Energy: Despite OPEC Cuts, a Crude Awakening Is Near at Hand

• OPEC and certain other countries agreed to extend their production cuts, originally set to expire at the end of June, by nine months (ending March 2018). There was no change to the magnitude of the production cuts of 1.8 million barrels per day, including 0.6 mmb/d from non-OPEC nations such as Russia, Mexico, and Kazakhstan.
• The cartel might pay a steep price for any near-term benefit. We believe it is underestimating the ability of shale producers in the United States to rapidly increase volumes in a $50-$55/barrel environment (West Texas Intermediate). After several upward revisions, the International Energy Agency currently expects U.S. crude production to end the year 0.8 mmb/d higher than year-end 2016; that looks conservative to us, as we forecast 1 mmb/d. As such, the rapid U.S. shale growth in the back half of the year will meaningfully increase U.S. oil supply.
• Once the OPEC cuts are lifted, full OPEC production coupled with rapidly growing U.S. output is likely to outstrip near-term demand growth and could easily tip the industry back into oversupply in 2018. Therefore, we are not changing estimates after this first look at the new OPEC agreement. Our 2018 and midcycle forecasts for WTI are still $45/bbl and $55/bbl, respectively.
• Energy sector valuations look fairly valued at current levels with an average price/fair value estimate of 0.96.

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 outlook 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 since markedly worsened. The reason is that the major increases in shale activity now have U.S. oil production firmly 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 likely to erase any market tightness and throw crude markets back into oversupply within the next six to 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 market share to U.S. producers--neither of which is likely to occur--oil markets have major problems looming on the horizon.

There remains a good chance that oil prices could rise further in the coming months if OPEC compliance remains high. Because surging shale production won't truly begin to 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 near at hand.

Top Picks

HollyFrontier

HFC

Star Rating: 5 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, 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 for the company's 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 in 2017, but a new administration increases the probability that reform will occur that ultimately reduces compliance costs. At a price/fair value estimate of 0.60, the current stock price offers an attractive entry point for long-term investors.

Cenovus Energy

CVE

Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: $17.00 (CAD 23)

Fair Value Uncertainty: Very High

5-Star Price: $8.50 (CAD 11.50)

Cenovus is our best pick among our Canadian integrated stocks and one of our best ideas. The stock is currently trading at a 60% discount to its fair value estimate, while on average the industry looks fairly valued. We believe the market is overlooking the immense growth potential in the company's oil sands reserves that can be brought on line with industry-leading, low-cost solvent-aided process technology in addition to the benefit from low-cost Palliser Block production. We also think the market is underestimating the application of SAP technology to the company's recent FCCL acquisition, which will provide Cenovus with ample opportunities to bring on low-cost bitumen production. Growth projects that once faced challenged economics are now positioned to add significant value to shareholders over the long term. Consequently, we believe the stock presents an attractive opportunity for long-term investors.

Antero Resources

AR

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $29.00

Fair Value Uncertainty: High

5-Star Price: $17.40

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 30% discount to our fair value estimate. Though natural gas still constitutes around 75% of the firm's production, a substantial portion of its acreage is situated in areas with fairly high liquids content, differentiating the company from its peers, which 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). Despite perennially weak natural gas prices in the Appalachia region, Antero's extensive firm transport and sales portfolio are enabling the company to sell the majority of its production at premium (out-of-basin) prices.

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