occur--oil markets have major problems looming on the horizon.

Nevertheless, there remains a good chance that oil prices could rise further in the coming months if OPEC compliance remains high or production cuts are extended past June 30 (when cuts are scheduled to lapse). Because surging shale production won't move the supply needle until the second half of the year, OPEC discipline would allow for significant global inventory draws in the interim. This could bolster the perception that oil market fundamentals are continuing to improve.

However, oil prices above current levels at any point in the coming months would be pouring gasoline on the fire, since this would encourage even higher levels of U.S. shale investment and production. Nothing is ever certain in the world of oil, but a crude awakening for energy investors could be at hand.

Top Picks

HollyFrontier

HFC

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $44.00

Fair Value Uncertainty: High

5-Star Price: $26.40

HollyFrontier operates a high-quality set of refining assets located solely in the Midcontinent, Rockies, and Southwest regions. Currently, the company is suffering from weak product margins, narrow crude spreads, and high renewable fuel supply costs. While we do not expect these poor conditions to persist, the market appears to be discounting a continuation for several years. Furthermore, we think the market is not fully crediting Holly for 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. The current price/fair value estimate of 0.60 offers an attractive entry point for long-term investors.

Tesoro

TSO

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $124.00

Fair Value Uncertainty: High

5-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, strengthens its retail network, and adds additional midstream growth opportunities in the Permian Basin for a reasonable price.

RSP Permian

RSPP

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $56.00

Fair Value Uncertainty: High

5-Star Price: $33.60

RSP Permian is a very lean company that operates exclusively in the Permian Basin, which is widely considered to be the lowest-cost tight oil play in North America (or at least one of them).

Though the entire industry is focusing on cutting costs and enhancing efficiency, RSP is well ahead of the curve. Operating expenses, including exploration and general and administrative, add up to less than $12 per barrel of oil equivalent, and the per-barrel cost of finding and development is around $20. That translates to a West Texas Intermediate break-even of just under $40 a barrel, well below our midcycle forecast.

These competitive economics look sustainable. The firm recently doubled its Permian footprint with the acquisition of Silver Hill Energy Partners, gaining entry to the Delaware side of the basin, which is at least as profitable as the Midland, where RSP’s core acreage is. As a result, the firm has several decades of cost-advantaged runway. We forecast a 50% compound annual growth rate for production through 2020. RSP is trading at a price/fair value estimate of 0.72.

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